Dear Dr. Don,
My company started offering the option of contributing to a Roth 401(k) this year. Would you recommend switching to the Roth 401(k) considering probable increases in tax rates over time?
— Guest Quest
What I like about the Roth 401(k) option is the tax diversification of your retirement investments. You’re contributing after-tax dollars into the account and will be able to take qualified distributions in retirement tax-free. One of the ways you achieve that tax diversification is that any company matching contributions are kept separate and are tax-deferred. You’ll owe income tax on the matching funds when you withdraw them as qualified distributions.
If you think tax rates are heading higher, and that certainly seems to be the way the fiscal wind is blowing, then you could be in a lower tax bracket today than the tax bracket you face in retirement. You can use Bankrate’s “What is your tax bracket?” calculator to determine your current bracket for 2010.
Another potential advantage is that you contribute more of your salary to retirement. The 401(k) and the Roth 401(k) have the same contribution limits, but since you’re contributing to the Roth 401(k) with after-tax dollars, you’re prepaying the tax on your retirement savings. If you’re in the 25 percent marginal federal income tax bracket, and contribute $15,000 to the Roth 401(k), it takes $20,000 in salary to contribute the $15,000. In contrast, a $15,000 contribution to a tax-deferred 401(k) plan reduces your take-home pay by $11,250, because your income taxes are reduced by $3,750. While you could invest the tax savings, not many people do, so the Roth 401(k) has you contributing more of your salary to retirement.
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