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: Traditional or Roth?
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 get you greater wealth in your retirement years.
- 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.
The Roth option is growing slowly in popularity. About 70% of employers who offer 401(k) plans include it as a choice, but only 19% of employees opt for it.
Below are the factors that should go into your decision.
Lower Taxes Now or Tax-Free Income Later?
When you opt for a traditional 401(k) plan, your employer deducts the amount you choose to pay in from your gross salary. On paper (and the paper is the IRS income tax form) your gross income has been reduced by the amount you pay in. The amount you owe in taxes from week to week goes down a bit, softening the blow of the income you've stashed away.
You must begin withdrawing money from a traditional 401(k) at age 70 1/2. A Roth account does not have that requirement.
After you retire, you'll pay regular income tax on the amount you withdraw. The taxes are owed on both the original contributions and your investment earnings.
If you choose a Roth 401(k) plan, your employer deducts the amount you choose from your net after-tax income. If you choose to contribute 3% of your salary, that 3% disappears from your take-home pay (along with the taxes you owe on that chunk of income).
Once you retire, you'll owe no income tax on the money you withdraw from the account. The contributions were taxed years ago, and the investment earnings are tax-free.
Factors to consider include:
- Can you take the strain on your budget of paying the taxes now? If you can, the Roth IRA may be the better choice.
- 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. The traditional IRA may be better for you.
Are You Saving for Your Heirs?
If you have a family, you should consider your 401(k) plan as a crucial part of your estate planning. If something happens to you, they will inherit the money in the account.
Or, 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.
But if your 401(k) is a traditional account, you must begin withdrawing money from it at age 70 1/2. It's called a required minimum distribution (RMD), and if you fail to take it, the IRS will slap a humongous 50% penalty on the money. The amount you must withdraw is based on a complicated formula that includes your life expectancy and your account balance.
If it's a Roth, there is no required minimum distribution at any age. (If your heirs get the account, they will be subject to an RMD but at least it will be tax-free money.)
Factors to consider:
- Do you hope to be able to preserve the balance in your 401(k) and keep it growing so that it will be available to your heirs?
- Alternately, do you hope to keep working well into your senior years and are saving for a remote future need?
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 up front). Or, you can roll over your Roth 401(k) into a traditional account (in which case your previous taxes paid on the income will be credited to the new account).
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.