Roth 401(k) vs. Traditional 401(k)
A Brief History of the Roth 401(k)
Though Roth IRAs had been available since 1997, it wasn’t until 2006 that the 401(k) Roth contribution option was made available to all 401(k) plans. At that time, there was a rush to add the Roth 401(k), and in many cases, it even became the primary funding type for a large percentage of 401(k) plans. The reason for this rush toward Roth 401(k)s was the thinking that taxes were at a historical low and they were likely to increase in the future.
How Can You Contribute to a Roth 401(k)?
Aside from employer contributions (Match or Profit Sharing) and possible loan repayments, there are two main ways to contribute portions of your pay into your 401(k) account:
· Before tax (traditional pre-tax deferral)
· After tax (Roth contribution made from after tax pay)
With the traditional deferral (before tax), a participant decides to delay taxes until they begin withdrawing money from their 401(k) account. No money is taken out for taxes at the time that it is contributed to the 401(k). When they decide to retire and begin withdrawals, they are taxed at the tax rate in the year of the distribution.
A person who chooses to contribute 100% of their deferrals as traditional pre-tax deferrals is, in a way, “betting” that their tax rate will be lower in their retirement years. They want to capture their tax benefit in the current period. Traditional pre-tax deferrals reduce taxable income by the amount of the contribution (Maximum of $19,000 for 2019; $25,000 for those over 50). However, as we mentioned, they will be taxed in the distribution phase.
On the other hand, a person who chooses to contribute 100% of their deferral to a Roth 401(k) is “betting” taxes will be higher during their retirement phase. They are forgoing their current-period tax deduction. However, at the time of distribution, the funds can be withdrawn tax-free (principal and earnings).
If taxes remain the same, the end tax liability/benefit (Pre or Post) is basically equal.
Should You Choose a Roth 401(k) or a Traditional 401(k)?
There are equal benefits to choosing either a Roth or traditional 401(k) to save for retirement. For instance, people who began contributing 100% of their retirement savings to a Roth 401(k) in 2006 and retired in 2020 may have “bet” incorrectly as taxes were generally lower for most income brackets for 2020.
So which is right for you? Like most important questions in life, it is a personal decision based on your expectations, tax rates, age, and a number of other factors.
However, much like diversifying your investments, having Roth and Traditional savings in your 401(k) plan allows you to control and diversify your taxable income in retirement.
In years where your earnings/taxes are higher, you can draw from your Roth “bucket,” as it does not increase your taxable income. In leaner years, with lower taxes, withdrawing from your traditional “bucket” will have less impact.
To determine if Roth is right for you:
1. Ascertain if your plan even offers a Roth 401(k) contribution option. If not, a Roth IRA may be an alternative option.
2. If a Roth 401(k) is available, speak with your accountant, advisor or tax professional, as they will have the most information regarding your personal financial situation.
3. If you decide to utilize Roth, you can generally execute the change via your 401(k) plan provider website.
4. It is important to note that by utilizing Roth you are NOT opening a new account of any kind. The money that is deposited into your 401(k) account will be identified and labeled as traditional pre-tax, Roth, Employer Match etc, depending on your selections and plan. You will see these as distinctive balances on the web or on your statements.
Again, using or not using the Roth feature is primarily a function of your personal financial situation and objectives.
