Question. My 401(k) now allows me to make Roth contributions. Should I do that or continue making the tax-deferred contributions I have been making for years?
A. It turns out that this is a very complex question, and anyone who pretends the answer is simple doesn’t really understand all the factors involved. There is no universally correct answer, only a right answer for you. However, rather than spending a lot of time worrying about how best to manage this decision, realize that both tax-deferred and Roth 401(k) contributions are very good things and both have great advantages. Also, when in doubt, it never hurts to just split the difference, minimizing regret either way.
Roth contributions are made with money that has already been taxed. When the money is finally withdrawn from the account in retirement, both the original principal and the earnings come out completely tax-free. Tax-deferred, or traditional, 401(k) contributions provide you a tax break in the year you make your contribution. They also grow in a tax-protected manner, but upon withdrawal, the entire principal and earnings are taxed at your full marginal tax rate. So the first factor to consider when deciding between Roth and traditional 401(k) contributions is the difference between the tax rate at which you would contribute the money and the tax rate at which you would withdraw it.
For a resident, who is most likely in a very low tax bracket, making Roth contributions is usually the right move. However, it can increase student loan payments due under the Income-Based Repayment and Pay As You Earn programs, as well as decrease any forgiveness received under these programs or the Public Service Loan Forgiveness program. For an attending in peak earnings years, the right move is usually to make tax-deferred contributions and then use that money to “fill up” the 0 percent, 10 percent, 15 percent, and 25 percent brackets in retirement. Putting money away at a 33 percent marginal tax rate and then withdrawing it at an effective tax rate under 25 percent is a winning formula.
Unfortunately, there are numerous other factors involved that complicate the decision for many people. First, it is nice to have both tax-free (Roth) and tax-deferred accounts available to you in retirement to provide tax diversification. This puts you in control of your retirement tax rate. You can withdraw from tax-deferred accounts up until you hit the higher tax brackets, then use your tax-free money if you need additional income. If your ratio of tax-free to tax-deferred accounts is very low, it may be more worthwhile for you to make Roth 401(k) contributions even in your peak earnings years. However, if you have a significantly sized Roth IRA from your resident years and you make annual backdoor Roth IRA contributions for you and your spouse, you may have a decent ratio already and would be better off maximizing your tax-deferred contributions.
If you are a great saver who wishes for more tax-protected retirement account space, Roth may be for you even during peak earnings years.
Making Roth contributions also allows you to put more money into retirement accounts, which have many tax, estate-planning, and asset-protection benefits. Because the limit is the same ($18,000 in 2015 for those under 50) for both a Roth and a traditional 401(k) employee contribution (employer match and profit-sharing contributions are always tax-deferred), if you choose Roth, you will have more after-tax money in your account. Think of it this way: you only own some of the money in a tax-deferred account. Uncle Sam owns a certain percentage, and you are just investing it for him until withdrawal, at which time you get your share and he gets his. However, with a Roth account, you own the whole thing. If you are a great saver who wishes for more tax-protected retirement account space, Roth may be for you even during peak earnings years. Great savers also run into the issue of having a very large tax-deferred account. Once your tax-deferred accounts are more than $2–$3 million in today’s dollars, the required minimum distributions alone will get you into a high tax bracket, so there won’t be much of an arbitrage between today’s tax rates and tomorrow’s. It turns out that the more you save for retirement, the less benefit you will see from using tax-deferred accounts. The same is true if you have a lot of taxable income from Social Security, a pension, or real estate investments.