Traditional vs. Roth 401(k) and Understanding the Differences
Oct. 19, 2018
By: Greg Stahl, Vice President, Wealth Advisor, BT Wealth Advisors
As a wealth advisor, I get the question often: Should I consider a traditional 401(k) or a Roth 401(k)? It’s easy to buy into whatever plan your employer is offering—sometimes what they are offering is a great fit—but it’s also a good idea to take a step back and consider all of your options when it comes to planning your retirement.
So, what is the difference between a traditional and a Roth 401(k)? Really, it comes down to when you pay taxes on your retirement savings. With a traditional 401(k), you make a contribution with pre-tax dollars, which gives you a tax break on the front end, at the time of the contribution. Withdrawals are considered ordinary income, so you pay the government their share at your current tax rate (depending on what state you’re in, you may also need to pay state taxes on the contribution as well). With certain exceptions, you will also pay a 10 percent penalty if you withdraw before you’re 59 ½.
A Roth 401(k) is basically the opposite. You make your contributions with after-tax dollars, meaning there's no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free at age 59½ or older, as long as you've held the account for five years.
So, by now I am sure you’re wondering, between the two options, what is best for you? It really depends on when it's better for you to pay the taxes—now or later. Usually, that depends on your individual situation and what your future looks like—not that we can always predict these things! A good general rule to follow: If you think your marginal rate is the same or higher when you contribute and when you withdraw, go with a Roth 401(k). If you think your marginal rate will be lower during withdraw, go with the traditional 401(k).
I often hear advice in the market suggesting that a Roth—whether an IRA or a 401(k)—is best for younger individuals. Typically, you are in a lower tax bracket during the early stages of your career, as well as during retirement, when you are no longer drawing a salary from employment. Being taxed on your Roth contributions on the front-end when you are younger, and receiving tax-free withdrawals when you are older, is advantageous given your low tax bracket status during both stages of life.
More and more, we’re seeing wealth advisors recommend a Roth account for older individuals as well. This is because, unlike a Roth IRA, there is no income limited on a Roth 401(K). Therefore, older (and often higher earning) employees can possibly reap the benefits of a tax-free withdrawal in the future.
Just remember, under our current tax rules, every dollar you withdraw from a traditional 401(k) could be reduced as much as 37 percent once you are in retirement, depending on your tax bracket. That makes a big impact.
Moral of the story? Do your research and plan ahead, regardless of your age and situation. In general, it’s just good to know what all your of options are when it comes to planning your retirement. If you are just starting out your career, or even if you’re in your 50s and 60s, a Roth 401(k) may be a good option for you, depending on your circumstances.
Stay tuned for my next article! I’ll be sharing a few hypothetical scenarios on this topic in an article I am planning as a follow-up. As always, if you’re interested in learning more about 401(k)s and which option is the best fit for you, please feel free to reach out to me directly at firstname.lastname@example.org.
This article originally appeared on The Bank of Tampa’s website. To read more about The Bank of Tampa, visit: thebankoftampa.com/news
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issued with a qualified tax advisor.
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