The 401(k) is the preferred financial vehicle for saving for retirement, and will likely be your largest asset when you do retire. If you’re starting a new job, participating in your company’s 401(k) plan not only allows you to capture tax advantages, but often includes an employer match of your contributions. As we discussed in #1 of this series, signing up is almost always a great idea.
Recently, many companies have added a Roth option to their 401(k) plans. Should you put your money into a traditional 401(k) or opt for a Roth 401k)? Let’s analyze the differences between the two by first taking a quick quiz:
1. Will I be in a higher tax bracket today, or when I retire?
- Today (generally, high earners and older workers): Traditional 401(k)
- When I retire (generally, low earners and younger people): Roth 401(k)
The most important distinguishing factor between Roth and traditional 401(k)’s is when the money is taxed. If you are a high earner now, you may need the tax deduction in the current year and thus, opt for a traditional 401(k). If you’re in a tax bracket that you believe is lower than your tax bracket will be in retirement due to tax hikes, you may be better off contributing to a Roth, and saving those tax breaks for later. In technical terms, Traditional contributions are pre-tax, Roth contributions are after tax. However, on the other end, Roth withdrawals are tax-free and traditional withdrawals are taxed as income. Generally speaking, a Roth 401(k) is best for low-income and young people, who are likely in the lowest tax bracket of their careers.
2. Is there a chance I’ll need to withdraw before age 59 ½?
- Yes: Roth 401(k)
- No: Traditional 401(k)
The government discourages premature withdrawals from your 401(k), and therefore levies tax penalties on anyone who withdraws prior to age 59 ½, an unqualified withdrawal, aside from a few exceptions.
It’s possible to make an unqualified withdrawal, that is, a withdrawal before age 59 ½ that’s not on the list of exceptions. No matter whether you have a traditional or Roth 401(k), you have to pay income tax on the withdrawal, plus a 10% early distribution penalty. However, traditional withdrawals are taxed on the full amount, whereas Roth withdrawals only tax the earnings.
Hopefully, you will never have to make an early, unqualified withdrawal from your 401(k) and you can let the money grow in your account until you retire. However, life happens and if you want the flexibility of being able to withdraw without as steep a tax penalty, a Roth 401(k) may be a better fit for you. Keep in mind, any employer contributions will be taxed as regular income upon withdrawal, no matter they type of 401(k) you choose.
3. Is there a time (before retirement) when I’ll be making less than I am now?
- Yes: Traditional 401(k)
- No: Roth 401(k)
After separating from your employer there are options both ways for rolling over the funds. However, with traditional 401(k)’s you’ll have a second chance to decide when you want to be taxed, by rolling it to a traditional vehicle or a Roth vehicle. If you roll over a traditional 401(k) to a Roth 401(k) or Roth IRA, you’ll pay income taxes on the amount you transfer, though you won’t pay taxes on withdrawals once you retire. Essentially, with a traditional 401(k), you have the flexibility to decide when you’ll pay taxes on the money. A Roth 401(k) can only be rolled into a Roth IRA, so even if your situation changes, you don’t have an opportunity to change your mind on when you pay taxes. There are many scenarios that fit into the category where converting traditional funds to a Roth makes sense…going back to school, becoming a homemaker, etc. If you time the conversion right, you could avoid significant tax liabilities.
In sum, Roth and traditional 401(k) accounts have similarities and differences. Depending on your current and future tax bracket, need for early distributions, and desire to roll over accounts, one type of retirement account may be more beneficial than the other. One option would be to contribute to both to add to your tax savings flexibility (tax diversification).
The best place to start is with a financial advisor that can dig deeper into your current and potential situation. Our retirement calculators allow us to calculate the benefits of many different scenarios, for clients in all situations. Please feel free to contact us for a free analysis of your financial options and to help connect your choices to your personal situation.