Retirement planning is tricky. There are so many unknowns that making choices now, while you are still working can literally cripple the decision making process. You have no idea what your tax rate will be when you retire. You have no idea what your income will be ten years from now, whether life will change everything including your outlook or you will simply bump along at a reasonable and modest pace. At some point though, you must make some sort of educated guess and be flexible.
The educated guess is a lot harder than you might think.
Planners/advisers/brokers all make educated guesses. The divine some sort of idea based on your initial and subsequent conversation, and in doing so, guide you along an investment path that is tailored to your needs. in this scenario though, it is us that is the problem. As Francois de La Rouchefoucauld pointed out, “We confess our little faults to persuade people that we have no large ones.” But we do and we don’t often confess them to the person we enlist with our future (fortunes).
But for the vast majority of us, we are left to self-confessionals and the choices in our defined contribution plans. Sometimes those choices are good; sometimes not. While most plans offer the basic investment opportunities (mutual funds, sometimes stocks, money market accounts) the landscape on how you choose to employ those choices is changing. Since 2006, the new choice in the defined contribution plan isn’t really a choice so much as a way to choose differently.
The 401(k), in its original form was designed to allow you to take money out, pre-tax and put it towards your retirement. It was and is still considered wise to defer these taxes until later in life, the theory being that you will be in a lesser tax bracket. You might be earning less and theoretically, you would be paying less. But no one can say for sure whether 20, 30, or 40 years down the road that taxes will be reasonable enough to make the bet on deferring now worthwhile.
Some folks insisted on hedging that bet and this created a new kind of entrant into the 401(k) world, the contribution that was made after taxes were paid. The Roth 401(k) allows after-tax contributions to be made, which in turn makes all qualified withdrawals tax-free. It does sound tempting. But there are certain groups of people that should use this and others, who may have access to it in the near future, who should not.
Plan advisers are paying close attention to the growth of the Roth 401(k) as it makes its way into more plans. Currently, according to Hewitt Associates, 29% of the plans now have it with an additional 25% considering adding the feature in the future. In a recent opinion piece examining this growth, they write: “Hewitt researchers had sympathy for those reluctant to jump into the Roth 401(k) waters. “Adding a Roth feature is not as simple as clicking an on/off switch—it takes considerable planning, implementation, and communication,” Hewitt wrote. “Communication is especially important, and tools must be made available to help employees navigate this new and complex decision.”
And it is this complexity that will find people who should use not doing so and those who shouldn’t use it, electing to. But to boil it down to its basics would do only partial service to the choice you might want to make.
In a nutshell, a Roth 401(k) is ideal for those who anticipate a higher tax bracket when they retire. Compared to a traditional 401(k), the Roth 401(k) begins to show its advantages when the taxes owed begin to impact your Social Security benefit. For the sake of this discussion, Roth 401(k) withdrawals are not seen as income and do not impact that benefit, which can be taxed should your income breach a certain threshold.
So it you are making less now and are younger but assume that this sort of income earnings will rise as you get older, starting a Roth 401(k) now might be a good choice. If you are making quite a lot and would like to increase your ability to put more money away, starting a Roth 401(k) might be a good idea as well. If you would like to leave your retirement account to a non-spouse or non-charity beneficiary, this is an excellent choice.
It is not a good idea if you can reasonably predict a lower or the same tax bracket when you retire. If you see your retirement as more reliant on Social Security than not, then the Roth 401(k) is something you should probably avoid. Employers, at least so far, offer no matching contribution for the Roth 401(k). So if your contribution to it impacts this employer match, it probably isn’t right for you.
There are numerous other considerations and this white paper put out by HeintzBerger (pdf) does a good job explaining it.
I have found that many 401(k) plans are not as good as they could be, with less than stellar choices. If you are concerned about your tax bracket or the inheritable feature that the Roth provides, use it outside your 401(k) in the form of a Roth IRA. Here the choices are almost limitless. You can adjust your contribution and you are permitted to withdraw those contributions after five years.
Related posts: