Comparing 401k Contributions

In this article we're going to discuss the three options most of us have with respect to our 401k contributions - before-tax, after-tax, and now the Roth 401k.  Starting back in 2006, many 401k plan administrators took advantage of the new Roth 401k and started offering it to their plan's participants.  Let's take a closer look at the difference this new option can make to your 401k contribution plans.

Choosing the Right 401k Contribution

You've always had the choice to make before-tax and after-tax contributions to a 401k plan, but today more and more plan administrators have added the Roth 401k to the mix.  If you're receiving matching funds from your employer, then chances are nothing will change if you decide to start funding the Roth - they will continue to match Roth contributions too.  But that doesn't help answer the larger question - Which 401k contribution option should I choose?

Funding Choices for 401k Plans

So to summarize what we've discussed so far, you've got three choices when it comes to funding your 401k plan:

• Before-Tax Contributions
• After-Tax Contributions
• Roth 401k Contributions

Let's take a quick look at the advantages and disadvantages of each before making direct comparisons.

Before-Tax Contributions

Making a before-tax contribution provides you with a benefit today by reducing your taxable income now.  By making this type of contribution, you're able to contribute more money to your plan while minimizing the impact on your take home pay - leaving you with more money in your paycheck.

On the down side, at the time of withdrawal both your earnings and your contributions will be subject to federal income taxes.

After-Tax Contributions

If you make after-tax contributions to your 401k plan you're not reducing your taxable income now.  But when you withdraw the money, you only have to pay income taxes on the earnings in your account.  And with this type of contribution, you plan usually allows you additional flexibility when it comes to accessing the contributions before age 59 1/2.

Roth 401k Contributions

The way a contribution to a Roth 401k works is very similar to the way after-tax contributions work.  You're making contributions on an after-tax basis, but if you hold the account for at least five years and you're age 59 1/2, then the earnings on your contribution are not taxed at the time of withdrawal.

On the other hand, any matching contributions made by your employer and the earnings on that match are subject to federal income taxes when withdrawn.

Comparing 401k Contribution Options

The following table shows a side-by-side comparison summarizing the three options you have when it comes to funding your 401k plan:

401k Contributions Comparison

 * - Account must be held for at least five years, employee must be at least 59 1/2, deceased or disabled.

Choosing Between Options

There are two important factors you need to consider before deciding if you're going to make before-tax, after-tax, or Roth contributions to your 401k account:

• Expected Income Tax Rate
• Expected Return on Investment

Unfortunately some of your decision is going to be based on a relatively unscientific best guess.  But here is some of the information you need to consider.

Income Tax Rate

Perhaps the single most important deciding factor has to do with the income tax bracket you expect to be in when making withdrawals during your retirement years.  If you believe that you'll be in a higher income tax bracket when retired, then funding a Roth 401k has an advantage because you're paying taxes now - while your rate is lower.

On the other hand, if you think you'll be in a lower tax bracket in retirement, then making before-tax contributions to your 401k has an advantage.  That's because you're not paying taxes now but you will during your retirement years when you're expecting your tax rate to be lower.

Return on Investment

The other question you need to think about is your expected return on your investment.  You'll also want to be thinking about when you'll need to start withdrawing money from your 401k account.  Here's why.

The higher the return on your investment, and the longer you can go without touching the money in your account, the higher the proportion of earnings you'll have in your account (relative to the money you placed into the account).

If you expect to have a high proportion of earnings in your account then you might be better off making Roth contributions to you 401k.  That's because Roths are allowing you to make contributions on an after-tax basis but the earnings (remember our assumption here is that earnings are a larger proportion of your total account balance) are withdrawn tax-free.

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