When it comes to planning for your retirement, there’s a lot to look forward to — travel, relaxation, developing new hobbies, sharing time with loved ones. While retirement can be an incredibly rewarding experience, getting to that destination can be a bit confusing, especially if you’re signing up for your first 401(k) or your employer’s plan provides options you’ve never heard of before.
One of those options might be deciding between traditional 401(k) contributions or Roth contributions. Roth 401(k) contributions have become more popular over the past few years. In fact, approximately 76% more employer-sponsored plans offered Roth as an option in 2020 compared to just a decade prior.¹ While having the option to choose is an added benefit for employees, many are still unclear of the actual differences between these two choices and, more importantly, how they can benefit from them.
Below, we’ve spelled out the important differences between traditional and Roth 401(k) accounts and considerations to keep in mind when creating your retirement savings strategy. In this post, we’ll cover:
Retirement plans like your 401(k) or an IRA are what are known as tax-advantaged accounts.
What’s a tax-advantaged account?
A tax-advantaged account is any type of account or savings plan that offers tax savings by:
Other tax-advantaged accounts you might be familiar with include health savings accounts (HSAs) and flexible savings spending accounts (FSAs), which can be used to help manage your healthcare costs.
What’s the catch?
There are limitations to just how much one can take advantage of these types of accounts. Typically, these limitations come in the form of how much you can contribute to the account each year.
The IRS refers to an employee’s contributions as “elective deferrals” (because you’re voluntarily deferring a portion of your paycheck) and the limit is reviewed and updated based on cost of living adjustments annually.
So, what exactly am I deciding between?
When it comes to your tax-advantaged retirement accounts, the individual can decide whether they want to get the tax advantage today (traditional) or if they want to enjoy that benefit in retirement (Roth).
Traditional vs. Roth 401(k):
You have questions, we have answers. Let’s break it down together:
What is a traditional 401(k) contribution?
Traditionally, 401(k) contributions have come from individuals’ paycheck on a pre-tax basis. This type of contribution is commonly known as a traditional or pre-tax 401(k). Your Guideline participant dashboard refers to this method as “pre-tax.”
What does ‘pre-tax basis’ mean?
When you contribute pre-tax funds from your paycheck to your 401(k), that money comes out before income taxes have been paid. This means that the IRS will tax these funds, including all gains and earnings, when the individual receives a distribution (or withdraws funds in retirement) from the plan. The federal and state taxes, if any, incurred are based on the retiree’s tax bracket in the year they receive their distribution.
What does that mean for me?
Traditional contributions lower your taxable income today by the amount you contribute. When you take your distribution in retirement, you will owe taxes on the amount you withdraw, based on your tax bracket in the year you withdraw.
When do I get that tax advantage?
When you make contributions to a traditional 401(k) account, you receive that benefit ‘today’ via a tax deduction on the amount contributed. Those amounts continue to grow tax-deferred, and when you withdraw in retirement, that’s when you’ll pay taxes on 100% of your withdrawal.
What is a Roth 401(k) contribution?
Roth 401(k) contributions, introduced in 2006, allow employees to contribute on an after-tax basis.
What does ‘after-tax basis’ mean?
This means that you will be paying federal and state taxes on your earned income before you contribute today, instead of when you withdraw from the plan in retirement. The amount deducted from your paycheck will be taken out after taxes have been paid, and therefore does not lower your taxable income today.
What does that mean for me?
While you won’t be taxed on qualified withdrawals in the future, it does mean your contributions will take a bigger bite out of your paycheck today. When you receive your qualified distribution (or, withdraw funds in retirement), you will not owe any additional taxes — on what you contributed or on any earnings from interest. Roth contributions are popular with individuals who believe they are in a lower tax bracket now than they will be in retirement.
Am I eligible to make Roth contributions?
