Hello
I am currently saving 10% of my income in my company's 401k program. They give me 2% match plus a 3% end of year contribution.
I am going to increase my savings to 15%. Do I put the extra 5% into 401k or into a Roth IRA since it will grow tax free?
If I put into 401k I will have a larger principal, so it will be worth more at retirement due to compounding interest, but I will pay taxes on it later. I plan to be in a lower tax bracket when I retire. What do you think?
The account name is irrelevant when it comes to compounding. At that point, it's neither 401-K money nor Roth money, but your money. Compounding will occur with sufficient time in either case.
Project out your anticipated 401k balances at the new and anticipated future contribution rates. How big will your 401k get with compounding? Remember that when you hit 70 1/2, you get hit with Required Minimum Distributions (RMDs), which occur according to a fixed formula. At that point, if your 401k is big enough, your plans for a lower tax bracket go out the window. Roths have no RMD.
You may want to eventually plan out your retirement distributions, between taxable, traditional, and Roth. If you plan to retire early, you need taxable investments, because you can't touch traditional and Roth prior to 59. Taxable has favorable (lower) capital gains tax rates. Traditional comes out at regular income tax rates. After it's exhausted due to RMD, then tap Roth. Roth is not taxed at distribution. Don't forget to account for Social Security, which can raise your income. If you tap the Roth last, it may be compounding for an extra 10-15 years more than the other accounts. And if your RMD is higher than you want, your taxable accounts may actually be growing as you add the excess withdrawals there.
So, your answer depends upon your current age, current income, your future plans, and how you structure your accounts.
Max out your traditional 401-k if possible. It lowers your income tax rate, so the difference in cash flow is probably less than you think. Savings rate may increase to 15% of gross income, but your net income after taxes may not decrease by 15% because you may be in a lower tax bracket (and they withhold less). If that happens, take the extra net income and throw it into the Roth. You may be able to fund both.