Should you select the new Roth 401(k) over traditional 401(k)?

Now that Congress has made the new Roth 401(k) permanent, should you select the new Roth 401(k) over traditional 401(k)?

To decide, plan participants have to evaluate which option, Roth 401(k) or traditional 401(k), is more effective for saving for their retirement.  The major difference between the two plans is that a traditional 401(k) is funded with pre-tax money, so you have more current cash flow, while the Roth 401(k) is funded with post-tax money, reducing cash flow.  Investments in both plans grow tax deferred.  However, the distributions from the traditional 401(k) plan are subject to taxation while distributions from the Roth 401(k) plan are not.  The choice then is one of taxation now, for its impact on current cash flow, vs. taxation later.  Because of the current tax savings, most people are better off contributing to a traditional 401(k) plan.  However, people who fit one of the following profiles may benefit from the Roth 401(k).

  • Individuals earning a very low income, under $30,000, are better off contributing to a Roth 401(k) given that their marginal tax rate on the contributions is effectively zero.  That is, they have no current tax savings.
  • Wealthy individuals who contribute to the Roth 401(k) and want to pass on this wealth have the tax-free distribution upon death.
  • Young, aggressive savers, such as 30 year old professionals who are saving 20% of current income and who expect their retirement income to be significantly higher and who also expect real returns on investments to be higher than 7% will be better off contributing to a Roth 401(k).  The expectation of these individuals that they will be in a higher tax bracket at retirement than their current tax bracket makes the Roth 401(k) a better choice. 
  • A professional such as a doctor with high compensation today who also has high employer contributions will be better served by contributing to a Roth 401(k) because the plan does not have a minimum required distribution at age 70 ½ and having part of the retirement income free from taxation might help lower his tax-bracket.