ROTH 401(k): Background and Strategies Part 2

In our previous post we talked about how ROTH contributions within a 401(k) came about.  Today we will discuss strategies.

Once you understand the basics of traditional pre-tax 401(k) contributions and ROTH contributions the next question is; “Which one is best?”

The only way to know which one is best given your situation is if you know the answers to certain questions such as:

                When am I going to retire and withdraw the money?

                What are future tax rates going to be?

                How much income am I going to have in retirement?

                How long am I going to live?

                What are my pre-retirement and post-retirement returns going to be?

As you can see there is no way to know with absolute certainty which is best.  There are some calculators that can be very useful in your decision (examples below)

http://scrs.schwab.com/tools/schwab_roth_401k_calc.htm

http://www.smartmoney.com/calculator/retirement/which-ira-should-i-choose-1304481988076/

 Considerations beyond the calculators

 Consider your current tax deduction

If you have participated in a 401(k) plan for a number of years contributing pre-tax dollars chances are you are going to miss the tax-deduction.  For example, an individual tax payer making $50,000/year would lower their federal income tax liability by $1,250 if they contributed 10% of their salary pre-tax.  If that person decided to make ROTH contributions with 10% of their salary that tax deduction is gone and they are going to feel the difference.

One solution to this is to keep your current pre-tax contributions the same and allocate any increases in the future to ROTH contributions.  A person moving their contribution percentage form 10% to 11% could keep doing 10% in pre-tax contributions and allocate 1% to ROTH contributions.

 Consider the makeup of your current retirement dollars

Since ROTH IRAs and ROTH contributions in a 401(k) plan have not been around very long it is likely that the bulk of retirement dollars have been allocated on a pre-tax basis.  In addition, all employer contributions such as matching or profit sharing contributions are made pre-tax.  That means that most of your retirement dollars will taxed as ordinary income in retirement.

By allocating more money to your ROTH “bucket” you can better manage your taxes in retirement.  Let’s consider an individual that retires from their full-time job but does some consulting in their retirement years.  It’s likely that they may need to withdraw some retirement money in addition to dollars brought in from consulting.  In a year when more money is made consulting than usual they may want to pull from their ROTH dollars in order to minimize their tax liability.

Creating a legacy

With traditional pre-tax dollars whether it be in an Individual Retirement account or 401(k) individuals must begin withdrawing assets when they reach the age of 70.5.  If your goal is to preserve assets as much as possible for the next generation ROTH contributions work the best.  ROTH IRA money is not subject to the required minimum distribution rules.  Please note that ROTH 401(k) dollars would be subject to the RMD rules at age 70.5 so in order to avoid this one would want to rollover their 401(k) money to an IRA at retirement.

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