Roth vs Traditional 401K when paying income tax in two states

Question

I graduated in May and got my first full-time job and would like to being contributing more to retirement. I live in New York State (not NYC) and work in Connecticut so I pay state income tax in both states.

Paying income tax in two states seems like a good reason to contribute to a traditional 401K; however, since I started working halfway through the year, I will only make half my salary which seems like a good reason to contribute to Roth. My full salary is $77,000 / year.

Should I contribute to a Roth or Traditional 401K or both? I am currently contributing enough split between the two to receive the full company match but I could afford to contribute a little bit more.

Answer 1

At the state level you should not have to pay income tax to both states for the same dollar of income. One issue is will your employer in Connecticut withhold New York State income tax, but that only impacts where the funds will flow when you file your state tax returns.

In general when a person lives in one state and works in the other, unless the states have an agreement, both will try and claim the income but give a credit for the amount you pay to the other state. So just figure you will end up paying money to the state that wants more in taxes.

Most people don't consider the state tax impact when determining the split between Roth and pre-tax retirement contributions. This is because the federal tax rate is almost always higher than the state tax rate.

In a related note:

Because you graduated in May and you make $77,000, you might not be eligible for the Retirement Savings Contributions Credit (Saver’s Credit)

Who's eligible for the credit?

You're eligible for the credit if you're:

• Age 18 or older,
• Not claimed as a dependent on another person’s return, and
• Not a student.

You were a student if during any part of 5 calendar months of the tax year you:

• Were enrolled as a full-time student at a school, or
• Took a full-time, on-farm training course given by a school or a state, county, or local government agency.

A school includes technical, trade, and mechanical schools. It does not include on-the-job training courses, correspondence schools, or schools offering courses only through the Internet.

There are also income limits.

But check the forms. If you do qualify for the credit, it might make sense to increase your contributions.

Answer 2

The choice between a Roth and a Traditional 401(k) is usually based on whether you think your marginal tax rate (fed and state combined) is higher now than it will be in retirement. If your tax bracket now is higher than you think it will be, it makes more sense to contribute to a Traditional 401(k) now since you get a higher tax break now, and thus can contribute more to the 401(k). If your tax bracket now is lower than it will be at retirement, then you should choose a Roth because you are missing out on a smaller tax break now for a larger tax break at retirement. That choice assumes that you put in an equal amount on an after-tax basis, meaning the tax savings is invested too.

I agree with the other answer that the state tax should not be doubled-up - you typically get a credit for taxes paid to the other state, and just end up paying the higher rate; some to one state and some to another.

The outlier is when you make enough money to max out your 401(k) contributions. In that case it's better to put it all in Roth since your after-tax balance will be higher in a Roth. If you put in 1,000 into a Roth at a 20% tax bracket, your after-tax balance is still 1,000 because it is tax-free at withdrawal. If you put 1,000 in a Trad, your after-tax balance is only 800 since you will owe tax on 20% of it at withdrawal.

If you max out your contribution, it is not a bad decision to put some in both a Roth and a Trad 401(k). That way you can still contribute more on an after-tax basis but aren't subject to as much tax now. The optimal path is still a Roth, all else being equal, but it's not a terrible option.