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401(k) Battleground: Traditional vs. Roth

Since January there has been a new option made available in 401(k)'s, the Roth IRA. Most likely, you have heard about it if you pay attention to personal finance options. Essentially, it is like its IRA cousin, the Roth IRA. Contributions to the Roth 401(k), as with the Roth IRA, are made with after-tax funds and you do not pay any taxes on the earnings as long as withdrawal guidelines are met. Like Traditional 401(k)s, they have the same contribution limits (for 2006, you are limited to $15,000). But, this is where the similarities end. You have several decisions to make when you plan for retirement, the first of which is whether or not to take action. That should be an easy choice. However, the other choices are not always so cut and dry.

I would recommend that you contribute up until your employer's match limit. There is no sense in not doing so, considering that it is free money. So that should at least some insight into the next question, how much to contribute. I would advise against contributing more unless you are already maxing out other retirement accounts and you still want to contribute more money to your retirement. Once you meet the match, I would consider other retirement opportunities such as IRAs, HSAs, and Coverdell ESAs for your childrens education.

A popular match plan is employers matching your contributions at 50% for the first 6% you contribute. This means, if you contribute 6% of your pay, and that equates $2400, then your employer will contribute $1200. So, at the minimum, and preferable not more to your 401(k), contribute to that match limit.

Before the advent of the Roth 401(k), your next choice was what to invest in. However, now the next question is whether to invest in a Traditional vs. Roth 401(k). With a Traditional 401(k), your contributions are made with pre-tax dollars, and they reduce your adjusted gross income. Further, your earnings grow tax-deferred until you withdrawal. If you are bordering on some limit for AGI, perhaps choosing a Traditional 401(k) is in your cards. However, do you really think that you are going to be in a lower tax bracket when you retire? The trend has been raising taxes. In 1929, total nationwide taxation (federal, state, and local) comprised of 10% of the Gross Domestic Product (GDP). Today, that amount is 30% of the GDP, with federal accounting for 20%, and state and local totalling 10%. While the choice is up to you, I would think chances are taxes will increase in the future.

So, if you decide to utilize a Roth 401(k), you deposit money that you have already paid taxes on. Your earnings are tax-free. But, a question that was looming in my mind was always what happened with matched contributions. If you are paying taxes on your own contributions, they are added to your income. However, if your employer matches, do these funds now count as income? For some, this could considerably raise their tax liability (I know it would for me, as I have a very good 401(k) plan). The answer is that employer matches are deposited within a Traditional 401(k), while your contributions stay in a Roth 401(k). This spells tax diversity! You get free money from your employer, and you can chance the future tax climate with those funds. With your own funds, you take safety in today's taxation.

As with all retirement accounts, you are limited to investments sponsored by your broker. And, if it were not for the free money aspect of a 401(k), I would completely ignore them and stick with IRAs and IRA-like investments like Coverdell ESAs and Health Savings Accounts (HSA). You can choose your broker, and by doing so you open up a much broader choice of investments. As a matter of fact, you could even use these funds to invest in your own business! While you can always roll your 401(k) into an IRA when you leave your employ, your funds are tied up until then.

When I am finally eligible to contribute to my companies 401(k) plan, I will opt for the Roth 401(k). The contributions made to the Tradition 401(k), by my employer, will be used to invest in standard securities, like stock, bonds, and mutual funds. The Roth 401(k) will be rolled into my Roth IRA (after I convert my current Rollover IRA into a Roth IRA, this week), and I will use this for investing in real estate and tax liens.


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