Employer sponsored retirement plans often comprise a large portion of an individual’s retirement assets. And it’s no wonder! Making contributions to those plans is virtually thoughtless, happens automatically, and they are made consistently with every paycheck. Not to mention the employer contributions that are usually built into the plan! That said the 401(k) retirement plan in particular has become the de facto replacement for the old pension plan system.
Despite being the most well-known retirement plan option in the country, many people still have questions about these types of plans and are unaware of their options. Specifically, many people have never heard about “Roth 401(k)” much less have any idea what that means! Although Roth 401(k) contributions came into existence in the early 2000s, they have seen an increase in popularity in the last decade . This option allows plan participants to designate their retirement plan contributions as Roth contributions. The easiest way to understand this is that contributions designated to a Roth 401(k) are made after taxes have been taken out. This is different from a traditional 401(k) where contributions are made pre-tax. So, which type of contributions should I be making? Normal 401(k) contributions or Roth? Well, just like many things in life, it all comes down to taxes.
In addition to saving for retirement, the second important aspect of a traditional 401(k) plan is the ability to make contributions pre-tax. This means that all of your contributions are excluded from your current income thereby deferring taxes on those dollars. Roth 401(k) contributions do not have the same effect on your current income. Rather, your entire paycheck is subject to your normal tax withholdings before the contribution is made to your retirement account. This means that by making Roth 401(k) contributions you do not receive the same current tax deduction that you would by making traditional 401(k) contributions. If you are in a lower marginal tax bracket (say 10 – 22% for example) this might not make much of a difference to you. However, if you are in a higher marginal tax bracket that could make a big difference to your current income! (Check your tax bracket here)
The benefit of a Roth 401(k) shows up when you go to make withdrawals from your account in retirement. In exchange for paying taxes on your contributions, you now have the ability to make withdrawals completely tax free once you have reached age 59 ½. This includes not only the amount of your original contributions but also any gains that your account made over the course of your career. By contrast, all withdrawals from a traditional 401(k) plan are taxed as ordinary income. This includes both your contributions as well as investment gains. Essentially, the Roth 401(k) provides you with tax-free investment growth and retirement income in exchange for paying taxes in the hear and now, while the traditional 401(k) offers tax deferred growth now for taxable income later.
Which is better?
Neither option is inherently better than the other but there may be an option that is better for you depending on your current income level and your projected income in retirement. As I mentioned before, if you are in a lower income tax bracket, your need for income tax relief is likely fairly low. If you are in a higher tax bracket, traditional 401(k) contributions can help to lower your current taxable income which may make this a better option for you.
On the flip side, if you are in a lower tax bracket now but expect your income to rise (particularly in retirement) then taking advantage of the Roth 401(k) makes a lot of sense. This would mean paying a lower tax rate on your income now and then withdrawing your contributions (+ investment growth) tax free! Additionally, if you are of the opinion that tax rates are going to rise over the course of your life (not an outlandish prediction) then that is also a case for the Roth 401(k).
In conclusion, the Roth 401(k) option is a great tool particularly for those in the 10% - 22% marginal tax bracket as well as those expecting to be in a higher tax bracket when they retire. Of course, every individual is different and the rule of thumb for one person might be entirely wrong for another. That said, we are by no means tax advisors so I highly suggest that you speak with a professional more suited to help you make those determinations!
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Today’s song of the week is a cheesy 90s country song. Enjoy!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.