Q: My employer offers both a Traditional 401k and a Roth 401k. Which one should I contribute to?
A: To correctly answer this question, we would need to know what tax bracket you are in now and what tax bracket you will be in during retirement. The first question is easy. The second one is much trickier (unless you have a crystal ball). The general advice has always been for younger workers to contribute to a Roth 401k (and pay taxes now) while older workers should contribute to a Traditional 401k and get the tax benefits now. I have two main problems with this line of thinking.
First of all, tax rates are at historically low levels right now. Currently the top Federal tax bracket is at 37%. As recently as 1980, this top tax bracket stood at 70%. Given the levels of our national debt and deficit spending, I think it is reasonable to assume that tax rates will rise in the future.
Secondly, many investors have the vast majority of their money in Traditional IRAs, 401ks and TSPs. Once an investor is retired, the distribution of these assets will lead to a large amount of taxable income. Not only can this income push you into a higher tax bracket in retirement, but it can impact the premium you pay for Medicare and how your Social Security benefits are taxed. By having diversification of the taxation of your assets, investors will have more flexibility to minimize their tax burden in retirement.
Clearly this advice doesn’t apply to everyone, but I think that all investors (young or old) should consider contributing to a Roth 401k based on the current tax rates.