Roth 401k vs. Traditional 401k: The Fight Continues

Xin Lu over at Wise Bread has a nice, easy-to-follow post about the pros, cons, and thinking points of considering a Roth vs. Traditional 401k. I've previously blogged about the Roth 401k conundrum, but considering Roth 401k's are such new offerings it's a good subject that bares repeating.

Points to ponder:

1. What tax rate do you expect to have in retirement?
2. Does your tax plan require you to lower your taxable income?
3. Do you plan to max out your 401k?
4. What will your Social Security check be like?
5. How long will you be at your present company?

To get the answers to these questions, see Xin's post!

Early Retirement Withdrawl: Your Money, Your Worst Enemy

Yes, it's your money. But it's not your money to spend until you reach 59 1/2 and/or your plan reaches its distribution period. Many people don't understand this. They also don't understand that there is a penalty (usually 10%) for early withdrawal on top of tax (usually another 10%) on the money withdrawn. AND the money withdrawn needs to be reported to the IRS since it's income.

So, basically withdrawing money early will mean an automatic loss of 20%. That's staggering. But there is a silver lining...

Some retirement plans are not taxable, such as Roth (since Roth money is contributed after-tax). Additionally, only the portion that is taxable (i.e. has never been taxed before), will be taxed. So, if you early withdraw from a Roth, nothing will be taxed since that money has already been taxed and is set to grow tax free. However, if you early withdraw from a Traditional 401k, all the money was contributed tax-free, so at time of withdrawal, it is taxed.

Basically, the easy way to say it is if you'll be taxed on the money when it is disbursed, you'll get taxed on it when you early withdraw.

And remember, no matter what plan it is, you cannot get out of the early withdrawal penalty!!!

For more in-depth info on taxes on retirement plans, see the following links:

• Publication 575, Pensions and Annuities (PDF 227K)
• Publication 590, Individual Retirement Arrangements (IRAs) (PDF 449K)
• Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax Favored Accounts (PDF 72K)
• Form 5329 Instructions (PDF 40K)

See here for more of my articles on retirement accounts.

Tax Document Clinic Part 1: What to Keep & How Long

Let's get right to it...

What Records Do I Keep?

• Tax Items: Returns, canceled checks & receipts relevant to your tax return, & records for tax deductions on your return
• IRS Contribution Statements
• Other Retirement Savings Plan Statements
• Bank Records
• Brokerage Statements
• Bills
• Credit Card Receipts and Statements
• Pay stubs
• House/Condo Records

How Long

One Year

• Pay stubs: Keep until you get your W-2(s) and make sure everything matches. If they don't, demand an amended W-2, known as a W-2C.

Ten Years

• Tax Items

• Bank Records: Keep the bank records relating to tax matters for seven years.

• Credit Card Receipts and Statements: Keep receipts until your month-end statements come, then match everything up, shred receipts, and keep statements.

Until You Sell

• Bank Records (the ones relating to home improvements and mortgage payments).

• Brokerage Statements (too prove capital gains/losses at tax time).

Permanently

• IRS Contributions Statements (to prove you paid tax on this money already).

• Other Retirement Savings Plan Statements: Keep the quarterlies during the year, make sure everything matches up at year-end, shred the quarterlies, and keep the yearlies forever.

• Bank Records (the ones relating to home improvements and mortgage payments.)

• Bills: Keep bills of large value items (to prove value); toss bills that are more than a year old and have been paid in full (a.k.a your utility bill from 3 years ago).

• House/Condo Records: Keep records documenting purchase price, permanent improvements, and expenses incurred in buying/selling the home. This will help you during tax time.

Seems like a lot of paper, huh? See Part 2 where I go into organizing those documents!!

Small business owner? See customized document info at A Tax Consultant for All Seasons:
What Records Do I Need to Keep?
How Long Should I Keep Records

Which one: Roth 401k vs. Traditional 401k? The truth is in your pay stub.

The first point to understand is, "What's the difference?"

A Traditional 401k is a tax-deferred retirement plan. Contributions are made up to a specified limit with the contribution being tax deductible. Money invested and earned in a Traditional 401k are subject to income taxes at the time of withdrawal.

Roth 401k contributions can be made up to a specified limit on a non-deductible basis. This means a contribution can be made to a Roth account but no deduction can be taken from income tax. Withdrawals at the time of retirement are tax free within certain limitations.

Many companies are starting to offer both a Roth and Traditional 401k. So why should you choose one over the other? Well, first I'll say discuss this issue with your financial planner. However, if you're looking for a basic explanation, here it is:

First Point-to-Ponder
Traditional 401k's allot you a tax shelter at the end of the year. Roth 401k's don't. Therefore, if you have enough money to need a shelter, a Traditional 401k is a good way to go. If you don't make enough to reap the benefits of a tax shelter or an additional deduction, then I'd allow my money to grow tax-free in a Roth until the time comes that getting that deduction outweighs the tax-free growth rate.

Another point to remember is tax brackets. Traditional 401k's allow you a tax deduction during your earning years and then you pay tax on that money when withdrawn. The deduction during your earning years is important since your tax bracket is projected to be higher during this time (meaning more tax paid), making the deduction worthwhile financially. When you retire your earnings naturally go down so that you're in a lesser tax bracket (meaning less tax paid). This means that although at retirement you'll pay tax, you're likely to pay less tax during this time than had you paid tax on those monies when earned. Therefore, Traditional 401ks can give you money back at the end of the tax year during your earning years and allow you to pay less tax on your money during your disbursement years, which could equal more disposable income for your overall.

Second Point-to-Ponder
Use of a Traditional 401k assumes that at retirement you will be earning less than when you were working. If you plan a lofty, extravagant retirement, the benefits of a Traditional 401k may not apply to you. In this case, a Roth 401k may seem smarter.

Third Point-to-Ponder
The first two points assume a static tax system with no change. Now both you and I know this is untrue, but we don't know how the tax system will change. If you would like to work with the tax brackets of today and not bet on tomorrow, a Roth is for you. If you're not too worried about tax law changes or are the gambling type, a Traditional 401k would be a better option.

In Conclusion
So, you've got some hefty decisions to make. In all, if I were young and just starting out I'd go with a Roth, keeping an eye on my paycheck. Once those raises and bonuses come in, it may be time to transition into a Traditional 401k. Oh, and a word of caution... once invested, money in a Roth cannot be rolled into a Traditional. So know that when deciding too.

Additional Resources:

Roth & Traditional 401k's per Wikipedia

Leave That 401k Alone, Or Else!

Traditional vs. Roth IRA

Roth IRA- Distributions Taxable or Not?