Most companies no longer offer new employees a pension plan, which used to be the standard retirement program. Nowadays, companies usually offer employer-sponsored retirement programs, the most common of which are the 401k plan or Roth 401k plan, which cuts costs for the employer and gives employees more control over their retirement savings.
The 401k retirement plan refers to the section of the IRS Code that gives employees the ability to set aside part of their wages on a tax-deductible basis.
There are generally two types of 401k plans that your employer might offer: traditional 401k plans and Roth 401k plans. From a tax perspective, they are very similar, so it’s important to understand when and how you’ll pay your 401k taxes when you’re planning for retirement.
Traditional 401k vs. Roth 401k: What Are the Differences?
Here are the major differences between traditional and Roth 401ks:
- Contribution: You contribute to a traditional 401k with “before tax” dollars, which means that you don’t pay taxes on your contribution when you receive your wages.
- Withdrawal: The minute you withdraw money from a traditional 401k, that money becomes taxable income. “[You] pay the piper when you start to make withdrawals at whatever income bracket you are at that time on all contributions and earnings,” said Karen Lee, a CFP at Karen Lee and Associates and author of “It’s Just Money. So Why Does It Cause So Many Problems?”
- Contribution: You contribute to a Roth 401k with “after tax” dollars, which means that you are investing part of your net take-home pay.
- Withdrawal: This is subject to certain requirements, such as your age and the length of time you had the account. When you withdraw your Roth 401k retirement savings, you don’t pay federal income taxes on those amounts. That’s because you paid taxes on it years earlier when you made your 401k contributions.
When to Choose a Traditional 401k
Choosing a Roth vs. traditional 401k depends on your current age and tax bracket.
“[W]hen you are earning more later in your career and are in a higher tax bracket, you may want the current year tax savings that traditional, tax-deferred contributions provide,” said Stuart Robertson, President of Capital One Advisors 401k Services.
“I would rather have a bird in the hand when it comes to my 401k,” said Damon Gonzalez, CFP and IRCP at Domestique Capital LLC, a financial planning firm headquartered in Plano, TX. “When I do a traditional contribution, I pay less taxes this year and get immediate benefits.”
You should also keep in mind that the current tax implications of 401k withdrawals are known, whereas the future is uncertain. “Many people are making a large gamble with the Roth 401k that the government will not change the rules by the time they retire,” Gonzalez said. “What if [your Roth 401k withdrawals] are no longer tax-free when you retire?”
When to Choose a Roth 401k
“For younger investors who expect to advance in their careers and earn a higher income, contributing into Roth now can be a smart move since your standard of living and earnings will likely increase by retirement,” said Robertson. “In this scenario, you can expect to be in a higher tax bracket in retirement than you are early in your career, and you save on taxes by paying more today (at a lower rate) and pay less at retirement (when you will presumably be at a higher tax rate).”
Contribute to Both If You Can
The most important thing to consider when deciding between these two retirement savings plans is whether you will benefit more from the upfront tax break that you’ll get with a traditional plan or the deferred benefit that you’ll get with a Roth plan.
“The higher your federal income tax bracket is today, the more attractive the traditional 401k is,” Lee said. “The younger you are, the longer your money will grow due to compounded earnings, thus the more potential gain you will have, [and] the Roth 401k becomes more attractive.”
However, it’s not an all-or-nothing decision when it comes to Roth vs. traditional. You might consider contributing some to each option if you have the opportunity.
Whichever 401k plan you choose for your retirement investment — whether traditional, Roth or both — it’s wise to contribute as much as you can now to enable you to have more lifestyle choices later.