Life 2.5: A Simple Explanation of Where to Safely Put Your Money In
Roth 401k vs Traditional – Which suits your Goals?
If you are in a full-time job, you probably already have a 401(k) – or some other kind of retirement account like a 403(b) or governmental 457(b) where money gets automatically deducted from your paycheck and put into your plan. But with more and more employers offering a Roth 401(k) as well, it’s wise to become a bit unconventional with your investments and consider the potential benefits of each.
We often hear that Roth accounts are best for young investors. It’s because of the tax-free withdrawal feature of a Roth down the road, whereas traditional retirement account leaves you with an up-front tax deduction at the time of withdrawal.
Recently, however, most financial advisors have been advising their older clients to go for Roth accounts as well. But since your situation is different from that of every other person out there, your preferences and solutions should be unique as well.
Before we dive deep inside, let’s start with the fundamentals.
A traditional 401(k) is an employer-sponsored plan that gives you a choice of investment options. Any contributions you make to a 401(k) plan and any earnings from the investments are tax-deferred.
You pay taxes only when you withdraw the returns. If your employer matches a portion of your 401(k) contribution, taxes on those matching funds are also deferred until you withdraw the savings. The taxes you pay are determined by your marginal tax rate (in the year you make the withdrawal).
A Roth 401(k) is also an employer-sponsored plan and similar to the traditional 401(k) with one major exception. Here the contributions you make are not tax deductible Rather, you pay income taxes on your contributions upfront. As a result, the money in your Roth account grows tax-free and you are not required to pay any taxes on your withdrawals when you retire if certain qualifications are fulfilled.
A Traditional or a Roth 401(k)—or Both?
It’s simply an issue of weighing the taxes now versus later. Do you think you’ll be better off paying the taxes now, or later? A tax deduction now when you’re young may seem to be an attractive option. However, you have to think of the future. At retirement, every $100,000 you withdraw from a traditional 401(k) could be 25 or 35 percent less depending on your tax bracket.
If you’re young and believe that you’ll be earning more and stand in a higher tax bracket in the future, Roth 401(k) should be the default choice. However, if you’re in your 40s, 50s, or 60s, you can still consider the Roth 401(k).
Contributing in traditional and Roth 401(k) together is usually considered as an insightful policy, which gives you both the taxable and tax-free withdrawal options. The industry experts call this tax diversification. For example, if you contribute on both accounts, you can take distributions from your traditional 401(k) until you reach the top of your tax bracket, and then withdraw whatever you need apart from that from the Roth, which is tax-free. This is just a simple example of the flexibility that you can have by diversifying your contributions.
A Few Added Thoughts
Like traditional 401(k)s and unlike Roth IRAs, you must withdraw a minimum amount from your retirement account each year when you reach 70½ unless you’re still working. This is called Required Minimum Distribution (RMD). You can eliminate such a requirement by rolling over your Roth 401(k) into a Roth IRA. However, before you go ahead with such a decision, you should carefully consider factor like fees, investment choices. distribution options, legal protection, loan provisions and others.
Sometimes, you can even think beyond that to estate planning, which would be beneficial for your heirs as they won’t have to pay taxes on the inheritance from Roth.
It’s always great to have options so that you can make an informed decision. Whatever you decide, the best part is that you’re already planning and saving for retirement. However, remember that different types of investments involve varying degrees of risk. And if you’re going to take any tax-related decision, you should discuss your situation with a tax and financial adviser to help you understand what is best for you.
(Andy is an editor with Oak View Law Group and contributes specifically on personal finance topics. You can also find him fielding queries based on money management topics at various online communities and social media platforms.You may find his writing here Comparecards, Realmoneyanswers, Familyshare.)