Everybody knows that you should save for retirement—how you should save is where it gets confusing. We can clear up one common puzzler right now: The difference between a Roth 401(k) and a traditional 401(k).
Both are designed to help you save for your retirement. What distinguishes them is how they’re taxed.
Traditional 401(k): Contributions are made pre-tax—which means you’re sidestepping the tax man (for now), thus lowering your taxable income each year you add to your account. Your earnings grow tax-free, but withdrawals (after age 59½) are taxed as ordinary income.
Roth 401(k): You contribute money that has already been taxed as income. But once invested, your earnings compound tax-free, and there is no tax on qualified withdrawals taken after age 59½.
Therefore, when choosing between a Roth and a traditional 401(k), it’s a case of deciding whether you want to be taxed now (Roth) or later (traditional).
The question of which type of 401(k) is best for you follows the same path as the decision to use a traditional IRA versus a Roth IRA. One thing to consider is whether you’ll be in a lower tax bracket once retired. Remember, even in retirement you will most likely still have income in the form of Social Security and required distributions from savings accounts like traditional IRAs or a 401(k) (both traditional and Roth 401(k)s require you to make withdrawals after age 70½).
If you’re well-established in your career and currently entering your peak earning years, your current income (and thus your tax bracket) is likely to be higher than your income will be in retirement. In that case, investing via a traditional 401(k) may mean you’ll ultimately pay less in taxes when you begin making withdrawals.
For younger professionals still climbing the ladder, their income in retirement may be higher than their present take-home pay. It’s still wise to max out your 401(k) contributions if you can, but for younger savers a Roth 401(k) may make more sense.
Other factors could be more important than your future tax bracket, though. High-earning couples or individuals may be ineligible to contribute to a Roth IRA due to income restrictions. In such cases, a Roth 401(k) might be a useful substitute since it provides similar tax benefits.
Of course, correctly predicting the amount of taxes you’ll face in the future can be a difficult business. Career paths can take sudden turns or Congress can change tax law. Building some flexibility into your retirement planning can help you deal with such risks.
At Adviser Investments, we often recommend that our clients split retirement plan contributions evenly between Roth and traditional accounts if their plan allows them to do so. This takes advantage of the unique tax benefits of both types of accounts, allowing for a tax deduction now as well as tax-free withdrawals in the future. (In 2019, you can contribute up to $19,000 in your 401(k), or up to $25,000 if you are over the age of 50.)
When it comes to 401(k)s, every situation is unique. We can provide you with advice tailored to your circumstances. Please contact us at (800) 492-6868 if you’d like to learn more about how to make the most of your 401(k) contributions. We are happy to assist.