Jenny (35 years old)is considering making a one-time contribution to either a traditional 401(k)plan or to a Roth 401(k)plan. She plans to withdraw the account balance when she retires in 40 years. Jenny expects to earn a 7 percent before-tax rate of return no matter which plan she contributes to. Which of the following statements is true?
A)If Jenny's marginal tax rate in the year of contribution is higher than her marginal tax rate in the year of distribution, she will earn a higher after-tax rate of return on the traditional 401(k)plan than on the Roth 401(k)plan.
B)If Jenny's marginal tax rate in the year of contribution is lower than her marginal tax rate in the year of distribution, she will earn a higher after-tax rate of return on the traditional 401(k)plan than on the Roth 401(k)plan.
C)Jenny will earn the same after-tax rate of return no matter which plan she contributes to.
D)Jenny is not allowed to make a one-time contribution to either plan.

Question

Quizplus · Accepted Answer

If Jenny's marginal tax rate in the year of contribution is higher than her marginal tax rate in the year of distribution, she will earn a higher after-tax rate of return on the traditional 401(k)plan than on the Roth 401(k)plan. This is because with a traditional 401(k) plan, Jenny's contributions will be made with pre-tax dollars, reducing her taxable income in the year of contribution, but she will pay taxes on the withdrawals in retirement. With a Roth 401(k) plan, Jenny's contributions will be made with after-tax dollars, so they will not reduce her taxable income in the year of contribution, but the withdrawals in retirement will be tax-free. Therefore, if Jenny's marginal tax rate is higher in the year of contribution than in the year of distribution, she will have a bigger tax savings by contributing to a traditional 401(k) plan.

Jenny (35 Years Old)is Considering Making a One-Time Contribution to Either