As long as your employer offers it as an option, you can elect Roth contributions for your 401(k). Unlike a Roth IRA, there are no income limitations in place that may exclude you from choosing that contribution method. Guideline 401(k) plans accommodate both Roth and traditional contributions. If you’re not able to benefit from the tax savings associated with a Roth IRA because of your income, making Roth contributions to your 401(k) is a way to diversify your tax strategy.
When do I get that tax advantage?
When you make contributions to a Roth account, you receive that benefit in retirement.
Which one is right for me?
There are benefits to both Roth and traditional methods of contributing, and there’s no ‘one-size-fits-all’ approach. Everyone has different needs and preferences when it comes to their personal finances, and you should consider what you are comfortable with when deciding what’s right for you. Here are some questions you should consider when creating a contribution strategy that’s right for you:
How long until you are planning to retire?
It’s helpful to think about whether you think you will be in a higher tax bracket in retirement. As you continue to grow in your career and earn a higher salary, your tax bracket will inevitably increase.
Depending on the income you will be earning in retirement (whether from Social Security, withdrawals from your retirement accounts or other investments, or even continued income), it’s possible for your tax bracket to be higher in retirement than it is before retirement. While that may sound counterintuitive, remember that retirement is your opportunity to reap the rewards of your hard work (and those gains from compounding interest.)
Individuals earlier in their careers often consider the benefits of Roth contributions given their (likely) lower tax-bracket today and the opportunity for the investments and compounding interest to grow completely tax-free. It’s like visiting an amusement park for the first time, and you can choose to pay an upfront fee to ride all the rides, or pay per ride once you’re inside. With Roth, you’re choosing to pay the upfront fee and enjoy the rides in perpetuity during your retirement (with no additional taxes paid).
As you near retirement and plan to withdraw, the benefit associated with Roth begins to get smaller since you have more visibility into your income at retirement and the tax bracket you’ll likely be taxed at. Additionally, there is less time for your earnings on interest to grow tax-free. To expand on the amusement park example, you now know what rides you want to ride and how those costs compare to paying the upfront fee, so it may make more sense to pay-as-you-go (i.e., pay taxes on what you withdraw) at this point.
What can your budget accommodate?
If you were to contribute the same amount (let’s say 5%) to your 401(k) via Traditional or Roth, your take-home pay would be higher if you opted for Traditional. Depending on your expenses and financial plans, that might be more important for you.
If you are not as reliant on that money today, and prefer that your retirement savings be ‘out of sight, out of mind,’ Roth contributions are a way to save a bit more for tomorrow (remember: you will have already paid taxes). Your contributions and earnings on interest will grow tax-free and you won’t be tempted to spend that money you’ve ‘earmarked for retirement’ in your checking account. Moreover, when you make a qualified withdrawal from a Roth account, you won’t owe any taxes. Think of it like a gift to ‘future you’.
In contrast, when you withdraw from a Traditional account when you retire, you will owe taxes on everything you withdraw – there’s no delineation between your contributions and your earnings.
Did you know you can opt for both?
With any investment strategy, diversification can help you get where you want to go. There is no sure way to know whether your taxes will be higher or lower in retirement, so having a mix of traditional and Roth contributions is a great way to hedge against that unknown.
Does your employer contribute to your 401(k)? Until further notice, the IRS requires that any employer contribution (like a match) is made using the traditional contribution method, even if you choose to make Roth contributions. This is an easy way to diversify your retirement savings and have both tax-free and taxable savings to pull from in retirement.
Whether you’re just setting out on your road to retirement or you’re well on your way and considering diversifying the path you take to get there, it’s never too early (or too late) to start setting your future self up for success.
The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax advice that considers all relevant facts and circumstances. You are advised to consult a qualified tax professional before relying on the information provided herein.
¹ This 76% growth rate is an approximation based on the 37% percentage point increase of Roth plans from 49% in 2010 to 86.3% 2020, as provided by Plan Sponsor Council of America. Learn more.
² Roth distributions will be tax-free if the following conditions are met: (a) you’re over age 59 1/2 AND (b) it has been 5 years since your first deposit.
This content was originally published here.