To Roth or Not To Roth?
The new craze sweeping the land has been “Should I or Shouldn’t I contribute to a Roth 401K?” This is a great question with many valid options, but the quick answer is “It Depends”.
Should I Use Roth 401K?
As most companies roll out Roth 401K options I’ve been peppered with the question “Should I be contributing to my Roth 401K?”. At first glance, this makes total sense. Pay taxes now and receive tax-free money later. As you peel back the onion there are several things to consider when making the decision.
Changing your contributions from Pre-Tax 401k to Roth 401K will increase your taxable income. Your pre-tax contributions are reducing your taxable income now which for most means more money in your bank account now. Changing to Roth contributions would increase your taxable income possibly reducing your monthly income and potentially increasing your taxes due at the end of the year.
Consider this when you make pre-tax 401K contributions you receive an “above-the-line” deduction. Unlike, below-the-line deductions, “above-the-line” deductions reduce your taxable income dollar for dollar.
Choosing pre-tax contributions over Roth contributions works best if you expect your income to reduce in retirement. During your working years, you are earning the most and paying higher taxes on each dollar you earn. Fast forward to retirement, and now you are earning less, so you are taking money out of your pre-tax savings at a potentially lower tax rate. Currently, tax rules allow you to convert all or a portion of your pre-tax savings to Roth. Ideally, you could do a Roth conversion when your income is lower. In this scenario, you saved on taxes while working and potentially reduced the taxes you paid when you converted to a Roth in retirement.
The decision to contribute to a Roth 401K versus Pre-tax 401K is a decision that isn’t straightforward. Consider your current and future taxes, and your long-term goals before leaping.