Debating whether to fund your 401K with Roth or Traditional contributions?

A Roth 401K option was introduced by Congress in 2006 and recently extended past 2010. The decision depends on your age, annual contribution amount, investment time horizon, your current tax rate, and your expected tax rate at retirement. Although every individual has specific needs and circumstances the graph below should help simplify your decision.

  21-30 31-40 41-50 51-55 56-60 61+
15% Roth Roth Roth Roth Roth Traditional
25% Roth Roth Roth Roth Traditional Traditional
28% Roth Roth Roth Traditional Traditional Traditional
30% Roth Roth Traditional Traditional Traditional Traditional
33% Roth Traditional Traditional Traditional Traditional Traditional
35% Traditional Traditional Traditional Traditional Traditional Traditional

Traditional 401K contributions use pre-tax monies. In other words, the tax savings are enjoyed each paycheck. Roth contributions use after-tax money. Contributing to a Roth effectively reduces your take-home amount each paycheck by foregoing tax advantages until retirement.

Let’s consider the following circumstances:

  • Using the “Rule of 72” your investments will double every 9 years while enjoying an 8% rate of return on your investments. A hypothetical $10,000 today could end up being $40,000 in 18 years. Would you rather pay taxes on $10K now or $40K later? If you have several years till retirement, a Roth might be the obvious choice.
  • An argument for Traditional IRA suggests the Taxpayer will be in a lower tax bracket during retirement. Although a low 15% tax bracket exists now, one must ask themselves: Will these low tax brackets exist when I retire?
  • The longer you remain invested in a Roth, the more likely you’ll benefit from tax-free growth. If your retirement is on the horizon, less than 5 years, you may benefit more from the immediate tax advantages of a Traditional 401K.
  • A combination contribution is available. One may elect 50% Roth and 50% Traditional or any combination thereof. Those on a tighter budget might elect to contribute only a portion of their paycheck to a Roth. Taxpayers who need to reduce AGI to qualify for income limiting tax deductions like the Student Loan deduction, Education Credits or the First-Time Homebuyers Credit may elect a higher portion to the Traditional 401K.
  • The Roth 401K election is virtually synonymous with a Roth IRA with the exception of Required Minimum Distributions must occur at age 70 ½. This can be overturned by rolling over to a Roth IRA in retirement.

Still unsure what to do? Please don’t hesitate to call or write with any questions: David@AirmanTax.com