There are benefits to both the traditional 401k contribution and the Roth 401k contribution. The Roth contribution may be the most under-appreciated investing opportunity for the American taxpayer. 2018 marks the 20th Anniversary of the Roth IRA. More recently the Roth contribution became an option in 401k plans. Don’t make your choice lightly. It is important to make an informed decision.
Traditional versus Roth Contributions
The basic difference between the traditional contribution and the Roth contribution is the way the money is taxed. The traditional contribution comes out of your paycheck before taxes and is referred to as a pre-tax contribution. The money grows tax-deferred until withdrawn and then you pay income taxes on every dollar distributed in retirement.
A Roth contribution is called an after-tax contribution. The contribution is deducted from your paycheck after withholding is calculated, and it does not reduce your taxable income. When you retire all the money in your Roth account is distributed tax free. The contribution was already taxed, and the growth on the money is never taxed when you follow the distribution rules. Having a tax free account in retirement is huge for retirees. When you look at your 401k account you think it is all yours, but in fact after taxes you keep maybe 60% to 75%. When you look at your Roth account it is all yours! Taxes make a big difference.
Who Benefits from Roth Contributions
The younger you are the more you benefit from making Roth contributions because you have a long time for the money to grow tax free. The more tax free growth you have the better it is. Also, younger employees are often in a lower tax bracket early in their careers. It makes a great deal of sense for younger people.
An advantage to high income earners is that the Roth 401k is available to all employees regardless of income. They are not capped from making contributions based on income as they are with the Roth IRA. A tax impact study is important for high income earners. There is an income level when it may be better to make pre-tax contributions and lower your taxable income. An advisor can help make that decision.
Most 401k plans will allow you to choose to put some or all of your contribution in a Roth account and you can change your mind and go back to the traditional pre-tax contribution if you decide you want the tax deduction. It is very flexible.
It is wise to seek professional help and consider the tax impact of your decision on your specific situation. Also seek help to be sure you follow all the rules.
Written by Connie C. Guelich, CFP, AEP, CLU, ChFC. This represents our view at the time of this writing and is subject to change. This is not intended to be personal investment advice. If you would like to discuss your own account, please don’t hesitate to call us. We are here to help and welcome your call.