Should I Use the Roth 401(k)?

Our next question is from Mike. He asks, “My employer recently announced they’re offering a Roth 401k option. Should I be using the Roth 401k? Also, I’ve been putting money in the Lifecycle 2035 fund. Is that a good idea?”

Listen Now: Should I Use the Roth 401(k)?

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We answer:

Should I use the Roth 401(k) or not?

Traditional 401k deferrals are done on a pre-tax basis. This means you get a current tax benefit, a tax deduction. Your money grows tax-deferred. When you get to retirement and you take it out, you pay taxes on your distributions.

Roth deferrals offer no current tax benefits. It’s an after tax contribution. The money in your account grows tax free. When you take it out, you will pay no taxes on the growth or the contributions.

The Roth option has a lot of benefits. There are some questions that you need to ask yourself to make this decision.

Will Your Taxes be higher today or in retirement?

If your tax rate is going to be the same or higher in retirement then doing the Roth makes a lot of sense. If you’re a higher income earner today, that tax benefit may be far more valuable than when you do retire.

Are you addicted to your tax deduction?

I make pre-tax deferrals in my 401k to reduce my tax bill. It’s very difficult for me to start sending the government more money. I’m addicted to my tax deduction.

Next year, I’ll be able to do the over 50 catch-up contributions. I plan to use the Roth 401k for these because I’m not used to that tax deduction.

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How long until you retire?

The longer you have, the better the Roth 401k is. If you can let this compound for 20, 30, or 40 years, then the Roth makes a whole lot more sense than the pr- tax deferrals.

How much have you saved in pre-tax accounts?

If you have a large balance in a traditional IRA or 401k funded with pre-tax contributions, you may want to use the Roth option. This can help with tax planning for your retirement income. Distributions from traditional IRA’s get taxed as ordinary income. Having assets in other types of accounts allow for tax planning in retirement.

In general terms, I like the Roth options. The longer you have, the better. If you’re under 40, you should absolutely be doing the Roth if you can. Taxes do matter, and it needs to be a factor in your decision. But the longer-term benefits are huge.

If you’re 50 or older, you may not benefit as much from the Roth. It does allow you that flexibility to plan going forward.

Target Date Funds

Lifecycle and Target Date funds are designed to be a one-size-fits-most option. The date in the fund is to help you identify which year is closest to the year you want to retire. The asset allocation of those funds depends on the length of time from now until the year in the name of the fund.

Here’s an example. Vanguard has lifecycle funds. Their longest one right now is 2060 or 40 years away. The 2060 Fund has 88% of its assets in stocks. Vanguard’s 2035 Fund looks at a retirement 15 years from now. It only has 72% of its assets in stocks. The 2025 fund has 58% of its assets in stocks. Each year the fund family will adjust that allocation as you get closer to that target date.

Does it make sense to use one of these? As long as you’re doing it, right, yes. Remember, just pick one and keep it simple. We see mistakes with this. Some people will put some in the 2060 fund, some in the 2035 fund, and some in the 2025 fund. That’s not how they’re designed to work.

If you want to control your allocation, use a combination of the other funds that are available. Otherwise, use one target-date fund.  

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About the Author

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors.    He specializes in helping hard working, middle class families plan for retirement.

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