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My wife's employer has two retirement plan choices; 401k & Roth 401k. Which is better & more tax efficient? Thanks!!

Dec 17, 2013 by Brian from Omaha, NE in  |  Flag
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7 votes
Peter C. Karp Level 20


Both retirement plans have their pros and cons, which leaves consumers to answer just one question: Should they convert their 401(k) to a Roth or stick it out with a traditional 401(k)?

Taxes …….Here's the main "perk" that a Roth has going for it: Workers pay today's tax rate on their contributions and are later able to withdraw them tax-free in retirement. This can work in many younger workers' favor, given the fact that income levels tend to grow with age, meaning a higher tax bracket. A traditional 401(k)works just the opposite. Workers contribute funds and aren't taxed until they start making withdrawals in retirement –– at whatever tax bracket they fall under then. If you've got a couple of decades to save for retirement ahead of you, the Roth may be the best option. Since you'll likely be in a higher tax bracket later in life, it makes sense to choose a Roth now, pay lower taxes on your money at your current rate and then enjoy it tax-free later in life.

Withdrawal penalties …….There are no penalties on withdrawals from Roths so long as workers don't tap into their investment gains, according to the IRS. And tax-free withdrawals for people over age 59 1/2 begin after they've had their account for at least five years. On the other hand, early withdrawals from a traditional 401(k) will cost you big. The IRS taxes 10% for dipping into your savings. There are a few exceptional circumstances, including if you are disabled or faced with significant medical expenses. Again, the winner here is the Roth. You'll escape hefty fees on early withdrawals and won't have to worry about them at all once you've entered retirement.

Contribution limits…….Here's where the difference end. Annual contributions for both Roth 401(k) and traditional 401(k)s are limited to $17,500 or $23,000 if you are over 50 years old.

If you meet the income requirements and think you'll enter retirement earning more than you do today, then a Roth 401(k) is clearly the winner. Not only will you save huge on taxes but you'll have peace of mind when you make tax-free withdrawals in your golden years. On the other hand, if you expect to be in a lower tax bracket when you retire than you are today you probably should stick with a traditional 401(k). Keep in mind you can contribute to both the traditional 401(k) and to a Roth 401(k) as long as you do not exceed the contribution limits when both are combined.

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Comment   |  Flag   |  Jan 08, 2014 from San Francisco, CA

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6 votes
Joe Day, CFA Level 13

The Roth 401(k) will not reduce your household's taxable income for the year, however, it will allow her to have these assets grow tax-free, until she is ready to withdraw the assets for retirement. The regular 401(k) gives you the benefit of an upfront tax-deduction, by lowering your taxable income through the automatic 401(k) contributions that are made out of her paycheck.

The longer your wife has until she needs these funds, the better the Roth 401(k) will be for you. It allows the assets to grow on a compounded basis, tax-free, as long as the money stays in a Roth 401(k) or is rolled into a Roth IRA. In addition, there are no required minimum distributions from a Roth IRA, when she eventually does roll it over.

A regular 401(k) allows your assets to grow "tax-deferred". This means that you will pay no taxes while in the 401(k) or while in a rollover IRA (if the assets are eventually rolled over). But, when you do pull the funds out you will be required to pay income tax at your current income tax rate, on all of the proceeds. In addition, you'll be required to take minimum distributions out of the account once you reach the age of 70 and 1/2.

In the long-run the Roth 401(k) can allow your money to grow with less tax-drag then a regular 401(k).

2 Comments   |  Flag   |  Dec 17, 2013 from Seattle, WA

I have been led to believe that with a 401(k) u will be taxed twice 1) when you pull out the money 2) income tax. Am i mistaken?

Flag |  Dec 23, 2013 near Omaha, NE
Kyle S. Clemson, CFP ®

When you take a distribution from a 401(k) or an IRA it is taxed once, at your marginal income tax rate.

