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lanning for retirement can be confusing: Which investments do I pick? How much do I contribute (always enough to get the match if one is offered!)? What does asset allocation even mean? This process can be complex to navigate even when you just have one option: the traditional 401(k) plan, in most cases. But...your employer may even offer another option: The Roth 401(k).
The Roth is becoming an increasingly popular addition to employers' retirement plan options: Since its inception in 2006, 11% of employees contribute to a Roth when it's made available. So, what can make the Roth a better choice for some people over the traditional 401(k) we've come to know so well? Choosing between these two options may not be as difficult as you think. Here's the breakdown:
Traditional 401(k)
- Pre-tax contributions: When you contribute money to this type of 401(k), it's before withholding taxes, which means you're receiving a tax benefit today. When you start taking money out of your account, you'll pay income tax on it based on the tax bracket you fall into for that calendar year.
- In 2015, you can contribute a maximum of $18,000 annually and if you're at least 50 years old, you can contribute an extra $6,000 for a total of $24,000, reducing your tax liability in the current year.
Roth 401(k)
- After-tax contributions: When it comes to Roth, you are saving money after taxes have already been taken out, which means you are delaying your tax benefit until down the road. When you take the money out in retirement, there will be no additional tax consequences (State, Federal or capital gains, under current IRS law.)
- Although, if your company offers a match, those match contributions are required to be made on a pre-tax basis. If you are getting a match for your Roth investments, it will work the same way your pre-tax match works according to your retirement plan's Summary Plan Description (SPD), but confirm with your HR team if you're unsure about your company matching formula.
- The same contribution maximums apply for Roth, as well, as stated above. You can designate savings as Roth, pretax, or a combination of the two as long as they don't surpass these dollar limits.
Which is right for you?
When it comes to deciding between Roth vs. traditional 401(k), the strategy is basically about one thing: Which one allows you to pay the least amount in taxes over your lifetime? If you're in a "lower" tax bracket and aren't a high earner, Roth may be the smarter option since you're paying taxes right upfront. That's why it can be great for the younger crowd, those just starting out in their careers and who haven't reached their full earning potential yet. So, for someone who is younger, or on/ahead of track to replace their desired amount of money for retirement, then saving at least a portion of your contributions into the Roth would be preferable. Plus, you'll benefit from all the years ahead of tax-free compounding interest and growth on your investments. Furthermore, if you expect your income to remain fairly stagnant throughout your career or you expect your tax brackets to be much higher upon retirement, you should consider going, Roth.
Conversely, if you're a high earner, you will likely benefit more from the immediate tax breaks that a traditional 401(k) offers. So for someone in a higher tax bracket today, who may not be fully on track to replace 100% of their needed income in retirement (ie. they will be living off of less when they stop working, adjusted for inflation), saving into a pre-tax account is preferable. For this reason, if you've been contributing to a Roth and are nearing retirement, it may be a sound idea to reevaluate switching savings vehicles to a traditional 401(k) since you may be at the height of your earning capacity once you take the plunge into retirement. If you'll be living off of less in retirement, it may make sense to pay taxes on your investments later, as opposed to while you're still working.
It's usually a good idea to try and make your investments as "tax-diversified" as possible. So, consider splitting up your retirement savings into both a traditional and a Roth 401(k), if your company offers both options. Remember, when you get to retirement you have the privilege, and the challenge, of determining when, and how much, you take out of your various investment accounts.
To illustrate this, here's a hypothetical example*: If a married couple is planning to live on less than $74,901/yr, under the current Federal tax rates, they will pay only 15% in taxes (and only 10% on the first $18,450 of ‘income’), plus applicable state taxes. If the said couple has properly diversified their savings sources and they were planning to live on $100,000 in retirement, then they could take withdrawals from their pretax accounts on the first $74,901 and then pull money out of their Roth account(s), on a tax-free basis for the additional $25,099 (which would save them $6,274.75, at the incremental 25% bracket, under current tax law).
The Roth is undoubtedly another great tool to save for retirement, with their benefits touted by many professionals in the personal finance industry. Keep in mind though, the Roth isn't always the best choice. We explain the Roth provision is not a one-size-fits-all solution for Americans. Using the Roth, in comparison to saving on a pre-tax basis, makes a ton of sense for employees in their 20s or early 30s, but the ultimate decision has to come down to whether or not you are ahead of track or behind when it comes to saving enough to achieve a dignified retirement. As with anything investment-related, everyone's situation is different and may change over time, but don't rule out the Roth if your employer offers it. It can be a great option for retirement savings, especially for younger employees.
*This is a hypothetical example and is for illustrative and informational purposes only. No specific investments were used in this example. Actual results will vary and are subject to change. Past performance does not guarantee future results.
The above material is provided for informational purposes only and should not be construed as advice. For more information on this topic or your particular circumstances, please consult your financial professional. We do not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.