ROTH 401(k) v. 401(k)

Since we are at the end of the year and considering various tax implications, I thought I would mention to our readers some of the reasons why I choose to starting funding a ROTH 401(k) instead of a traditional 401(k) when my employer offered a new retirement plan.

For those of your wondering about the differences between a traditional and a ROTH 401(k), let’s start there. In a nutshell, the biggest difference is that with a ROTH it means that you pay your taxes on your income before you invest it. This means that all of the earnings that you gain are later withdrawn tax free (since you’ve already been taxed on the initial earnings).

Advantages of a ROTH:

1) Paying taxes now might hurt a bit more, but this means that in my case, I’ll have about 30 years for that investment to grow without having to pay taxes on it again.

2) Most people fall into the category of making more money over time, and thus one is likely to pay higher taxes over time. While this part is a bit of a gamble in terms of what the tax environment will look like at the time of your retirement, generally it a pretty safe bet that taxes tend to maintain or increase over time.

3) As you make more money, you also phase out of being eligible for ROTH contributions. Given that James is still on a student salary, now is a good time for us to take advantage of making less money.

4) Overall both the ROTH and traditional investments have advantages, but the real lure is that they help to balance each other out and diversify the risk. It is like managing your stock portfolio to help ensure that it has a variety of different asset classes.

5) You likely may be less familiar with ROTH 401(k)s than you are with ROTH IRAs, as many employers don’t have plans that offer ROTH 401(k)s. I thought that since my employer does offer it, and we still earn under the threshold, that it would be good time to switch over.

6) The last reason is that I can still manage to max out and handle the additional cost of paying the tax on this up front. This will mean less of a deduction on our taxes, but since it was only for the second half of the year and our salary is still considerably lower than it will once James is out of school, now is a good time for us.

Each of you may be in a bit of a different tax or financial situation, but I hope that reading about my decision making process on why the ROTH 401(k) makes sense for us will be helpful.

Readers: I’d love to hear how many of you might have ROTH 401(k)s, or if you are eligible, why it may or may not work for you.

Cheers,

Miel