Traditional or Roth 401(k): Which is Best for You?
A commonly asked question in personal finance is whether one should contribute to a traditional or a Roth 401(k). To put it simply, a “traditional” 401(k) is funded with pre-tax funds, while a Roth 401(k) is funded with after-tax funds. The biggest difference is when you pay taxes.
Many employers now offer the Roth 401(k) alongside the traditional version. If yours does, where should you contribute? Here’s a quick breakdown..
How They Work
Let’s say George received $100 in income. He contributes it to his 401(k) without paying any taxes. Over the years the account grows 4x from $100 to $400. When George retires, let’s assume he will be in the 30% tax bracket. Here’s how much he would have:
$280 = ($100 x 4) x 70%
Now let’s pretend Amy’s income is $100, but she has to pay 30% in taxes, leaving her with $70 to contribute. She invests it directly into the Roth where it grows 4x by time she retires. Here’s how much she would have:
$280 = ($100 * 70%) x 4
Both George and Amy end up with $280 in retirement spending. The only difference between the two is when they paid the taxes. George paid them at the end and Amy paid them in the beginning. This is why it really doesn’t matter which you contribute to if you don’t expect any change in your tax rate.
When the Roth 401(k) is Better
Low Tax Bracket
If you are confident you’ll be in a higher tax bracket in the future, the Roth 401(k) is a good choice. You can do this by estimating how much income you will need in retirement and where you plan on taking that money. This will help give you an idea of your future tax bracket compared to your current.
If you expect an increase in taxes, opting for a Roth 401(k) might be a better option. This increase could be from changes in federal, state, or local income taxes. Unfortunately, no one knows for certain what tax rates will be in the future.
Maximize Tax Deferred Savings
By maxing out your Roth 401(k), you are placing more total dollars in a tax-advantaged account than a traditional 401(k). Let’s say you contribute the maximum amount, which is $22,500 in 2023. By choosing the Roth 401(k) the full balance is tax-free. If you choose the traditional 401(k), you would still owe taxes on any distributions.
When the Traditional 401(k) is Better
High Tax Bracket
Because the traditional 401(k) gives you a tax deduction on contributions today, it can make sense to use if you are in a high tax bracket. Individuals in their peak earnings year will likely be in a higher tax bracket now than during their retirement.
With the traditional 401(k) you have more control when you pay your taxes. For example, if you have a year with low income, you can use this time to convert your traditional 401(k) to Roth IRA at a lower tax rate.
Besides timing, you can also change where you retire in order to avoid taxes. For example, you might be living in New York now but plan to retire in a different state. You can choose to pay your taxes when you are in a low or no income tax state.
The good news when it comes to a traditional vs Roth 401(k) is that it doesn’t have to be an all or nothing choice. You may be able to decide year-by-year as your circumstances change. This enables you to enjoy the benefits and flexibility that come with both types.
I hope you found this guide as a useful starting point to determining what is the right choice for you. If you have any questions please do not hesitate to reach out.
Disclaimers / Sources:
Roth 401(k) Early Withdrawal example from Investopedia:
For example, if your account balance is made up of $9,000 in contributions and $1,000 in earnings, then your earnings ratio is 10% ($1,000 ÷ $10,000). In this case, a $4,000 withdrawal would include $400 in taxable earnings. This $400 would need to be included in the gross annual income reported to the IRS on your taxes. There’d also be a 10% tax penalty on the $400. There are no taxes or fees assessed to the other $3,600.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.