Roth vs. Traditional

Last week a client asked me if he should invest in his company’s Roth 401(k) or Traditional 401(k).  What I did do was provide him a quick answer: Roth 401(k).  What I didn’t do was bore him with all of the details and mental math that went into making that decision. 

Some clients prefer a simple solution while others want to see what’s under the hood.  Which one are you? 

For those of you who need to know what’s under the hood, here are some of the reasons why I recommended the Roth 401(k). 

First, this client is starting his first job out of college which means he is in a relatively low tax bracket.  According to Rob Berger in his articleon forbes.com, this client would top out in the 22% tax bracket this year. 

Second, any employer contributions will go into the Traditional 401(k).  Therefore, if the client contributes 5% and the company matches 5%, the client will effectively be building both types of accounts.  This will provide him with some great diversity as each type of account has its pros and cons.  I typically suggest that clients fill 3 buckets for retirement: Taxable, Tax-Deferred, and Tax-Free. 

The pros of the Roth account are that contributions grow tax-deferred and distributions in retirement are tax-free.  This can be a great benefit if income tax rates rise in the future.  Also, there is no requirement to start taking Required Minimum Distributions after turning 70 ½ years old.

The downside is that employee contributions are after-tax.

The pros of the Traditional 401(k) is that they are pre-tax which can reduce your AGI and potentially lower your taxes in the year of the contribution.  The downside is that you must start taking distributions after turning age 70 ½.  Also, according to Arielle O’Shea of nerdwallet.com, distributions in retirement are taxed as ordinary income.  This could be an issue if income tax rates are higher when you retire. 

Another factor to consider is that Roth IRA’s have AGI contribution limits.  For a person filing single in 2018 the income limit is $135,000.  Once they exceed that limit, they can no longer contribute to a Roth IRA.  Therefore, it might be beneficial to fill that “tax-free” bucket while you can and contribute to the Roth 401(k) at your place of employment. 

Of course, each situation is unique.  Therefore, you should always consult with a professional Financial Advisor to see which plan is right for you.  Feel free to schedule a free consultation by visiting our website at www.prudentfinancialplan.com and we can run the calculations for you.