One of the most common questions I receive from people wanting to start contributing to a 401(k) is which type is “better” – Traditional or Roth. The truth is, one is not necessarily better than the other for everyone. The right type of 401(k) will depend on your personal situation. Here’s an overview of how Traditional and Roth 401(k)s work, how they’re different and which situations they’re best suitable for.
Traditional 401(k)s work by the employee specifying a fixed percentage to be deducted from their paycheck and deposited to a retirement account created by their employer. Then the funds are invested in stocks and bonds – that you have chosen based on the right asset allocation approach for you – for future growth to fund your retirement. If an employer offers a company match, these proceeds will also be invested in the Traditional 401(k) account.
Traditional 401(k) contributions are made on a pre-tax basis, which simply means that income taxes are not withheld on those amounts set aside for retirement. Instead, you pay income taxes when you take a distribution payment from the Traditional 401(k) when you retire.
Roth 401(k)s work similarly to Traditional 401(k)s in that employees also specify a fixed percentage to be deducted from their paycheck and deposited in an employer-created retirement account. However, the major difference that comes with Roth 401(k)s is that contributions are made on an after-tax basis. This means that taxes are withheld on the amounts you contribute to your retirement fund, and the net amount after withholding is invested for future growth. When it comes time to take a distribution payment from the Roth 401(k) after you have retired, no income tax is due – it was already paid when you set the money aside earlier.
Keep in mind, even if an employee contributes to a Roth 401(k) and they are eligible for an employer match, the employer’s contributions will be placed into a Traditional 401(k) plan and will be taxable upon withdrawal.
Choosing the Best Option for You
Now that you understand the difference, which 401(k) should you choose? This answer largely depends on income tax rates. If you expect income tax rates to increase in the future, a Roth 401(k) contribution makes more sense, as it’s better to pay the lower income tax rate today and avoid the higher income tax rate in the future when you are retired and begin taking distributions. On the flip side, if you expect income tax rates to decrease in the future, a Traditional 401(k) contribution is preferable.
Additionally, if you expect to earn a much higher income in the future than right now, which would bump you to a higher income tax bracket down the road, it may make more sense to contribute to a Roth 401(k) to take advantage of the lower tax bracket you’re in now.
Without a crystal ball, it is difficult to know what approach is best for you. You might consider hedging your bets and making both Traditional 401(k) and Roth 401(k) contributions. For example, you could split your 10% 401(k) contribution and put 5% in a Traditional and 5% in a Roth, if your plan allows. Be sure to consult with your accountant/tax preparer, a wealth advisor and your Human Resources representative for more details.
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