A 401k can be a very effective vehicle for building your wealth for retirement. But investing in a 401k isn’t as straightforward as you might think. In addition to the many investment options available to you, there is another critical decision you’ll need to make: Should you invest in a Roth 401k or a traditional 401k?
As with all financial decisions, there isn’t a one-size-fits-all answer. Many factors will influence whether a Roth or traditional 401k is best for you.
First, Some Similarities
When it comes to building your nest egg, both types of 401k accounts offer advantages. You can make sizable contributions to your retirement account and reap the benefit of compounding growth for decades, assuming you start investing early in your career. Many employers match a percentage of your contributions, which helps to further build your retirement portfolio.
On the other hand, both types of 401k accounts have two limitations:
1. Once you turn 72, you must take Requirement Minimum Distributions (RMDs) each year. (However, with a Roth 401k you have the option to roll the funds into a Roth IRA, which does not have RMDs.)
2. If you take 401k withdrawals before you reach the age of 59½, you’ll pay a 10% penalty. With a traditional 401k, the penalty applies to your entire withdrawal; with a Roth 401k, the penalty only applies to your earnings, not your original contributions.
Where Traditional and Roth 401ks Differ
The primary difference between a Roth vs a traditional 401k involves taxes—specifically, at what point you pay those taxes.
- You fund a traditional 401k with pre-tax money. You aren’t taxed on your contributions in the year you make them, so when you withdraw the funds later, they will be taxed as ordinary income. Your contributions and earnings grow tax-deferred in the meantime.
- You fund a Roth 401k with after-tax money. Since you pay tax on your contributions at the time you make them, you won’t owe any tax when you withdraw those funds later, assuming you are at least 59½ and your account has been open at least five years. Both your contributions and earnings grow tax-free.
At first glance, that may seem like a wash: Pay the tax now or pay the tax later. However, it isn’t that simple. When you pay the tax can impact how much tax you owe.
Should You Pay the Tax Now or Later?
Whether it is better to pay the tax on your retirement contributions upfront (with a Roth 401k) or pay the tax later (with a traditional 401k) depends on several factors. While they’re not hard-and-fast rules, they provide helpful guidelines for determining which type of 401k account may be best for you.
Age. Often, young investors are in a lower tax bracket now than they will be when they retire. With less of a tax break to gain today, those investors may do better by funding a Roth 401k with after-tax money. But if you’re older and further along in your career—and potentially earning more than you expect to in retirement—it may be better to fund a traditional 401k with pre-tax money and enjoy a larger tax break now. Investing the associated tax savings can help your portfolio grow even faster, by putting more money to work sooner.
Current vs projected income and tax bracket. Aside from age, there may be other reasons you expect your income (and tax bracket) to increase or drop between now and retirement. For example, if you plan to retire before you begin collecting Social Security or a pension, there may be a period where you have little or no income. In that case, a traditional 401k could be advantageous since your withdrawals would be taxed at a low rate during those years. But if you expect your income and tax bracket to be higher in retirement, a Roth 401k may be the better bet. (One note: While there is no way to predict the future, many industry professionals believe that tax rates are likely to increase in the future, which may favor a Roth 401k.)
Other investments. If you already have a traditional 401k, it may be beneficial to add a Roth 401k, assuming your employer offers both. Having a tax-deferred retirement account and a tax-free retirement account gives you the flexibility to be strategic about how and when you make withdrawals to minimize your tax bill. For instance, if you’re at risk of bumping up to a higher tax bracket this year, you could opt to withdraw more from your tax-free account and less from your tax-deferred account (as long as you make your RMDs) to avoid reaching a higher bracket.
Social Security benefits. Once you begin receiving Social Security, the percentage of your benefits subject to federal income tax will depend on your total taxable income. Taking high RMDs from a traditional 401k will increase your taxable income—and that could require you to pay tax on a higher percentage of your Social Security benefits. The larger your Social Security check, the more money you could lose to taxes. However, since Roth 401k withdrawals aren’t taxed, they won’t impact the percentage of your Social Security benefits that are taxable. (Higher income in retirement also may impact the cost of your Medicare Part B premiums.)
RMDs. If you prefer to limit your RMDs in retirement for tax reasons, a Roth 401k is a good choice because it gives you the flexibility to roll your funds into a Roth IRA, which doesn’t have RMDs. A traditional 401k does not provide the same option.
Estate plans. If you intend to leave money to your heirs, a Roth 401k can help you limit their tax burden. When your heirs inherit a Roth 401k, those funds will not be taxable upon withdrawal as long as the account is at least five years old.
With so much to consider, choosing the right type of retirement investment account may seem overwhelming, but it doesn’t have to be. The professionals at Marshall Financial Group can help you make the optimal choice by talking through the various factors that impact whether a traditional 401k or Roth 401k is best for your specific situation. Contact us to schedule a retirement planning consultation today!