Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared Feb. 15, 2012.
Question: I'm trying to decide between contributing to a Traditional 401(k) or a Roth 401(k) at work. I know that the main difference between the two is whether I pay taxes on the money now or later, but how do I decide which is best for me?
Answer: Take the tax break now or take the tax break later. It's a simple dilemma, and yet in this case it forces us to do something that's very difficult: predict the future.
There are many variables at play here, including the number of years until you retire, your salary now and years from now, your risk tolerance, and more. These are the factors that are somewhat within your control. But there are outside factors, as well, namely, what tax rates will look like when you retire. Let's take a closer look at some of these factors. And because many of the same issues apply when considering a Traditional IRA versus a Roth IRA, we'll refer to "Traditional retirement accounts" and "Roth accounts" for simplification.
Personal Factors: What Does Your Future Look Like?
The key question to ask yourself when considering whether to opt for a Traditional retirement account, in which pretax dollars are invested and later withdrawn as taxable income, or a Roth, in which aftertax dollars are invested and later withdrawn tax-free, is: How will your future tax rate compare with your current rate? If you think your tax rate will be higher in the future, the Roth is a better choice because you'll be paying taxes on the money now, while rates are lower. If you think it will be lower in the future, the Traditional IRA or 401(k) is better since you'll be paying taxes on the money after your rate drops.
However, how do you know if your tax rate will be higher or lower? For younger investors who expect to see their incomes rise considerably during their careers, a Roth makes a lot of sense because they are likely to pay a higher tax rate by the time they retire. For older workers in a higher tax bracket but with little saved for retirement, a Traditional account is apt to make more sense because their income level is likely to drop them into a lower bracket. If you think your rate will be the same, weigh how important the near-term tax break on a Traditional retirement account is to you versus the potential benefit of tax-free withdrawals later in life. To read what Morningstar.com users have to say about whether their tax rates went down in retirement, click here (http://socialize.morningstar.com/NewSocialize/forums/p/299270/3200842.aspx#3200842).
Outside Factors: What Will the World Look Like When You Retire?
Even the most prudent investor can only control so much. When weighing the tax implications of a Traditional versus a Roth account, external factors inevitably come into play. In this case the real question is: What will happen with tax rates at the national, state, and local levels?
The federal debt, which recently surpassed $17 trillion, is now larger than the entire U.S. economy, ratcheting up pressure on leaders in Washington to address the problem. Some analysts see higher taxes as inevitable.
"Looking forward, it's almost certain taxes will rise, and the only question is how will taxes be distributed among people," Roberton Williams, a senior fellow at the Tax Policy Center, a Washington-based think tank, told Morningstar last year. He said entitlement costs, in particular, will weigh heavily on the nation's long-term budget picture.
From a historical perspective, income tax rates right now are on the low side. This year the top marginal rate rose from 35.0% to 39.6% (on income higher than $450,000 and for those filing jointly). But that's still lower than it was for most of the past century.
Williams said that, for younger workers, a Roth is probably the way to go. "Young people starting out are likely to see the lowest tax rates of their lives right now," he said.
And the federal government isn't the only one with financial woes. Many states and cities that levy income taxes also are facing budget problems, so those rates also could be affected down the line. (Note that some states and cities do not exempt Roth distributions from taxation, so it's best to check the rules where you live.)
What You Can Do Now
Now that you've reviewed the factors that come into play in choosing a Traditional retirement account or a Roth, it's time to put your plan into action. One good place to start is Morningstar's IRA calculator, which lets you compare various long-term scenarios relative to your situation.
Also, if your situation is not as clear-cut as some of the examples above, or you just can't decide between Traditional and Roth retirement accounts, consider funding both. This provides tax diversification, which is a great way to hedge your bets against whatever your tax rates look like down the road.
Make sure you pay attention to what's happening in Washington, too. The government's decisions today will affect tax policy for years to come, which has a direct bearing on how you invest for retirement.
Last but not least, don't discount peace of mind when making your decision. All things being equal, a Roth offers the closest thing to tax certainty one can get in these uncertain times. Giving up any potential advantage if your income tax rate should drop in retirement seems like a small price to pay for the guarantee of tax-free withdrawals, and maybe a better night's sleep.