Choosing Between a Roth or Traditional 401(k)

How to decide if you should pre-pay or defer tax on your retirement savings.

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A Roth retirement account is a great way to save for retirement. Roth contributions are made with after-tax money, so you won’t get any tax benefit in the year you make the contribution. However, in retirement, you can withdraw from a Roth account without paying any additional tax.

Contributions to traditional 401(k)s and IRAs are tax deductible, and you will realize the benefit right away by paying less income tax in the year you make the contribution. However, income tax is due on each withdrawal.

Many employers now offer the choice of both a Roth 401(k) and traditional 401(k), and you have the option to pre-pay or defer taxes on IRA accounts as well. Investing in both types of accounts will give you more withdrawal options once you retire.

For 2012, the maximum contribution allowed for an IRA is $5,000 for those age 49 and below, and $6,000 for those 50 and older. You can also deposit up to $17,000 in a 401(k) if you are under 50 years old. Those who will turn 50 or older in 2012 can contribute an extra $5,500 to a 401(k), for a total of $22,500.

If your employer offers a 401(k) match, then it is essential to contribute enough to receive as much of the employer match as you can. The return an employer contribution provides on your investment is hard to beat.

Once you capture your employer’s 401(k) match, then you need to decide whether to stick with a traditional 401(k) or invest in a Roth account. Do you want to take the tax benefit now or after retirement? To decide which choice is best, compare your current tax rate to what you think your retirement tax rate will be.

Most people’s tax burden will drop once they retire because they will have much less earned income. If you are in one of the three lower tax brackets now (25 percent or less), it’s probably better to pay the tax now and contribute to a Roth account first. Most people earn more as they get older, and once you are in the 28 percent tax bracket or above, then it’s better to take the tax deduction from the traditional retirement account. As you near retirement age, you will have a much better idea of your post-retirement tax bracket, and then you can adjust your allocation to Roth accounts accordingly.

Another reason to contribute to Roth accounts is the required minimum distribution rules. Roth IRAs can give your more flexibility when it’s time to withdraw the money. When you reach 70½ years old, you must withdraw the required minimum amount from your traditional retirement accounts each year. Roth accounts are not subject to this rule, so they will give you more withdrawal flexibility. For example, if you have $1 million in a traditional 401(k) when you reach 70½ years old, you will need to withdraw about $36,500 the first year. However, if you have $500,000 in a traditional 401(k) and $500,000 in a Roth account, then you will need to withdraw $18,250 from the traditional account. You can keep the $500,000 in the Roth IRA or withdraw it as needed.

Roth accounts typically work best for people in lower tax brackets. Young people and those who will not retire for a long time generally have the most to gain by contributing to a Roth account. But even if you are in a higher tax bracket, it can make sense to allocate a portion of your retirement fund to a Roth IRA because of the withdrawal flexibility.

Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.