To Roth Or Not To Roth?

One of the questions that will come up in 401(k) plans, if your offers a Roth option is: Are you better off making Roth contributions to your 401(k) plan or the traditional pre-tax.  My answer is: tell me what the tax rates will be like when you retire, and I’ll give you the right answer to your question.  What’s that you say?  You don’t know what the tax rates will be?  Well, then, I can’t tell you which will be better for you.

While that exchange is somewhat facetious, it’s also true.  For those of you who aren’t clear on what Roth contributions are, they are after-tax contributions to 401(k) plans.  Traditional pre-tax contributions are not taxed when they go into a 401(k) plan.  The contributions and their earnings are taxed when they are withdrawn.  So, while pre-tax contributions let you avoid a tax bill today, you have a tax bill in the future.  Roth contributions are taxed on the way in, but not taxed when withdrawn.  In addition, provided certain conditions are met, the earnings are also not taxed when withdrawn.  So you pay the taxes today, but not when you retire.

Considering The Tax Rates

If you were to do some spread sheeting on which is better for you, and you assumed that your tax rate is the same today as it will be when you withdraw, then there is no advantage for pre-tax over Roth or Roth over pre-tax.  It works out that you have exactly the same number of dollars to spend either way.  The deciding factor then would be: when do you think tax rates on you would be higher?  Some people are convinced that taxes will have to be raised in future years.  If that turns out to be true, then you’re better off with Roth, because you’ll pay the taxes now, when rates are lower, and not when tax rates go up in the future.    However, I would point out that, under current tax law, someone over age 65 gets an additional exemption.  Also, if your overall income is less when you retire (which will be the case for most of us), your marginal tax rate will be lower than it is today.  Again, that’s looking at current tax law.

I can’t tell you what the right decision for you is.  You will find people adamantly in both camps, who will passionately explain why they are right in thinking the way they do.  If you look into their argument, though, you’ll see that there’s an assumption about tax rates that has to be made to answer the question.  My own personal decision has been to start making some Roth contributions, but most of my contributions are still pre-tax.  You might say I’m hedging my bets in some way, but I’m still betting more on my tax rates being higher today than when I retire.  Also, I’m taking the bird in the hand – a current assured tax reduction – instead of the birds in the bush – the possibility of higher rates.

So good luck with whatever your decision will be.  The main thing is to save something, and whether it’s Roth or pre-tax, you’ll be much better off in retirement than if you dither and do nothing.