As you continue your journey towards building your financial future, one key decision you may be facing is whether to contribute to a Traditional 401(k) or a Roth 401(k). Both options have unique advantages, and your choice depends on your current financial situation and long-term goals.
Here’s a brief overview of each option to help you make an informed decision:
TRADITIONAL 401(k)
- Pre-Tax Contributions: Contributions are made with pre-tax dollars, which can reduce your taxable income for the current year. Understand that deferring taxes now means facing uncertain tax obligations in the future, when both your income level and applicable tax rates may be different and less predictable.
- Tax-Deferred Growth: Investments grow tax-deferred until you withdraw funds in retirement.
- Taxable Withdrawals: Distributions are taxed as ordinary income when you retire. If you withdraw money from a traditional 401(k) plan before you turn 59½ (age 55 if you separate from your current employer), you pay taxes and may potentially owe a 10% penalty on the entire distribution.
- Required Minimum Distributions (RMDs): Mandatory withdrawals from a traditional 401(k) must begin by April 1st following the year you turn 73 (or 75 if born in 1960 or later). If you are still working for the same employer when you reach your required beginning date and are not a 5%+ owner, you can defer your first RMD until April 1st following the year you retire.
ROTH 401(k)
- After-Tax Contributions: Contributions are made with after-tax dollars, meaning you pay taxes on the money before it goes into your account. By paying taxes on that money now, you’re shielding yourself from a potential increase in tax rates by the time retirement rolls around. However, the contribution and taxes will reduce your paycheck by more than a traditional 401(k) contribution.
- Tax-Free Growth: Investments grow tax-free.
- Tax-Free Withdrawals: No tax is owed on qualified withdrawals, making it an attractive option for those anticipating higher tax rates in retirement. Non-qualified withdrawals are a pro-rata amount of your contributions and earnings, and you may potentially be subject to the 10% early withdrawal penalty on funds that are considered gross income. To be a “qualified distribution”:
-
- You must be at least 59½ (or have died, become disabled, or age 55 and separated from your current employer), and
- At least five years must have passed since the first day of the calendar year in which you first made a Roth contribution to the retirement plan.
- No Required Minimum Distributions (RMDs): Roth 401(k)s are not subject to RMDs during your lifetime, which allows those assets to have the opportunity to grow tax-free for longer and provides greater flexibility in retirement.
To make the best decision for your unique circumstances, consider these questions:
What is your current tax bracket? Do you anticipate being in a higher tax bracket in retirement?
If you expect your tax rate to be higher in retirement than it is now, a Roth 401(k) may be advantageous. Conversely, if you anticipate a lower tax rate in retirement, a Traditional 401(k) might be more beneficial.
How long do you plan to work?
Think about your retirement goals and how the flexibility of tax-free withdrawals from a Roth 401(k) could align with those plans. Consider your retirement income needs and the potential impact of taxes on your overall financial plan. Longer-term investors may benefit more from the tax-free growth of a Roth 401(k).
Are you eligible to make Roth IRA contributions?
This may be an alternative way to accumulate Roth dollars – through a Roth IRA.
- You are eligible if you have an annual earned income below a certain level ($161,000 for a single tax filer in 2024).
- You can contribute the lesser of $7,000 or up to your total earnings.
- Contributions to a Roth IRA account are not tax-deductible.
- Roth IRAs do not have required minimum distributions.
- Note that you can withdraw your contributions to a Roth IRA at any time; however, you will pay taxes and penalties on any earnings withdrawn before age 59 ½, subject to certain exceptions.
If your employer offers both a Roth 401(k) and a traditional 401(k), you can contribute to both. You can’t really know what future tax rates will look like, so building the flexibility to use multiple accounts to manage taxes in retirement is important and helpful. However, keep in mind that your annual contribution limit would apply across both accounts.
With their tax-free earnings and large contribution limits, Roth 401(k)s can be a useful addition to the retirement-savings toolbox. Ultimately, the best choice for you depends on your individual circumstances and financial objectives. Remember, your retirement savings decisions are personal, and there’s no one-size-fits-all answer. By carefully evaluating these factors and your financial situation, you can make an informed decision about whether a Roth or traditional 401(k) is the right choice for you.
Take Action Now!
- Review your contributions based on your current tax and financial situation. Reassess when your circumstances change, e.g., when you receive a raise, or your tax filing status changes.
- Does your employer offer a 401(k) match? If so, this is a “free” contribution, so do your best to maximize this benefit. An employer-match calculator can help calculate the monthly contribution to your retirement savings.
- Know your company’s vesting schedule. If you change jobs, you could forfeit a portion of your 401(k)-matching contribution.
- Understand if you are eligible to make Roth IRA contributions. This may offer another way to accumulate Roth dollars if you elect to contribute to a traditional 401(k).