If you have a job, you probably have a 401(k)—or another workplace savings plan like a 403(b) or governmental 457(b) plan. Having money automatically taken out of your paycheck and put into your plan should be a no-brainer, especially if your employer matches contributions—which many do.
Your employer may also give you a choice of the type of 401(k) to save in: a traditional or a Roth. Plus, some employers allow participants to do what’s called an in-plan conversion, converting their traditional 401(k) savings to a Roth 401(k).
What to do?
Before we dive in, rather than repeating all six types of accounts—traditional and Roth 401(k)s, 403(b)s, and governmental 457(b) plans—throughout, we’ll just use 401(k) to keep things simple.
First, the basics
With a traditional 401(k), your contributions are pretax, meaning you get to subtract them from your taxable income and lower your taxes in the year you make the contribution. You don’t avoid taxes entirely, though; you’ll pay income taxes on your contributions and any investment earnings, when you withdraw the money. Typically, you will make withdrawals when you’re retired; the tax on your withdrawals is determined by your marginal tax rate (in the year you make a withdrawal).
With a Roth 401(k), you pay income taxes on your contributions up front. Your contributions do not reduce your taxable income. But—and this is a big but—the money in your Roth grows tax free, so you won’t have to pay any tax on your withdrawals, including any investment earnings, when you retire, if certain qualifications are met. 1
Below are the four key questions that most people ask when determining whether a traditional or Roth 401(k), or both, might be right for them.
1. Should I contribute to a traditional or a Roth 401(k)—or both?
The answer comes down to taxes. Do you think you’ll be better off paying taxes on the money now or later? In general, the longer you have until you retire and if you expect your tax rate in retirement to be higher than your current rate, the more likely you are to benefit from a Roth 401(k) account vs. a traditional 401(k).
Hypothetical example: Let’s look at two 45-year-olds, Tom and Elaine, both of whom contribute $5,000 to their 401(k) plan in the same year—Tom to a traditional 401(k) and Elaine to a Roth 401(k). They won’t need the money until they’re 75. With tax rates and investment returns being equal, Tom’s initial contribution will have grown to $27,404, after paying taxes at the time of withdrawal, while Elaine will have $38,061. Choosing the Roth 401(k) gave Elaine $10,657 more than Tom.2
Let’s look at the numbers another way. Tom takes the $1,400 he saved in taxes from his $5,000 pretax contributions, and invests that money in a taxable brokerage account. That could boost his total at age 75 to $35,445. But it’s still $2,616 less than Elaine’s 401(k) Roth savings.3
Keep in mind: This example assumes that Tom and Elaine’s marginal tax rates didn't change when they retired. If you think that your marginal tax rate will be lower when you retire than it is now, then a Roth 401(k) loses some of its appeal.
On the other hand, if you think your marginal tax rate will be higher, the Roth 401(k) could be even more attractive. Keep in mind that your marginal tax rate is not just a function of your taxable income—it could change if you move to a different state after retirement, for example, and the federal government might raise or lower the rate applied to you even if your income stays the same.
It may be appropriate to contribute to both a traditional and a Roth 401(k) if you can, giving you taxable and tax-free withdrawal options. Financial planners call this tax diversification, and it's generally a smart strategy. For example, with a combination of Roth and traditional 401(k) savings, you could take distributions from your traditional 401(k) until you reach the top of your tax bracket, and then withdraw whatever you need beyond that amount from a Roth 401(k), which is tax free, provided certain conditions are met. This is just one example of the flexibility that tax diversification provides. Reducing your taxable income may also be advantageous for other reasons, such as the taxation of Social Security benefits and financial aid qualification.
2. Should I convert money in my traditional 401(k) to a Roth 401(k)?
If you're likely to end up with more savings and flexibility with a Roth compared with a traditional 401(k), and your plan allows it (not all do), then converting some or all of your money could be a prudent move. But here’s the rub: You will have to pay taxes on any pretax contributions and earnings that you convert.
Hypothetical example: Michael has $6,000 of vested pretax assets and earnings in a traditional 401(k). He’s considering converting these "in plan" into a Roth 401(k). He and his spouse file their taxes jointly, and their combined taxable income is $125,000, putting them in the 25% tax bracket for 2013. If Michael converts all the money in his current 401(k) to a Roth 401(k), his tax bill will be $1,500. If that’s more cash than Michael has on hand, he could convert a smaller amount over several years. Or he could forgo a conversion and simply begin directing all, or a portion, of his new contributions to a Roth 401(k), which would still provide him with additional flexibility in retirement.
