How to Choose the Right 401(k)

Roth or traditional? A bit of both saves taxes now and later.

By Mary Beth Franklin, Senior Editor

From Kiplinger's Personal Finance magazine, April 2008

Michael Bell is a young lawyer on the fast track. He has maxed out annual contributions to his 401(k) over the past four years. Now he faces a choice: Should he continue to contribute to his traditional 401(k) -- which saves him more than $5,000 a year in state and federal taxes -- or should he switch to a Roth 401(k), which offers no upfront tax breaks but promises tax-free income in retirement?

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Bell, who works for a law firm in Washington, D.C., wants to make sure his retirement account is as large as possible and hesitates to give up the current tax break. "But there's a good possibility that tax rates will increase in the future," he says. "Maybe the Roth 401(k) is a more appropriate approach."

Tax hedge. James Lange, a CPA and attorney in Pittsburgh, agrees that Bell, 34, is a good candidate for a Roth 401(k). "If he is going to be in the same tax bracket or higher when he retires, which is quite likely, the Roth 401(k) is the best way to go," says Lange, author of Retire Secure (Wiley, $24.95; www.paytaxeslater.com). Even if tax rates are slightly lower when Bell retires in 30 years, the Roth 401(k) would still be a better choice because of the potential for three decades of tax-free earnings, says Lange. In a traditional 401(k), your earnings also grow unfettered by taxes, but all of your withdrawals (including your earnings) are taxed at your ordinary income-tax rate.

Just as investors should diversify their retirement assets across a broad class of stocks and bonds, they should also diversify their future tax liability by holding both traditional and Roth retirement accounts, says Stephen Utkus, director of Vanguard's Center for Retirement Research. A Roth 401(k) "is an excellent hedge against possible tax hikes," says Utkus.

Thanks to his early and aggressive start on saving, Bell already has more than $80,000 in his traditional 401(k). Assuming that money earns an average of 8% per year, the account would be worth more than $800,000 in 30 years, even if he never adds another dime. Diverting some or all of his future contributions to a Roth 401(k) would help him diversify his tax liability.

Bounty of benefits. Because Roth 401(k) contributions are not tax-deductible, choosing a Roth would reduce Bell's take-home pay by about $5,000 a year. But if he can absorb the tax hit now, he'll be able to spend more after-tax income in retirement.

The Roth 401(k) is an even better deal than the more familiar Roth IRA because you can contribute more each year and there are no income-eligibility limits. This year you can contribute up to $5,000 to a Roth IRA ($6,000 if you are 50 or older) as long as your income doesn't exceed $169,000 if you are married filing jointly ($116,000 for single filers). But if your employer offers a Roth 401(k), you can contribute up to $15,500 ($20,500 for workers 50 and older), regardless of income.

Roth accounts are superior to traditional retirement plans in a couple of other ways as well. Although a Roth 401(k) requires annual distributions once you reach age 70, you can easily roll over the account to a Roth IRA, which has no distribution requirements. And you can leave a Roth account to your heirs tax-free.

Despite their advantages, Roth accounts are not right for everyone. Middle-aged workers who get a late start on retirement savings are unlikely to be in a higher tax bracket in retirement. As a result, they may be better off sticking with a traditional 401(k) and claiming a bigger tax break now, says Lange.

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