Should you make your contributions into a Roth 401k (post tax money) or make contributions to a non-Roth 401k (pre tax money).
Q: My husband and I are trying to determine whether he should continue to make retirement contributions into a Roth 401K or whether he should resume contribution to a regular, tax deferred 401K.
His company began offering the Roth option a couple of years ago, when we were at an economic low point as a household, and it seemed that the Roth 401K made sense for us at the time. However, since then our income has rebounded and he will be promoted with an accompanying salary increase plus quarterly performance bonuses. This will put us out of the range of being able to contribute to a Roth IRA, and made us think that the Roth 401K is no longer a good choice for us.
Can you give us some suggestions of how to run the math to help us make that choice?
A: Rather than deal with a mathematical answer to your question, we feel that we should deal with a different underlying issue in your question.
It’s great for you to think about investing for your retirement. For many Americans doing that, they can choose to put money into a retirement plan with pre-tax dollars or after-tax dollars. Pre-tax dollars are those funds that you have that you can take out of your paycheck before the federal government taxes those funds. After-tax dollars have already gone into your pocket and have been taxed. Pre-taxed dollars are generally taken out from your paycheck before you get paid.
It’s important to make that distinction in what funds you use to fund your retirement. Some retirement specialists recommend only using after-tax dollars for some of their clients while others will always recommend pre-tax dollars.
Let’s talk about the differences. If you use pre-tax dollars, depending on how much money you would have paid on that money, you immediately see a benefit on day one. Whatever you save in federal income taxes today is a gain for you and can get invested for the future. But all that money will be taxes to you in the back end when you take the money out of the account in retirement.
Your question is part of a broader question that goes to your estate plan and what you should do when it comes to estate planning. You may want to sit down with an estate planner to discuss some of your options and to see if you are making the wise choice with your retirement contributions along with any other assets you may have.
If you use after-tax dollars now, you might have less money to put into the account for retirement, but all of the money you put into the account will grow tax-free and you’ll pay no federal income taxes when you make withdrawals.
When you were making little money, your federal income tax rate might have been quite low. So if you used pre-tax money to put into your retirement plan you didn’t get as big a bang for your buck when investing. That is to say if you are in the top federal income tax bracket and you put one thousand dollars of pre-tax money into a retirement plan, you might avoid paying the federal government around $350. But if you do the same when you are at a much lower tax bracket, you might only save around $100. We know these numbers are rather simplistic and there are other considerations, but it gives you a sampling of how putting in pre-tax dollars allows you to put in more money now. But all that money will be taxed when you withdraw it. And if you are at higher tax brackets then, you might lose out.
If you put in after tax dollars now, all that money will grow and you can take it out from the retirement account – but you must follow the account rules to take the money out – and you won’t pay any federal income tax on that money.
[ad#in_content_1500]We’ve seen mathematical models that show that using post-taxed money is better in many circumstances, but some of those models base their assumptions certain tax rates that may or may not apply to a person like you.
You can get some advice on this subject by going to some of the web sites for the large mutual fund companies. They have information there that can assist you in seeing what might be best for you. You can also go to their local offices and talk to their representatives. Most of these companies will be happy to talk to you for free and go over a retirement investment plan for you without an obligation and without having to deposit money into an account with them.
After you have reviewed this information, you can then decide where you think your financial future will be. Will your income continue to grow? Will you be in a higher income tax bracket this year and in the years to come? And you need to think about when you would start to take money out of your retirement plan and whether you will be working at that time. If you are working and earning a considerable income, all of your retirement withdrawals might be taxed at a quite high level.