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Dear Dr. Don,
My employer offers a 401(k) and a Roth 401(k) option. In light of the potential for much higher taxes in the future, would it be wise to focus 100 percent of my retirement savings in the Roth 401(k) alternative?
— Mike Myriad
Roth 401(k) plans made their debut in January 2006. They were scheduled to sunset in 2010 but instead were extended by the Pension Protection Act of 2006. Companies aren’t required to offer the Roth 401(k) option in their retirement plans. Since yours does, I’ll stop with the history lesson.
Contributing after-tax dollars to the Roth 401(k) has you front-loading your tax obligation versus back-loading with a conventional 401(k). By front-loading, you won’t have to pay income taxes on the qualified distributions when you withdraw them in retirement. You also pay at today’s rates versus an unknown rate in retirement.
Since you pay the tax upfront, it takes more pretax dollars to contribute up to the limit allowed by the tax code in a Roth 401(k) than in a traditional 401(k) plan. Even with that, it makes sense to front-load the tax obligation if you expect to be in a higher tax bracket when you take the money out. Tax prognosticators expect rates to rise in the future to cover the rising cost of government spending.
One downside is that employer matching funds don’t go into the Roth 401(k) but instead are held in a tax-deferred account. Your contributions grow tax-free but the employer’s do not. The split in how the contributions are handled, however, gives you an automatic diversification of tax-advantaged accounts.
I like the Roth 401(k) because of its higher contribution limits than a Roth IRA, and the tax diversification afforded by any employer matching contributions. But because I don’t know your full financial picture, I’m hesitant to recommend that you put 100 percent of your retirement savings contributions into the Roth 401(k) account.
Read more Dr. Don columns for additional personal finance advice.