Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates)
19 Pages Posted: 28 May 2009 Last revised: 31 May 2009
Date Written: May 27, 2009
The advent of the Roth 401(k) significantly expanded opportunities for tax-preferred retirement saving, but at the same time it created much confusion for individual savers regarding whether to save in the form of pre-tax or Roth dollars. The financial community’s conventional wisdom is based on comparing current and future tax rates. We show how relying solely on the conventional wisdom can be wrong. We first show that comparing different saving strategies requires making an apples-to-apples comparison, which can be achieved by keeping take-home pay constant. An individual currently saving pre-tax can maintain the same take-home pay by switching to a lower amount of Roth saving. However, some important rules imposed by either 401(k) plans or the IRS encourage “tax illusion” by treating pre-tax and Roth dollars as if they were equivalent. First, moderate savers need to take care to understand how switching to Roth saving could lose them free money through employer matching contributions. Second, the IRS limit on annual 401(k) contributions means that aggressive savers who save Roth dollars can save more in a tax-advantaged way than those who save pre-tax dollars. For both of these groups, the conventional wisdom can be completely reversed under fairly normal circumstances.
Keywords: Roth, 401(k), tax deferred, saving, retirement, employer match, tax diversification, tax illusion
JEL Classification: D91, H24, H31, J26
Suggested Citation: Suggested Citation