With retirement planning, there are so many options. Now that there’s increased availability of the Roth 401(k), the question is whether its better than the traditional 401(k). It’s challenging to pinpoint which plan is best. Like most things dealing with money, it depends on your situation.
A 401(k) is a retirement investment account that has funds based on stock market funds or life cycle funds that are risk-adjusted to your estimated retirement date. You can contribute part of your paycheck by dollar or percentage, and sometimes your employer offers matching contributions.
The traditional 401(k) saves pre-tax income and is considered tax-deferred. You will be taxed on all earnings when you begin mandatory withdrawals from the retirement account at age 59 and a half. The 2020 limits are $19,500 under the age of 50 and $26,000 over age 50, including $6,500 in catch-up contributions. The government increased both limits by $500 from the 2019 values.
The Roth 401(k) is a hybrid of the Roth individual retirement account (IRA) and the traditional 401(k) established in 2006. This type of retirement plan is increasing in popularity but isn’t available everywhere just yet. It has conventional terms in contribution limits and age minimums like any other 401(k). However, it has the tax benefits that may prove beneficial for your goals like an IRA. With a Roth 401(k), you pay the taxes upfront and withdraw your contributions and their earnings tax-free later. Although, if your employer matches contributions, the deposits and their gains are taxable when withdrawn.
Tax Benefits of the Roth 401(k)
When and how much you pay in taxes depends on your income and which retirement plan you choose. If you think you will have more annual income when you retire, which will put you in a higher tax bracket later, it may make more sense to participate in a Roth 401(k). If you plan to drastically decrease your income when you retire, thus lowering your annual tax bill, you might want to try the traditional 401(k).
Additionally, you must have the Roth 401(k) account for at least five years before you can make withdrawals. If you are over the age of 55, it may be too late to open a Roth 401(k) for the tax benefits. It’s very likely that your tax rate will be the same before contributing and after you start withdrawing. However, at that age, you can add catch-up contributions that could boost your earnings in either type of retirement plan.
If you’re young with access to both types of accounts, consider participating in one or both options. By participating in the traditional plan, you lower your current tax liability now, and the Roth plan reduces your tax liability later. You will pay taxes on both ends either way, but you might find that you have a good balancing act by using both to your advantage. If you have steady income growth, you can use the Roth 401(k) at first because your taxes are lower then switch to traditional 401(k) once you enter a high tax bracket to minimize your liability. If you want to pay less in taxes earlier to save more of your take-home pay, you can participate in the reverse, with the traditional plan first.
There is no perfect plan, but you have options for your needs.