Choosing the Right 401(k)
Many companies offer employees a choice between two 401(k) plans. The version with which you’re probably most familiar is now considered a “traditional” 401(k). As before, you can choose to defer some salary and defer the income tax as well. You’ll also defer the tax on any investment earnings. However, when you withdraw tax-deferred earnings and tax-deferred investment income, you’ll owe income tax. You’ll probably owe a 10% penalty on withdrawals before age 59½, too.
Another option you may have is a Roth 401(k). With this account, you’re not deferring income tax, so you’re contributing after-tax dollars. Again, you won’t owe tax on any investment income inside the plan. After you’ve had a Roth 401(k) for five years and after age 59½, all withdrawals are tax-free.
Aside from those key differences, the two 401(k) options are similar. You can contribute up to $16,500 of income this year. If you are 50 or older in 2011, you can contribute an extra $5,500, for a maximum total contribution of $22,000. With either the $16,500 or the $22,000 cap, you can divide your contribution between the two plans in any way you choose, or you can put all the money into one type of 401(k).
Making the choice
Generally, you are better off contributing to a Roth 401(k) when you are in a low tax bracket.
Example 1: Jacob Benson is in the 15% tax bracket. If Jacob defers tax by contributing to a traditional 401(k) this year, he will get little benefit from the tax deferral because he will defer few tax dollars. Jacob eventually may pay tax at a higher rate when he takes money out. Therefore, Jacob chooses the Roth 401(k), where he will pay relatively little tax on the money he contributes while arranging for possibly tax-free withdrawals in the future.
With the same reasoning, workers in a high tax bracket may be better off in a traditional 401(k).
Example 2: Diane Evans is in the 35% tax bracket. Diane will get a substantial benefit from tax deferral this year so she chooses the traditional 401(k). Diane hopes to be in a lower tax bracket after she retires. If that is the case, Diane may be able to convert her traditional 401(k) funds to a Roth IRA and pay less tax than she would pay by contributing after-tax dollars to a Roth 401(k) now. Diane might choose to convert her traditional 401(k) to a Roth IRA after she retires because all withdrawals will be tax-free five years after the conversion, as long as Diane is at least age 59½. In addition, Roth IRA owners never have to take required minimum distributions.
Not so simple
At first glance, you might think this is a simple matter. You can look at your income tax return from last year and see the taxable income you reported, adjust for any increase or decrease in anticipated income from this year, and then go online to see the tax tables for 2011. If you’ll be in the 10% or the 15% bracket, you might lean towards the Roth 401(k); in the 33% or 35% bracket, a traditional 401(k) may be appealing. In between (25% or 28% brackets), you could straddle the fence, contributing some to a traditional 401(k) for immediate tax relief and some to a Roth 401(k) for possible tax-free cash flow in the future.
However, the calculation of your real tax rate for 401(k) purposes is far from simple. That’s because of all the income-based tax breaks in the Internal Revenue Code. Going from a traditional 401(k) to a Roth 401(k) will raise your income and may increase your vulnerability to losing tax benefits. You also might move into a higher tax bracket. Conversely, going from a Roth 401(k) or no 401(k) at all to a traditional 401(k) will lower your income and may provide other tax savings on your return.
Example 3: Previously, we had seen that Jacob Benson is in the 15% bracket. Assume that Jacob is married and reported $60,000 in taxable income on the joint tax return that he and his wife filed for 2010. That was because Jacob deferred $15,000 of his salary in 2010. If he puts that $15,000 into a Roth 401(k) for 2011, the Bensons’ taxable income will go from $60,000 last year to $75,000 this year. That will move them over the $69,000 cap for the 15% tax bracket and into the 25% bracket.
What’s more, increasing taxable income by switching from a traditional 401(k) to a Roth 401(k) generally will increase your adjusted gross income (AGI) and your modified adjusted gross income (MAGI) as well. With a higher AGI and MAGI, you may lose tax benefits, such as the student loan interest deduction, the child tax credit, the passive loss deduction for real estate losses, and so on. Losing tax benefits will drive up the immediate cost of switching from a traditional 401(k) to a Roth 401(k).
On the other hand, moving into a traditional 401(k) will lower your AGI and MAGI, providing additional tax benefits.
As you can imagine, determining the tax implications of choosing between a traditional 401(k) and a Roth 401(k) can be complicated. Our office can go over your tax return to help you determine the true tax cost so that you can make a well-informed decision.