In recent years, an increasing number of employers have been offering Roth 401(k) Plans or have been allowing their employees to contribute to both Traditional and Roth 401(k)s. Since this has become more and more common, you may face the question:
Which option is best for me?
The answer is not as cut and dry as some might think. There are a number of factors to consider when deciding which option may be best for you. Before we examine them, let’s backtrack a little to cover some of the fundamentals of retirement savings plans and why it is imperative to have a basic working knowledge of them.
401(k) retirement plans are sponsored by employers – in layman’s terms, you can save for retirement with the help of your employer. The amount you contribute varies from employer to employer, with the most common method being that they match the amount you contribute to the plan, dollar for dollar, up to a certain limit. In other cases, the employer only provides the 401(k) plan as an option for you to contribute to, but they don’t actually contribute any additional funds into the account.
So why is this important? You can contribute a maximum of $18,000 and your employer can contribute up to $36,000 on top of that, with a total of $54,000 maximum contribution between both parties in the 401(k) account. With the help of your employer, you can potentially more than double the amount you put toward retirement each year rather than if you were to simply put that same $18,000 in a personal savings or investment account.
The most significant difference between a Roth 401(k) and a Traditional 401(k) is how the contributions will affect your taxable income that year.
The contributions you make in a Traditional 401(k) are made with “pre-tax” dollars, meaning you don’t pay taxes on the amount you put into your account. Instead, you pay taxes on the money when you withdraw from the account.
These pre-tax contributions will lower your taxable income. For example, if you make $100,000 this year and contribute $10,000 of your income to a Traditional 401(k), you’ll pay income taxes on $90,000 rather than the full $100,000.
On the contrary, Roth 401(k) contributions are made with “after-tax” dollars, meaning you pay taxes immediately on the amount you contribute to the plan (i.e. it does not reduce your taxable income the year the contributions are made).
However, when you withdraw the contributions later, they come out tax free. Additionally, any interest, dividend income, or capital gains generated in the account can also be withdrawn tax free during retirement.
Having a blanket answer for when to contribute to either retirement plan completely disregards a number of factors and situations. Before you decide on which type of 401(k) to contribute towards, consider these three common factors.
1. Planning for the Long-Term
Will my income increase significantly during my retirement years?
The amount of taxes you pay will vary depending on the level of income you have. The United States has a progressive tax system, meaning the lower your income, the less you will have to pay in income taxes.
If you have a high level of income now and do not expect it to get much higher by the time you retire, a pre-tax Traditional 401(k) retirement plan may be most advantageous for you. Since your income isn’t expected to increase significantly by the time you retire, the amount of taxes you pay when you take money out at retirement may be either around the same as you are paying today or even lower.
If you anticipate that your income will be higher during retirement than it is today, contributing to an after-tax Roth 401(k) retirement plan may be more advantageous for you because you may be able to withdraw money tax free during retirement; thus, helping you reduce your future tax liability.
2. Planning for Year to Year Anomalies
Should I always stick to contributing to one account?
Long-term planning aside, knowing when to contribute to either account if your taxable income fluctuates from its normal level is imperative for tax-planning purposes.
For example, you may want to consider contributing to a Traditional 401(k) if you receive a large bonus that would bump you up to the next tax bracket that year. In the next year, you can switch back to contributing to a Roth 401(k).
3. Planning for Regular Years
Can you split contributions between accounts?
Don’t limit yourself to only contributing to one account each year – it may be savvy of you to split your contributions between accounts if your employer offers the option. You can change your 401(k) contribution options on a payroll period basis; however, keep in mind you can only contribute a total of $18,000 between the two accounts annually.
Some companies will only match if you contribute to a Traditional 401(k) plan, not to a Roth 401(k). Before you make any changes to your contributions, be sure to consult with your HR department or the administrator of your 401(k) plan.
All in all, a Roth 401(k) is no better than a Traditional 401(k). Whether you should contribute to one or the other boils down to how much tax liability you may face each year. Keep in mind that just because a Traditional 401(k) is best for you in one year, it does not mean it’s best for you every year. Review your tax planning each year to make sure you are reducing your tax liability and taking full advantage of all your tax sheltered accounts.
Lastly, it is wise to consult with a CPA or tax advisor to accurately estimate the tax liability you may potentially face each year. Then, you can make a more sound decision on whether a Roth or Traditional 401(k) is best for that year.