When it comes to choosing the best place to stash your retirement savings, the answer, at least in part, depends on your likely tax situation once you stop working.
The "Roth" contributions are already taxed, as they are after-tax contributions, as so withdrawals, including any earnings, are tax-free. "Traditional" contributions, meanwhile, are tax-deferred, since they are before-tax contributions, and, as such, withdrawals to these contributions are taxable. The "Roth" helps you hedge against the tax hit you'll face when you start pulling money out of any tax-deferred plan, such as a traditional 401(k).
Is a Roth right for you? The answer essentially comes down to one question: Will your taxes be higher or lower in retirement than they are at the time of contribution?
Your future tax rate, of course, can be a big unknown. Income tax rates are relatively low now: the current top rate is 35%, compared with 50% in 1986 and 91% in 1950, according to the Tax Policy Center. Many people assume lawmakers will increase rates in coming years, in part to help reduce the budget deficit, but then, some lawmakers now are seeking to reduce tax rates. Other variables to consider when making the decision are: the length of time you intend to invest (a longer time horizon allows for Roth tax-free accumulation) and the necessity for current tax deductions from your income.
My recommendation would be to consider splitting your annual contributions 50%-50%: this gives you an immediate reduction from current taxes (by half), as well as tax-free distribution (to half of your income).
Remember: the combined contribution limits for both the Roth and the Traditional are $16,500 and $22,000, respectively, (and not $16,500 or $22,000 each).
Other information concering Roth contributions is as follows:
- Employers can match Roth 401(k) contributions, but an employer's dollars must go into a pre-tax account, and not into the Roth, according to the Internal Revenue Service.
- Under a new rule set last year, workers can convert their traditional 401(k) to a Roth 401(k) if their employer plan allows this. (You'll owe income tax on the conversion.)
Brown & Brown of Detroit