In our newest blog series “Ask a Trainer” we will be answering all of your money questions! Want to submit a question? Shoot it over to email@example.com and we will be sure to answer it on the blog!
Congrats! You have an important decision to make, and at the end of the day you have a choice between two great options. Whichever you choose, future you will be thankful!
The first step in making this choice is to understand the similarities and differences between the two retirement savings vehicles. Both of them will give you a tax advantaged opportunity to invest for your retirement. Both will allow for your investments to grow tax free. Both are only available through employer sponsored plans, and should share the same investment options. Ideally, they also involve employer matches, which, depending on how you look at it, is free money, or money you are entitled to as part of your overall compensation package that you should take advantage of.
But what are the differences? Well, the essential difference between Roth and Traditional contributions is when you pay taxes on the money invested in the account. In the case of the Traditional 401k, the more common option of the two, your contributions are referred to as pre-tax, or tax deferred. That means that if you make $100,000 in 2021, and you contribute $10,000 to your 401k, you’ll only be taxed on $90,000 in income. However, all income is taxed at some point, and retirement contributions are no different. With Traditional contributions, you’ll be responsible for paying income taxes on your withdrawals in retirement, at whatever your income tax rate is at that time.
Roth 401ks, on the other hand, are tax advantaged on the other side. The contributions are made post tax with money that you have already paid taxes on. Since you’ve settled your bill with Uncle Sam up front, you won’t be taxed on that money when you retire. A lot of people would argue that tax rates are more likely to go up than down, so you are better off paying tax now than later when they might be higher.
So which is right for you? That depends on a few things.
If you think that your income (and therefore tax burden) will be higher in retirement than it is right now, then a Roth might be right for you. By taking advantage of the Roth, you’ve locked yourself into your lower income tax rate, forever. Conversely, if you’re predicting a retirement income that is leaner than what your salary currently supports, it may make sense to wait and pay lower taxes later on.
If cash is tight for you right now, the pre-tax Traditional 401k option might be the best choice. For instance, if you invest $500 per month in a Traditional 401k, your paycheck will only take a $400 hit (assuming a tax rate of 25%). If you contribute the same amount to a Roth 401k, you’ll be out $625: the $500 contribution, plus the income taxes you pay upfront.
Paying less in taxes (and getting a paycheck boost!) can open up money to invest in a traditional brokerage or in other ways. If you can afford to put the money you save in taxes to work this way, you might benefit from using the Traditional 401k option.
It is also important to consider what sources of income you may have in retirement. For example, let’s consider a situation in which you are drawing $24,000 in social security annually, another $30,000 from traditional retirement accounts, and earning $26,000 in rental income. All of this will be considered taxable income and bring your total taxable income to $80,000. Any Roth distributions you draw will not count toward your overall taxable income. You could take $10,000 or $100,000 from your Roth 401k and it wouldn’t bump you into a different tax bracket, which could result in you paying more in taxes later than you would now.
Whether to choose a Traditional or Roth 401k is a personal decision that depends on your salary trajectory, your predicted income bracket in retirement, your capacity for investing extra cash, and the variety of income sources you expect to draw from in the future.
Regardless of which you choose, what matters most is that you are saving for retirement!
“I have the option to contribute to a Traditional 401k or a Roth 401k. Which should I choose?” is written by Terri Bennett, A Certified Financial Trainer for financialgym.com