Between student loan repayments, taxes, and insurance, understanding personal finance is complicated. Deciding on a retirement account is no different.
While you may have heard of the traditional 401(k), often offered by your employer, you might have also noticed a Roth 401(k) option. In fact, 59 percent of large companies and 60 percent of medium-sized ones now offer a Roth 401(k) option, according to a study by Transamerica.
Though the two retirement plans are similar, there are a few key differences that you should consider when choosing between them. Here’s why a Roth 401(k) might be a better 401(k) option.
How a Roth 401(k) and traditional 401(k) differ
While you can contribute the same amount per year to both accounts (up to $18,000 in 2017 and $18,500 come 2018, not including any employer matching, and an extra $6,000 for those 50 and over), it’s how you’re taxed that’s the fundamental difference.
Taxes on a Roth 401(k)
“With a traditional 401(k), your employer will deduct your 401(k) contribution before taxes, then your money can grow tax-free,” said Lauren Zangardi, a certified financial planner with Evolution Advisers. “But when you withdraw the money from your traditional 401(k) (after age 59 and a half), you will owe income taxes on those withdrawals.”
John Decker, one of the top retirement consultants in the nation according to the National Association of Plan Advisors, gives a scenario. If you make $40,000 a year and contribute 10 percent to a traditional 401(k), you would contribute $4,000 a year. In January, your resulting W2 would show you earned $36,000 (not $40,000) because each dollar contributed reduces your taxable income dollar for dollar.
Taxes on a traditional 401(k)
A Roth 401(k) deducts your contribution from your paycheck after tax, according to Zangardi. Since tax is already accounted for by the time funds are contributed to your Roth 401(k), you won’t be taxed when withdrawing funds at retirement age.
Using the same example with a Roth 401(k), your W2 would show that you still earned $40,000. However, now that $4,000 will grow tax-free indefinitely and won’t be taxed at withdrawal.
Benefits of a Roth 401(k)
The primary advantage of the Roth 401(k) over a traditional 401(k) is the ability to make tax-free withdrawals in retirement. By having the option to take some money in retirement from tax-free accounts, you can better anticipate how much money you’ll have at retirement age.
John Beshears, the lead author of a Harvard study on 401(k)s told the Wall Street Journal that having tax-free dollars at retirement actually “translates into more purchasing power.” The reason is that people don’t change the amount of contributions based on the account, so you’d end up with more money at retirement age.
In his example, Beshears said that if you “save $5,000 a year in a 401(k) for 40 years and earns 5 percent return a year, the final balance will be more than $600,000.” With a Roth 401(k) plan, that full amount is available when you retire. With a traditional 401(k), taxes are due on the withdrawn amount.
If your tax rate is 20 percent at the time of retirement, according to Beshears, then the difference is “$120,000 in spending power” or “$700 a month in extra spending.”
Who should consider a Roth 401(k)?
Some people might benefit from a Roth 401(k) more than others. “A Roth option is great for people who are in a lower tax bracket compared to the tax bracket they anticipate they will be in during retirement,” said Zangardi. “It can also be a good option for people who expect to be in a similar tax bracket in retirement.”
Often, younger workers are in a lower tax bracket now, compared to where they’ll be at retirement age. If that’s the case, a Roth 401(k) option might make more sense since it will equal more money later on.
But, if you are in your peak earning years, you might be better off maximizing your tax-deductible 401(k) and then saving extra money in a taxable account.
Or, if you are struggling to save money, the tax deduction with 401(k) might help your monthly take-home amount. This could help if you’re new to the workforce and have other debts like student loans. Then, once you have some other debts under control and have more ability to save, you could slowly add Roth contributions over time.
Keep in mind that this is not an either-or scenario. You can contribute money to a traditional 401(k) and a Roth 401(k) at the same time, so long as you don’t go over that overall contribution limit. If your plan allows you to contribute to both, consult a financial adviser to determine the best way to divide it up.
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