I recently had the opportunity to switch from a traditional 401(k) to a Roth 401(k). A Roth 401(k) is appealing for the tax benefits. As with a Roth IRA, you don’t get a tax break on your contributions. But as long as you follow certain rules, your money grows tax-free and is 100% yours when you retire — though your employer’s contribution is always considered pre-tax; therefore, it’s always taxable when you withdraw it.
While the idea of tax-free income in retirement is certainly appealing, I decided to pass on a Roth 401(k). Here’s why I stuck with my traditional 401(k).
1. Present-day me can use a tax break
The general rule of thumb is that you invest in a Roth account when you expect to have a higher marginal tax rate in retirement than you currently have. I’m not convinced that I’ll be in a higher tax bracket at that point.
I work a full-time job, plus a couple of side hustles. Those long hours mean that my current income is relatively high. There’s a good chance my income will be significantly lower in retirement.
Regardless, I max out my Roth IRA, which means I’ll have a source of tax-free income once I reach age 59 1/2. But my traditional 401(k) contributions give my present-day self a welcome dose of tax relief. In fact, I used my pre-tax 401(k) contributions in 2021 to avoid crossing the Roth IRA income limits.
2. I can afford to invest more
One thing that’s often forgotten in the pre-tax versus post-tax calculation: Investing pre-tax dollars gives you more money to invest upfront.
Suppose you’ve budgeted $10,000 to invest for the year, and let’s say your marginal tax rate, i.e., the tax rate you pay on the last dollar of income you earn, is 22%. If you’re making post-tax contributions, you’re limited to $10,000. But theoretically, you could invest $12,820 if you made pre-tax contributions. Thanks to the tax break, only $10,000 would come out of your pocket.
The math can get complicated here. But it’s worth considering whether having more money to invest initially that compounds over time is worth giving up the tax break later on.
3. A Roth 401(k) isn’t as flexible as a Roth IRA
A Roth 401(k) has many of the same tax benefits as a Roth IRA. But it lacks some other features that make a Roth IRA so appealing for investors.
One big benefit of a Roth IRA is that you can access your contributions whenever you want without paying taxes or a penalty. I hope I don’t have to touch my retirement money until I’ve actually reached retirement age. But knowing I have the option to access my Roth IRA contributions if I need to in a worst-case scenario gives me some peace of mind.
But with a Roth 401(k), early withdrawal penalties apply to part of your withdrawal, even if the amount you take out is less than you’ve contributed. Of course, if I withdrew money from my traditional 401(k), I’d pay taxes and penalties on the entire withdrawal. But knowing I can’t easily access my post-tax contributions if I need to makes a Roth 401(k) less appealing to me.
Should you choose a Roth 401(k)?
Though I opted not to invest in a Roth 401(k) for now, I’m certainly not saying that this decision is best for everyone. My reasoning was based on my personal tax situation.
It’s often wise to invest in a mix of Roth and traditional accounts for tax diversification. You get some tax benefits now but also get some tax-free income in retirement.
Both traditional and Roth retirement accounts come with significant tax benefits. You can’t entirely predict your tax situation decades into the future. Regardless of whether you choose a tax break now, later on, or a combination, the most important thing is to start investing as early as possible.
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