Question: Should I change my 401k deferral from the pre-tax contribution to the ROTH option?

401k eggsAnswer:

It depends.  The benefit of the pre-tax contribution is that it immediately reduces your income taxes when you make the contribution.  It reduces your tax withholding on every paycheck so some of your contribution is actually coming from money which would otherwise go to the state and federal government.  When you receive the benefits later in life at  retirement time, all of your distribution will be taxed as ordinary income based on your tax bracket when you receive the money.  Your contribution and the growth on your money is tax-deferred until you take it out.  Then it is all taxable.

The ROTH contribution is not currently tax deductible, it is an after tax contribution.  So, if you make a change, you will see your tax withholding on your paycheck go up, thus reducing your current take-home pay.  The reward for making ROTH contributions is that the money grows untaxed and when you receive the benefit at retirement it is all tax free.  You already paid the tax on the contribution when you invested, and the growth on your money will be free of tax, if you follow the ROTH rules.

Basically it is a pay me now or pay me later situation with your taxes.  The longer time you have until retirement, the greater the tax free benefit can be from ROTH contributions.  In general terms, the younger you are the bigger the benefit from making ROTH contributions because you have a lot of time for the money to grow.  Also, as a young person you may be in a lower tax bracket now than you will be in the future.  You want to pay taxes when you are in the lowest tax bracket.

To make a wise decision you have to weigh your current tax situation against the benefit of no taxes in retirement.  It is not a one-size-fits-all answer, and it is not only for the young.   There are benefits for older people as well, including benefits for their heirs.  Some people like to do a combination of pre-tax and after-tax contributions so you have some tax diversification opportunities in retirement.   If you believe your taxes will be higher in the future, you may benefit from paying tax on your contribution now in the form of a ROTH.  A professional advisor can help you consider what is best in your personal situation.

 

This report is a publication of Guelich Capital Management LLC, a registered investment advisor.  Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed.  All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.

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