Keep in mind: It is typically not advisable to convert to a Roth 401(k) if you have to use money from your traditional 401(k) to pay the tax. If you're under age 59½, this is particularly true because you would likely be penalized 10% on the amount you withdrew to pay the tax, which could easily offset the potential benefit of the conversion. Moreover, those savings would be removed from your account and would not have an opportunity to grow over time.
3. If I decide to convert to a Roth 401(k), what should I convert—pretax or after-tax money?
If you have after-tax money in a 401(k), converting that money to a Roth 401(k) first can be a smart move, if your employer permits it. You’ll have the same tax diversification when you retire, and all future earnings on the converted amount can be tax free, whereas they would be taxable if unconverted. Plus, the tax you pay to convert the assets may be minimal, because you would be paying taxes only on any earnings on the after-tax money you convert. Of course, if the earnings on the after-tax contribution are large relative to the original contributions, the cost of conversion may be higher.
Hypothetical example: Joan has accumulated $120,000 in her traditional 401(k) account. Of that, $90,000 is pretax and $30,000 is after tax. She would like to convert as much of her assets as she can to a Roth 401(k), but she has only about $11,000 to pay the tax bill. With annual income that puts her in the 25% tax bracket, Joan decides to convert $40,000 of her pretax assets, which will cost her $10,000 in taxes. She also plans to convert the full $30,000 in the after-tax account, which consists of $27,000 in contributions and $3,000 in earnings. The tax on that amount will be just $750, because it applies only to the earnings. This brings her total Roth conversion to $70,000—$43,000 of which is taxable—and her total tax to $10,750.
Keep in mind: Converting traditional after-tax money to a Roth 401(k) will likely result in a much lower current tax liability than converting pretax money. When converting a significant amount of pretax assets to a Roth, beware of leaping into a higher marginal tax bracket. For example, if Joan were already on the edge of the 28% tax bracket, she might want to reconsider converting $40,000 in pretax assets and moving into a higher tax bracket.
Here’s another strategy to consider if your plan offers after-tax contributions to a traditional 401(k). If you would like to contribute more of your annual income to a Roth 401(k) plan than the tax code allows ($17,500 in 2013, minus any pretax contributions), you could also contribute to a traditional after-tax 401(k) until you reach $51,000, the maximum you can contribute in total in 2013 to workplace accounts. Then you could convert the after-tax money in your plan to a Roth 401(k) with little or no additional tax liability.
4. If I have the choice of converting to a Roth 401(k) or rolling over into a Roth IRA, which is the best option?
This is a question primarily for those who have reached age 59½ or have changed jobs. If that’s your situation, consider this: You have until October 15 of the year following a Roth IRA rollover to change your mind and recharacterize it back to a traditional IRA. You can’t do that with a conversion into a Roth 401(k). Also, Roth 401(k)s are subject to minimum distribution requirements, beginning at age 70½, while Roth IRAs are not. Plus, a Roth IRA may provide additional flexibility to choose your investments, which may or may not be important to you.
Hypothetical example: Andrew is 60 and has $200,000 in a traditional 401(k). He would like to covert $150,000 of that to a Roth because of the added flexibility it will give him in leaving the money to his heirs. Andrew has some stocks in a brokerage account that he can sell to cover the $42,000 tax bill (he’s in the 28% tax bracket, and he doesn't have to worry about capital gains tax on the sale of the stocks because he has tax loss carry-forwards to offset them). He wants to invest his Roth money in individual stocks through a brokerage account, which his 401(k) plan doesn't offer. So Andrew chooses to move his money into a rollover Roth IRA.
Keep in mind: A Roth conversion might not be a good idea if you intend to leave your assets to a qualified charity that is already exempt from paying estate and income taxes on estate-gifted IRAs. You would essentially have paid the conversion tax for no reason. Also, if you’re planning to leave your 401(k) assets to your heirs, a Roth IRA conversion may not be as attractive if they are in a much lower tax bracket than you are. That's because they might pay considerably less tax on 401(k) withdrawals compared with the tax paid to convert the account to a Roth IRA.
Make an informed decision
401(k) plans can vary considerably, so before you get too far with making any changes, be sure you understand your plan's rules. As with any tax-related decision, it is important to discuss your situation with a tax and financial adviser to help you fully assess what is best for you.