If your company offers a 401(k) retirement savings plan, as most do, one of the big questions you may have to answer is this: Which version do you want—traditional or Roth?
Although it's not quite as prevalent, the newer Roth variety is growing in popularity. About 70% of employers who offer 401(k) plans include it as an option, but only 23% of employees choose it.
The question is whether you will contribute to your retirement in pre-tax money or post-tax money. The short answer is that saving pre-tax money in a traditional plan is easier now, during your working years, but saving post-tax money in a Roth can earn you greater wealth for your retirement years. Below are the factors that should go into your decision.
- A Roth 401(k) uses after-tax dollars to grow retirement assets tax-exempt.
- Because of this, a Roth 401(k) does not give a current tax deduction for your income taxes. But, if you can bear the immediate hit to your take-home pay, the Roth may be your best choice.
- If you expect to be in a lower tax bracket after retirement, the traditional 401(k) may suit you.
- If you can't decide, consider splitting your savings between the two types of accounts.
Lower Taxes Now or Tax-Free Income Later?
The Traditional Account
When you opt for a traditional 401(k) plan, your employer deducts the amount you choose to contribute before it even shows up in your paycheck. On paper (and the paper is the IRS income tax form), that means your gross income has been reduced by the amount you pay in. And that means the taxes you owe from week to week go down a bit too, softening the blow of your pay being reduced by your 401(k) contributions.
After you retire and begin withdrawing money from your traditional 401(k), you'll pay ordinary income tax on the amount you withdraw. The taxes are owed on both the original contributions and your investment earnings.
The Roth Account
If you choose a Roth 401(k) plan, your employer deducts the amount you choose from your net after-tax income. That means no deduction and no reduction in your taxable income. For example, if you choose to contribute 3% of your salary, that 3% disappears from your take-home pay after it's already had income tax taken out of it.
Now for the good part. Once you retire, you'll owe no income tax on the money you withdraw from the account. Because the contributions were taxed years ago, they and any investment earnings they generated over the years are tax-free.
In general, you can withdraw your earnings without owing taxes or penalties if:
- You're at least 59 ½ years old.
- It's been at least five years since you first contributed to any Roth IRA (the "5-year rule").
The 5-year rule applies regardless of your age when you opened the account. If you are 58 years old when you make your first contribution, for example, you still have to wait until age 63 to avoid taxes.
The clock starts ticking on Jan. 1 of the year you made your first contribution to any Roth. Because you have until April 15 of the following tax year to make a contribution, your five years might not be a full five calendar years.
For example, if you contribute to your Roth IRA in early April 2020—but designated it for the 2019 tax year—you'll only have to wait until Jan. 1, 2024, to withdraw your Roth IRA earnings tax-free, assuming you’re at least 59½ years old.
Roth 401(k) and Estate Planning
Let's say you have no intention of retiring at an early age or any age at all. You
want to keep the money in your 401(k) for the distant future when you really need it. Or, you'll have plenty of other sources of income in retirement, and you want the 401(k) funds earmarked for your surviving family and loved ones.
Roth 401(k)s offer a distinct advantage in estate planning. Heirs will benefit from the tax-free treatment of money in a Roth 401(k) just as the original owner would have.
If you do retire, and have to start taking distributions from the Roth 401(k), you can roll it over directly into a Roth IRA (either a new one or an existing one), and make your heirs the beneficiaries. That will preserve the tax-free status of the funds for them. Although they will have to start distributions from the IRA when they inherit it, the money won't be taxed.
Why Not Consider a Split?
This doesn't have to be an either/or decision. You can split your savings between a traditional 401(k) and a Roth 401(k). You can roll over your traditional 401(k) into a Roth when you can afford it (though you'll owe the taxes on your contributions upfront).
If you split your money between the two types of accounts, the financial pros will tell you that you're hedging your investments. That is, you can't say realistically whether your tax rate will be higher or lower when you retire. This way, you're guaranteed some tax-free and some taxable income.
A more mundane explanation might be that you can afford a little loss of post-tax income, but not a lot. Hence the split between Roth and traditional 401(k) plans.
The Bottom Line
So, which plan works better for you? Factors to consider include the following:
- Can your budget handle the strain of a smaller take-home paycheck? If you can, the Roth 401(k) may be the better choice. If not, opt for the traditional type.
- Do you expect to be in a lower tax bracket after you retire? Many people are. If so, the taxes you will owe on your withdrawals isn't as big an issue, and the traditional 401(k) may be better for you. If the opposite is true, then the Roth version has advantages.