When you set up your Roth 401K, you may have two options – Roth vs traditional 401K accounts. Both are a great way to save for retirement, but they have different tax consequences that you should be aware of and understand how they work.
What is a Traditional 401K?
The traditional 401K is the program most employees use. You set aside a percentage of each pay check to contribute to your retirement account. Your employer deducts the funds before taxes, which lowers your tax liability today. You only pay taxes on the income after your 401K contributions.
Your investments also grow tax deferred. This means you don’t pay taxes on your capital gains as they happen. But, you pay taxes when you withdraw the funds, both your contributions and earnings.
You pay taxes at your tax rate during retirement. Many people use this option when they’re sure their tax rate will be lower during retirement than it is now, putting more money in their hands during retirement.
What is a Roth 401K?
A Roth 401K isn’t as common, but you get to take the tax break during retirement rather than now. You still earmark a percentage of your pay check for your retirement plan, but the contributions are taken out after taxes.
So you don’t get the lower tax liability now, but your earnings grow tax-free AND your withdrawals are tax-free. This means you pay no taxes during retirement. The only exception is if you withdraw the funds before retirement age (59 ½). If you withdraw prior to that age, you’ll pay taxes on your earnings.
Which is Better – Roth 401K or Traditional 401K?
Everyone wants the answer – which is better between the two retirement accounts? But there isn’t a one-size-fits-all answer.
Instead, you must look at the big picture. Ask yourself the following questions.
Are you in a Low Tax Bracket Now?
If you’re just starting out and are in a low tax bracket, you may want to use the Roth 401K and take advantage of your low tax bracket. This is especially important if you think your tax bracket may increase over time.
You’ll make your tax payments now and then not have to worry about it again for your retirement funds. Any money in your retirement account (as long as you wait until after age 59 ½) will be tax-free.
Do you Need a Tax Break Today?
If you’re in a high tax bracket right now, you may be looking for any tax break possible and the traditional 401K can provide it. By contributing funds before taxes, you lower your tax liability today.
If you use the money saved on taxes to invest even further, you’ll compound your retirement savings and have a larger nest egg during retirement.
Do You Worry About Increasing Tax Rates?
If you worry about increasing tax rates, it may give you more peace of mind to pay your taxes now with a Roth 401K and not have to worry about your retirement funds. Even if you don’t anticipate making more money in the future and increasing your tax rate, if rates increase for everyone, you’ll pay more.
A Roth 401K can be a great way to diversify some of your funds, contributing after tax so you know a portion of your withdrawals during retirement won’t be taxed.
Do you Worry About Required Minimum Distributions?
With a traditional 401K, you must take Required Minimum Distributions by a certain age. This means you’re forced to take out a certain amount of money and pay the taxes on the amount. If you can’t afford the taxes at the time, it can backfire on you.
Roth 401K accounts don’t have RMDs because you already paid your tax liability on the funds contributed.
Do you Car About Employer Match?
Employers don’t match contributions in a Roth 401K, only on a traditional account. If you can, it’s best to have both accounts so you get the matching contributions, but also set yourself up for favorable tax events during your retirement.