$tarrBuck Report for August 13, 2006: 401(k) — Traditional or Roth?

August 13, 2006

$tarrBuck Report for August 13, 2006: 401(k) — Traditional or Roth?

by R. M. Starr

“Paper or plastic?” “Decaf or regular?” “Original or extra crispy?” “Traditional 401(k) or Roth?”

Paper, regular, extra crispy. I’ll have to get back to you on the 401(k).

Beginning this year many employers offer their workers a choice of 401(k) defined contribution retirement plans: Traditional or Roth. The big difference is that in the traditional plans all of the taxes are deferred and the income is taxable when withdrawn, but with Roth plans the contributions are made with after-tax income and no tax is due on a qualified withdrawal. The contribution limits are the same with both plans.

The first point to remember is that 401(k)’s are excellent investment vehicles. That’s true for their cousins 403(b) and 457(b) too. Tax-deferral means that money contributed grows faster than in taxable investments because taxes don’t slow down their growth. They only get taxed once: at the end of their growth in traditional plans, at the start in Roth. If tax rates are the same at the start and the end then the payoffs are the same.

What’s your tax bracket?
When you pay income taxes, your tax bracket is the additional tax you pay on each additional dollar of taxable income, also known as your marginal tax rate. Your Federal income tax bracket at low income (with two children) could be as low as negative 40% (including the earned income tax credit); the Internal Revenue Service pays you! For higher income earners who don’t qualify for the EITC, Federal tax rates start at zero and go as high as 35% (you pay them). State income taxes add on. Generally, as your income goes up, so does your tax rate.

When is traditional right for you?
If you’re in a high tax bracket now, and expect to be in a lower tax bracket on retirement (or whenever you take a withdrawal from your account) traditional is right for you. Don’t pay those high taxes now. Wait for a lower tax rate later. However, if you’ve planned and funded your retirement well, you’ll have roughly the same income in retirement as while you’re working. Then the tax rates will be the same. Postponing the tax bite on your initial contribution won’t do you much good.

When is Roth right for you?
If you’re in a low tax bracket now, and expect to be in a higher tax bracket on retirement or withdrawal, then the Roth really makes sense. Of course you have to be able to afford to defer the income. A low-income (and low tax-bracket) student or part-time worker who can rely on support from family should find the Roth plan a really great deal.

What about contribution limits?
Contribution limits are $15,000 in a calendar year, $20,000 at age 50 and over. The limits are the same for Roth and traditional. But Roth contributions come from after-tax income. If you’re up against the contribution limits in your traditional plan and want to contribute more, switch to Roth. You’ll be squeezing more after-tax dollars into your plan.

What about early withdrawal?
401(k) plans are for patient money. If there’s a chance you’re going to need the money soon, don’t put it into a retirement plan. There are limits and penalties for early withdrawal. But if an early withdrawal is needed, the withdrawal is taxable income. In a traditional plan none of the money has been taxed before; all of the withdrawal is taxable. In a Roth plan, some of the money has already been taxed — it doesn’t get taxed again. The proportion that hasn’t been taxed before gets taxed on withdrawal. An early withdrawal is likely to occur during a financial emergency — a time when your tax rate is low anyway. If that happens, you’ll be happier with traditional — you don’t want to regret the taxes you paid when you contributed.

Bottom line
Tax deferral is good investment planning. Go for it! Go for traditional if your tax rate is high now and likely to get lower on withdrawal. Go for Roth if your rate is low now and likely to get higher. Go for Roth if you’re up against contribution limits and want to squeeze more after-tax income into your plan.

(c) Copyright R. M. Starr 2006

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One Response to “$tarrBuck Report for August 13, 2006: 401(k) — Traditional or Roth?”

  1. Grand Canyon University Says:

    Grand Canyon University

    Grand Canyon University

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