Choosing Between a Roth 401(k) and a Traditional 401(k)

Daniel Penzing
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No Income Limitations

One of the most appealing features of the Roth 401(k) is that there are no income limitations. If your employer’s 401(k) plan offers a Roth option, there isn’t a maximum taxable income that prevents you from having one. In other words, if your employer offers a Roth option, you can contribute to a Roth 401(k) even if you’re making quite a lot of money.

You Must Make Your Contribution in Income for a Traditional 401(k)

The ideal situation is that you have a lower income and contribute to a Roth 401(k). However, it’s not always the case. You might have an income that’s too high to contribute to a Roth plan. In that case, you’ll typically contribute to a traditional 401(k) plan.

The great thing about traditional 401(k)s is that they have employer contributions. You can set it up such that your employer’ll put money into your traditional 401(k) on a pre-tax basis. This way, you’re not only saving on federal taxes, but you’re also saving on state taxes.

Taxes Now or Later?

Making the decision between contributing to a traditional 401(k) plan or a Roth 401(k) plan is one of the most important decisions you can make before retirement.

While both of these accounts will grow tax-free, with a Roth you will pay taxes now and be able to access those funds tax free later in life. If you choose the traditional 401(k), you will pay the taxes on contributions today and be able to withdraw those funds tax free later.

Before making this choice, you will want to figure out a few things.

How much will I need to retire comfortably?

When will I need to begin making withdrawals?

What is the tax rate I will be in when I need to begin drawing funds?

This is because each of these options can result in a higher or lower quality of life in retirement.

If it is more likely that you will be in a higher tax bracket when you begin taking retirement funds, a Roth 401(k) is a good choice. This is because you will already have paid your taxes upfront and will be able to continue to grow your retirement funds without paying any more taxes. If you believe that you will be in a lower tax bracket in retirement or do not believe you will be required to withdraw funds in your lifetime, a traditional 401(k) will likely result in the most tax-efficient outcome.

Tax Diversification

If you have an IRA, you can invest in both a Roth and a traditional account. The best strategy to take with those accounts is to split them up based on how soon you plan to make withdrawals and the type of investments you’re comfortable with.

If you’re young and you have a lot of time to ride out the market fluctuations, go with a Roth. But if you’re closer to retirement age or you don’t have a lot of time to ride out dips and dives in the market, stick with a Traditional. It’s that simple.

From a tax standpoint, this advice can be a little tricky, though.

You won’t get any immediate tax benefits from the Roth, but your money will be tax-free in retirement.

With the Traditional, your money will be out of your hands for tax purposes immediately, but you’ll get a nice tax deduction upfront. The benefit of this deduction, of course, is that you’ll be able to shave off a nice chunk of income on your taxes in the year in which you contribute to the account.

Planning Opportunities

Employers often sweeten the pot to attract great employees, and a 401(k) plan is a great way to sweeten the pot.

Employers often offer 401(k)s as a way to add to overall employment package.

Roth 401(k) contributions don’t count toward income limits for eligibility.

Non-workplace Roth 401(k)s may be beneficial if you are still undecided at the end of the year about your contributions.

401(k) plans are available to the self-employed.

Summary

The decision between a traditional 401(k) and a Roth 401(k) plan can be confusing. They are similar, but not identical, which can add to the confusion. Both types of 401(k) accounts offer a tax break for employees. To help you understand when to choose a traditional 401(k), here is information on the two plans.

A traditional 401(k) plan allows employees to contribute tax-free to a 401(k) account. However, when money is withdrawn from the account, there can be taxes due on the amount of money that has grown. A Roth 401(k) is similar to a traditional 401(k) in some respects. The initial contributions are also tax-free. Withdrawals can't be made before a designated retirement age without incurring a tax penalty. Unlike a traditional 401(k), however, contributions from a Roth 401(k) account are made with post-tax dollars.

Rules of the Program

The plan can be set up by your employer as a new type of retirement plan.

It Must Be a Defined Contribution Plan

Even though employees can rollover their account to a Roth IRA account, the IRS doesn't allow individuals to rollover a traditional 401(k) account to a Roth IRA account after 2010.