Flag |  Dec 23, 2013 near Bloomington, IL

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6 votes

Hi Brian, Both Joe and Pam have provided great answers so far. The only one thing I can think to add is the five-year waiting rule. In order to receive a distribution from a Roth account tax free and penalty free (qualified withdrawal) you must have an attained age of 59 1/2 and have met the five-year waiting period. The five-year period begins the first day of the calendar year in which you make a contribution. For example, if you were to make a Roth contribution in May of 2009, as of January 1, 2014 you have met the five-year waiting period. A point to keep in mind in reference to the Roth 401(k). Say you never established a Roth IRA account. You do have your Roth 401(k) and it has met the five-year rule. You leave your employer and decide to roll the Roth 401(k) into a newly created Roth IRA account. This account will have a new five-year waiting period. To avoid this, you should already have an established Roth IRA and rollover the money to this account. Hope this helps as well. Good luck!

2 Comments   |  Flag   |  Dec 17, 2013 from Bloomington, IL

Currently, i have a 401(k) and a Roth IRA. She has and IRA and trying to make the decision of either of the two. Thanks for the help!

Flag |  Dec 23, 2013 near Omaha, NE
Kyle S. Clemson, CFP ®

Things to consider: Current tax rate, future tax rate in retirement, income needs, what guaranteed income sources you may have, and the values of the various account balances.

Flag |  Dec 23, 2013 near Bloomington, IL

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2 votes

HI Brian! I tend to favor the Roth 401(k), particularly if you have a long time until retirement. Joe hit all the highlights during the time you are working and saving. I have seen some some people who have retired with substantial IRA assets and when they reach the age for required minimum distributions, their income level moves them into a new tax bracket where their social security payments become taxed. This does not happen when withdrawing from a Roth account, so that is another benefit.

2 Comments   |  Flag   |  Dec 17, 2013 from River Hills, SC

Correct me if I'm wrong but wouldn't it better to compare it to when someone will need the Roth 401(k) funds not when they will retire? I believe that most people will be better off using the Roth funds last, after they have used up all of their IRA funds. It might be many years before these funds are need. Or am I being too anal in my thinking?

Flag |  Dec 21, 2013 near Livermore, CA
Pam Horack, CFP®

Hi Randy! I was referencing the amount of time a person has to save until they need retirement funds. If they only save in a traditional 401(k) or IRA, the funds are taxed as ordinary income when withdrawn. As such, they may fall into a situation where their Social Security is taxed once they reach 70 1/2 and have to take required minimum distributions (RMD). If a person were to only save in a Roth or Roth 401(k), the funds are not taxed on withdrawal and they would not run into the issue of SS taxation. I would guess that many people have both types of accounts and it is worth the effort the determine the most tax efficient withdrawal method depending on each individual situation.

Flag |  Dec 21, 2013 near River Hills, SC

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2 votes

Hi Brian,

All good information from my colleagues here. But I think the best answer comes from reframing the question: "Which is better and more tax-efficient for YOU (and your wife)?"

• Your tax situation -- now and in retirement

Both 401(k) and Roth 401(k) can be good and tax-efficient options. The decision--and it doesn't have to be just one or the other, it can be both--depends largely on your own tax situation now and in future retirement.

For example, if you and your wife file a joint return and are in one of the higher federal income tax brackets, the deductibility of a regular 401(k) contribution may be worth more to you now, especially if you anticipate being in a lower tax bracket in retirement.

On the other hand, if you're in one of the lower tax brackets now and you anticipate being in a higher bracket in retirement (either because tax rates will go up or you'll have more taxable resources), then forgoing a tax deduction now and contributing to the Roth 401(k) may be the smarter approach.

Pam made a great observation about tax-managing your future retirement income, particularly with respect to taxation of social security. I'll add that some taxpayers have found that contributing to a regular 401(k) and getting the tax deduction in a state with a high income tax, and then moving to a state with a low/no income tax in retirement, has also helped them tax-manage their resources. Nobody knows the future, of course, but be sure to also consider state income tax implications in the decision.

• Check details on employer match

Many employers will match employee retirement plan contributions up to a specified percentage of compensation. The match tends to be made on a tax-deferred basis (tax will be paid in the future) rather than tax-free basis (like a Roth 401(k) contribution).

If that's the case with your wife's retirement plan, then she could make her contributions to the tax-free Roth 401(k) while the employer is matching them with tax-deferred contributions. She would automatically end up with both types, which should also give you options to tax-manage your income in retirement.

Comment   |  Flag   |  Dec 17, 2013 from Clackamas, OR

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