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Roth or Traditional 401(k)?

Some employer sponsored 401(k) plans may offer multiple ways to contribute to your retirement savings. 401(k) plans can offer traditional contributions or Roth contributions. The basic difference between a traditional and Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make contributions with pre-tax dollars, meaning you do not owe tax on the dollars you contribute to your 401(k). This lowers your current income tax bill. The money- both contributions and earnings- then grows tax-deferred until you withdraw it. At that point, withdrawals are considered ordinary income and you will owe tax at your current tax rate.

A Roth 401(k) essentially reverses that equation. You make your contributions with after-tax dollars, so you do not get the upfront tax deduction. Instead, you will owe tax on the dollars contributed. However, withdrawals of both contributions and earnings are tax free as long as you have held the account for five years.

To simplify it, the decision mostly comes down to deciding if it is better for you to pay the taxes now or later. Weighing paying taxes now or later really comes down to a personal decision rather than a hard and fast rule; however here are several important factors to consider:

  • If you are young and confident you will earn more later in your career and be in a higher tax bracket in future, the Roth 401(k) may be a good choice.

  • If you are in the height of your career and in a higher tax bracket, the Traditional 401(k) may be a good choice.

  • Withdrawals from traditional retirement accounts could potentially move you into a higher tax bracket in retirement, which may increase your tax bill and increase Medicare premiums in retirement. Roth contributions can help give flexibility for tax planning in retirement.

  • Some employer plans allow you to change contribution types each year or even split your contributions between both types of accounts.

  • If you receive an employer match, it will always be pre-tax, even if you contribution on an after-tax basis.

Having flexibility is very helpful in retirement. Having a bucket of pre-tax money and a bucket of after-tax savings is helpful in giving more flexibility with tax planning once in retirement. Also keep in mind that tax laws can change in the future. While Roth account withdrawals are most often not taxed today, tax laws can change that in the future. Having money in each bucket may help diversify the risk of tax law changes.


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