That is a common question. Whether you are enrolling for the first time ever in a 401(k), reassessing your retirement plan mid-career or you are trying to maximize savings while you approach retirement, it’s always a good practice to intentionally look at your savings vehicles. Not all 401(k) plans offer a Roth option, so check with your plan guidelines. But if your plan does, choosing how much to allocate between a Traditional and Roth 401(k) can be daunting, and since over-analysis leads to paralysis, let’s review the differences to help you decide what is best for you.
To start, we’ll discuss the similarities between the two. The 2020 maximum contribution for both the Traditional and Roth 401(k) is $19,500 with an additional $6,500 catch up contribution for those over the age of 50. They are both funded with contributions withdrawn directly from your paycheck. Typically, plans match Roth contributions at the same rate, but employer matches are always made into the Traditional 401(k). For both account types, once you have turned 72 years old, there is a Required Minimum Distribution. The IRS will only allow your money to avoid taxes for so long; they want their money. There is an exception if you still work for the company sponsoring your 401(k), in which case you do not have to take an RMD.
The biggest difference between Traditional and Roth 401(k) is when you pay taxes. Traditional 401(k) contributions are deducted before tax withholding. Your taxable income is lowered by the amount you contribute giving you the tax advantage now. Your contributions and earnings grow tax deferred until you take distributions in retirement. Distributions are taxed at ordinary income levels. There are some exceptions, but if you withdraw money before 59 ½ there is a 10% penalty.
Roth contributions are deducted after tax withholding. Your taxable income is not lowered by your contribution, there is no immediate tax advantage. However, contributions and earnings grow tax free and are not taxed when you take a distribution. Tax free distributions are allowed if you are 59 ½ or older and have funded a Roth for at least 5 years. A Roth 401(k) does not have earning limits like a Roth IRA does, thus allowing high earners to take advantage of a Roth.
As fun as it is to discuss the regulation and tax differences between Traditional and Roth 401(k), how are you supposed to choose what is best for you? The question is how do you maximize the tax advantage? A Roth is most advantageous if your tax rate will be higher in retirement than when you’re contributing to it. Since your crystal ball is in the shop and you can’t predict your future, a general rule to follow is if you are younger in your career and on the lower end of your earning potential, pay the taxes now while you are in a lower tax bracket. The more time your Roth 401(k) has to grow, the more likely you will gain a benefit from tax free growth. There is no way to predict how legislation will affect taxes in the future, but if you expect taxes to increase, a Roth would be a way to combat that. If you are later in your career and near peak earnings, it may be best to take the tax break now with the Traditional 401(k) expecting that your income will decrease in retirement.
You can to contribute to both a Traditional and a Roth 401(k) at the same time. You may split your contributions between the two, which can be beneficial because it allows you to receive the tax advantages of both. There are more intricate details between Traditional and Roth 401(k) and we will discuss those in a later article. Regardless of your choice, the act of saving for retirement is always a good decision and a great step in building wealth.
Wealth Manager & Employee Engagement Consultant