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The 2014 Contribution Limit for 401k retirement accounts remains $17,500 (same as 2013). This limit applies only to the employee’s contribution, not to any employer contributions. The 401k Catch-Up Limit for older employees remains $5,500. This means that employees age 50 or older can contribute up to $23,000 (the $17,500 base amount plus the $5,500 Catch-Up). Separately, you can also contribute to a Traditional or Roth IRA, subject to certain Traditional IRA income limits and Roth IRA income limits.
Traditional vs. Roth 401(k)
The limit of $17,500 applies to both Traditional and Roth 401(k) plans. In a traditional 401(k) plan, employees make tax-deductible contributions. These contributions grow without being taxed on dividends, earnings, or realized gains until the money is withdrawn in retirement. As funds are withdrawn, they are taxed at ordinary income tax rates. In a Roth 401(k) plan, employees make contributions with after-tax dollars. These contributions grow without being taxed and can be withdrawn at retirement without being taxed. So the choice is yours – pay taxes up front with a Roth 401(k) or later with a Traditional.
If your tax rate is the same now as in retirement, the Traditional and Roth options are mathematically equal. If your tax rate will be higher in retirement, then you are better with the Roth. If it will be lower, go with Traditional. Below are some reasons that would justify a belief that your tax rate is relatively low now (Roth) or in the future (Traditional).
Reasons to Choose a Roth 401(k) (Pay Taxes Now)
- You are young and expect to make more money later in your career – If you are just starting out and are currently in a relatively low income bracket but have a lot of future potential, you might expect your tax rates to be higher in retirement.
- You believe all tax rates are going up – Are you worried about the American economy? Concerned that the budget deficit and national debt are out of control? Think that current tax rates, which are on the very low end of the historical range, are unsustainable and must go up over the next few decades? Then you’re probably better off choosing a Roth over a Traditional and paying your taxes now.
- You are taking a break from paid work – Are you temporarily out of the work force for part of the year? Taking time off to have a baby or to go back to school? If for whatever reason this is an abnormally low income year for you, take advantage of the situation by choosing a Roth and paying your taxes at your current unusually low rate.
- You are about to marry someone who earns more than you – If your tax bracket is about to go up permanently, make sure you get in some last minute Roth contributions at your old, lower rate. Just be careful – if you get married at any point in the year your new marital status applies to the entire year retroactively.
- You are older and anticipate earning less in retirement than you do now – The rule of thumb is that you will need 80% of your pre-retirement income during retirement. This can come from a variety of sources including earnings from continued employment, savings and retirement account withdrawals, and social security. Consider how much taxable income you anticipate having in retirement and compare it to what you earn today. For most workers nearing retirement, the anticipated taxable income in retirement will be less than their final working income. If this is the case for you, choose a Traditional account and hold off on paying taxes until you are in your lower retirement tax bracket.
- You believe tax rates are going down – Convinced that the Tea Party is about to be elected and drastically cut government spending and taxes? Then you’re probably better off choosing Traditional and waiting to pay your taxes.
- You anticipate taking a break from paid work – If you earn a moderate salary and think you’ll make more in a few years you may be planning to do a Roth to pay lower tax rates now in anticipation of being in a higher tax bracket later. But what if you take a year off to care for a child or sick family member or to transition between jobs or to go back to school. Your income for that single year could be unusually low, giving you a temporary low tax bracket. Take advantage of this by converting accounts from Traditional to Roth during that down year. If you have zero income, your taxes on the conversion may be close to zero. So if you think this type of situation may apply to you in the next few years, plan ahead for it by contributing to a Traditional account (and not paying taxes) so that you have something to convert at the temporary low tax rate.
- You are about to marry someone who earns less than you – If so, your marginal tax rate is probably going to go down slightly. It may make sense to go with Traditional and then convert once married and paying the lower rate.