Timing Uncle Sam’s take from your nest egg

If your company offers both a Roth 401(k) and a regular 401(k), investing in both may be your best option, says Money Magazine’s Walter Updegrave. But how much should you put into each?

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Question: I’m a young professional in my first job who anticipates being in the 28% tax bracket for at least the next five years, although I may move to a lower bracket after that. My company offers both a traditional 401(k) and a Roth 401(k). What proportion of my contribution should I put in the regular 401(k) and how much should go into the Roth? —Mike Davis

Answer: As more companies with 401(k)s begin offering a Roth option, more people are going to face the quandary you do now: Where should those 401(k) contributions go? Into the good old regular 401(k) where you contribute pre-tax dollars and then pay tax on your contributions and investment earnings at withdrawal? Or into the Roth 401(k) where you invest after-tax bucks but enjoy tax-free withdrawals in retirement?

I wish there were a simple formula I could give you to make this decision. Alas, there isn’t. What I can do, though, is describe how each of the options works and explain the pros and cons of the two so that you can decide how to divvy up your contributions.

Regular 401(k)s vs. Roth 401(k)s

Mathematically there’s no difference between the two. Let’s say you’re in the 25% tax bracket and you have $15,500 in pre-tax pay that you can contribute to your 401(k). Whether you put that $15,500 of pre-tax dollars into a regular 401(k) or pay $3,875 in taxes (25% x $15,500) and put the remaining $11,625 after tax into a Roth, you end up with the same amount of after-tax dollars in retirement. Click here to see how much you would have.

But as readers of this column already know, this little example assumes that your tax rate is the same when you pull out the money as when you put it in. If you are in a lower tax bracket when you withdraw the money, then you would net more money in the regular 401(k) because you would have avoided tax at a higher rate and paid it at a lower rate.

And if you’re in a higher tax bracket in retirement, then the Roth would be the better deal because you would have paid taxes upfront at the lower rate.

But there’s another factor to consider—namely, Congress, in its wisdom, decided to make the maximum dollar contribution limits the same for regular 401(k)s and Roth 401(k)s. For 2008 that limit is $15,500 (plus another $5,000 if you’re 50 or older) regardless of whether you’re contributing to either one or both.

This means you can put away more money on a tax-advantaged basis in a given year by doing the Roth 401(k), assuming you’re willing to contribute the max.

For example, let’s say you decide to contribute $15,500 after taxes to your Roth 401(k). To contribute the equivalent amount in pre-tax dollars to a regular 401(k), you would have to sock away $20,667. Why that amount? Because for someone in the 25% tax bracket, $20,667 before taxes is the same as $15,500 after taxes. (Subtract 25%, or $5,167, for taxes from $20,667 and you get $15,500.)

The rub is that you can’t contribute $20,667 in pre-tax dollars to the regular 401(k) because you would exceed the $15,500 limit. Thus, the Roth allows you put away more money each year.

Hedging your bets

So, back to your question, how much should you contribute to the regular 401(k) and how much to the Roth?

The issue that you raised in your question about moving up or down the tax-bracket ladder during your career isn’t really important in making this decision. What matters is the tax bracket you’re in when you invest the money in and the bracket you’re in when you pull it out.

But can you really be sure what tax bracket you’ll be in down the road? If the answer were yes, then deciding which type of 401(k) to fund would be a simple matter of going to a calculator like this one and plugging in a few numbers.

But I don’t think the answer is so clear cut for most of us. Your future tax bracket depends on a lot of factors, including your career trajectory, the amount of money you save for retirement and, perhaps the biggest wildcard of all, what tax laws Congress passes in the future.

So I see this as a case where you want to hedge your bets and put some money in a regular 401(k) and some in the Roth. As for arriving at percentages, that’s more art than science. But a reasonable way to go about it would be to pick a split as a starting point and then refine it according to your circumstances.

Divvying up your contribution on a 50-50 basis might seem like a logical place to start. But remember: You’re dealing in pre-tax dollars with the regular 401(k) and after-tax with the Roth. So if you were to contribute the $15,500 max and put 50% in each option—$7,750 in the regular 401(k) and $7,750 in the Roth—you would actually be favoring the Roth option because $7,750 after-taxes is the equivalent of $10,333 before taxes if you’re in the 25% tax bracket.

So you might want to use, say, a 60-40 split with 60% going to the regular 401(k) as a starting guideline. If you think you’re more likely to end up in a lower tax bracket in retirement, then maybe you tilt to 65% or 70% in favor of the regular 401(k).

If you feel you’ll probably move into a higher tax bracket, then you tilt the mix the other way toward the Roth, shifting it more depending on how likely you see the possibility of ending up in a higher bracket.

Peace of mind

Of course, there are other factors that might affect the split you settle on. If you’ve already got lots of dough sitting in a regular 401(k) or IRA account, then maybe you’ll lean more toward the Roth 401(k). Or if the idea of having a tax-free stash of money to draw on in retirement gives you peace of mind, you might also favor the Roth.

I wouldn’t get too obsessed about coming up with an “ideal” split each year. For one thing, over the course of a career, you’ll likely have opportunities to re-jigger the proportion of savings you have in each account by funding one type more than the other in subsequent years.

Besides, it’s virtually impossible to know in advance what the best combination of regular and Roth contributions will turn out to be. Even if you could predict exactly how much you’ll earn and save the rest of your career, you can’t predict what sort of tax regime will be in place when you finally retire.

So I suggest you go through the process I described above, make the best judgment you can and then periodically re-evaluate where you stand. As long as you have at least some money in both types of accounts, the extra flexibility you’ll gain for managing withdrawals in retirement will almost certainly make you better off than if you had plowed all your money into just one option.

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