We’ve all heard the sage advice to “max out your 401(k)” whenever you can — the earlier you start doing this, the earlier you start reaping the benefits of tax breaks and compounding in your retirement plan.
Today, investors are faced with multiple ways to save to their 401(k). The two most commonly available and understood ways to save to your employer’s plan are through a Roth or a Traditional 401(k). Both account types are great ways to drive tax-advantaged growth in your retirement plan, but there are some key differences to be aware of when deciding which option is right for you.
In a nutshell:
- Traditional 401(k) contributions are made with pre-tax dollars. You’ll save on your taxes the year you contribute, enjoy tax-sheltered growth over the life of the account, but pay taxes on your withdrawals.
- Contributions made to a Roth 401(k) are made with after-tax dollars, also enjoy tax sheltered growth over the life of the account, but provide tax-free withdrawals.
So, the most common answer to which 401(k) is right for you is:
- If you believe you will be in a lower tax bracket now, invest in a Roth 401(k) to pay a lower tax rate now and avoid higher taxable distributions in retirement.
- If you believe you are in a higher tax bracket now, then it’s better to invest in a Traditional 401(k) and pay lower income tax in retirement.
However, there are several other factors when determining which retirement account is right for you including tax savings, penalties, time horizon, restrictions, personal financial goals, and preference. To be sure you’re considering all factors within the context of your personal financial plan, schedule a call with your financial advisor.
How are Roth and Traditional 401(k)s similar?
First, what do these account types have in common? Traditional and Roth 401(k) accounts have a maximum annual elective-deferral contribution of $19,000 if you’re under 50, or $25,000 for workers 50 and over. As long as you remain under the contribution limits for the tax year, you’re able to invest in one or both types of retirement accounts.
Both enjoy tax-sheltered growth, meaning year-to-year you’re not paying capital gains tax on that year’s realized profits or taxes on dividends/interest generated within the accounts, both are eligible for company matching contribution programs, and both must be funded through an employer.
How are Roth and Traditional 401(k)s different?
When deciding between a Traditional and a Roth 401(k), the main difference to consider is whether it makes more sense to have your taxes taken out now, or later.
At the Time of Deposit
Traditional 401(k) contributions go in pre-tax, meaning less income tax being paid by the employee in the year they make the contribution. Roth 401(k) contributions go in after taxes are withheld from the employee’s paycheck, meaning you still pay income tax on your contribution.
For example, if you make $80,000 and deposit $5,000 in a traditional 401(k), the IRS will view your taxable income for the year as $75,000. If you made the same investment with a Roth 401(k), your taxable income would still be seen as $80,000.
At the Time of Withdrawal
On the other hand, Traditional 401(k)s require you to pay income tax on withdrawals made during retirement, while Roth 401(k) withdrawals are typically made tax-free.
So, if you had taxable income from other sources of $80,000 at age 75 and you took a $5,000 distribution from your Traditional 401(k), you would have $85,000 in taxable income. If you had instead taken that $5,000 distribution from your Roth 401(k) your taxable income would only be $80,000.
Penalties and Restrictions
Pro-Traditional: In most cases, both traditional and Roth 401(k)s require you to wait until you’re 59 1/2 to withdraw funds from your 401(k) penalty-free. However, Roth 401(k) accounts must be held for at least five years, or you may face additional penalties.
Pro-Roth: You may be ineligible for a Roth IRA if you earn above $137,000 for single filers or $203,000 for married filers. Roth 401(k) accounts do not have income limits, so Roth 401(k)s offer an opportunity for high-income individuals to participate in accounts that grow tax-free.
Here’s a brief overview of the differences between a Roth and Traditional 401(k)
|Contributions||Made with pre-tax dollars. Can contribute up to $19,000 in 2019 ($18,500 in 2018). If you are over age 50, you may contribute up to an additional $6,000/year.|
|Eligibility||You must work for an employer that provides a 401k.|
|Taxes on Withdrawals||All withdrawals are taxed at federal and state income tax rates.|
|Penalties||10% penalty on withdrawals made before age 59 ½. There are some exceptions.|
|RMDs||If you are retired, must begin taking RMDs by age 70 ½.|
|Contributions||Made with already taxed dollars. Can contribute up to $19,000 in 2019 ($18,500 in 2018). If you are over age 50, you may contribute up to an additional $6,000/year.|
|Eligibility||You must work for an employer that provides a Roth 401k. There are no income limits like a Roth IRA has.|
|Taxes on Withdrawals||None for qualified distributions.|
|Penalties||10% penalty on withdrawals of earning made before age 59 1/2, with a few exceptions. You can generally withdraw your contributions at any time.|
|RMDs||If you are retired, must begin taking RMDs by age 70 ½.|
Which 401k is right for you?
Expecting a higher tax rate in retirement is the main reason to go Roth. So how do you know if your tax bracket will change? Unfortunately, you don’t. The government could increase or decrease taxes. Or, you could be making a lot more or less in retirement than you imagine. However, you can make some educated guesses.
As a rule of thumb, if you’re early in your career, it’s likely your taxes will be higher in retirement. If you’re in your high-earning years and approaching retirement, it’s likely your retirement income and tax bracket will be lower in retirement.
There are quite a few other factors to consider that should be discussed with your financial advisor as everyone’s situation is unique. For example, in some instances a person that wants to retire early, say age 50, might benefit from purely pre-tax contributions, then once they retire, if they are in a low tax bracket, they can do annual Roth conversions to take advantage of the low tax rate and ideally have little to nothing subject to RMDs by the time they hit age 70 and 1/2 years old. Again, every situation is unique and there are no one-size-fits-all solutions to the Roth versus traditional debate.
Next steps for your 401(k) plan:
- Are you currently participating in your employer’s 401(k)? Refresh on the plan’s details if you are – or start contributing if you aren’t.
- Does your company offer a “match” program? Make sure you’re contributing enough to at least earn all the match your employer is offering. Don’t leave free money on the table.
- Is the Roth option available? If so, it’s time to think about whether a Roth makes sense.
- What are the investment options in your 401(k)? And when’s the last time you brushed up on them? Try our Personal Capital Investment Checkup tool to see if those investments are right for you or schedule a free consultation with one of our dedicated financial advisors to receive customized advice on your 401(k) options.
- Have you maxed out your 401(k)? If you’re able to contribute more to your 401(k), consider doing so. If you haven’t maxed out your contributions this year, you may have until your tax return deadline to set up and make contributions for the previous tax year.
- Consider alternative Roth funding options with your financial advisor.
- Use Personal Capital’s fee analyzer to see if your employer-sponsored plans are costing you more than an IRA which could offer you more freedom of choice. If you are not receiving an employer match, you might be better off investing in an IRA account over your 401(k), or a combination of the two.
Whether you’re looking for additional tax deductions or just a way to boost your savings, talk to your Personal Capital financial advisor about which investment option is right for you. Once you retire, you’ll be glad you made the right decision.
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