Traditional 401(k) or Roth 401(k): Do the math

by Center for Personal Finance editors

NEW YORK (5/4/06)--Some lucky employees have a new retirement savings option: the Roth 401(k). Know the pluses, understand the catch, and plug in your numbers to see whether this new plan is right for you (SmartMoney.com).

What is a Roth 401(k)? It combines the features of both a traditional 401(k) plan and a Roth individual retirement account (IRA). Similar to the Roth IRA, your contributions to a Roth 401(k) are made on a post-tax basis, and withdrawals taken during retirement are tax free. Similar to the traditional 401(k), the Roth 401(k) has no income restrictions. You're eligible--as long as your employer offers it.

The Roth 401(k) allows you to diversify your tax exposure. According to the Roth IRA Advisor Web site, if you have two plans--one a traditional 401(k) and the other a Roth 401(k)--with the same amount of money in both, the Roth 401(k) plan will be of greater value since the income taxes imposed on withdrawals from the traditional 401(k) greatly reduce its overall value.

What's the catch? If you're used to saving for retirement on a pretax basis, switching to after-tax contributions means you probably will have a higher annual tax bill during the year you make contributions. And--assuming you don't adjust your contribution amount--that also means you'll have a slightly lower take-home paycheck.

How can you do the math? To determine whether you should contribute at least some retirement savings to a Roth 401(k), use the Roth 401(k) Estimator at smartmoney.com by comparing two scenarios: contributions to a traditional 401(k) or to a Roth 401(k). Keep in mind that you can choose to contribute to both options at the same time, but you can't exceed the total contribution limit of $15,000 in 2006 for both plans combined--not including the company match.

Will your income taxes be higher in retirement than they are now? You can't predict this with certainty, but if you could, you'd know for sure whether you're better off with a Roth 401(k) than with a traditional 401(k).

If you use the work sheet, smartmoney.com offers the following tips:

If you receive an employer match--which is made with pretax dollars in both traditional and Roth 401(k) plans--the calculator will show a balance in the traditional 401(k) plan field, even if you contribute only to a Roth 401(k).

The last line ("Difference in 401(k) totals") shows which 401(k) plan comes ahead and by how much. You then need to compare that number to the "Total return on paycheck difference" result above. If the difference in 401(k) totals is smaller than the difference in paychecks, you may be better off with a traditional 401(k), assuming you save or invest the tax savings to use for retirement.

The results you get with this work sheet are only estimates--a starting point for evaluating your 401(k) options.

For more information, read "Introducing the Roth 401(k)--A New Workplace Savings Opportunity" in the Home & Family Finance Resource Center money savvy section.