Roth vs. Traditional 401(k)—Which Is Better?
Roth vs. Traditional 401(k)—Which Is Better?
July 23, 2014
I've been contributing to a regular 401(k) for 8 years but my employer just started offering a Roth 401(k) plan. How can I decide which is best?
The sheer number of retirement accounts can make anyone's head spin. Once you've opened a specific type of account—for instance a traditional 401(k)—it's tempting to just figure you're set. But with more and more employers now offering a Roth 401(k) as well, it's smart to take a step back and consider the potential benefits of each. So thanks for bringing this up.
You'll often hear that a Roth account, whether an IRA or a 401(k), is best for young investors. That's because they are currently in a low income tax bracket, and the up-front tax deduction of a traditional retirement account is less valuable than the tax-free withdrawal of a Roth down the road.
Lately, however, financial advisers have been pointing their older clients toward Roth accounts as well. Unlike a Roth IRA, there are no income limits on a Roth 401(k), so the door is wide open for older, higher-earning employees to get the benefits of tax-free withdrawals later on.
So how do you decide? Let's start with the basics.
It's a question of when you pay the taxes
The basic difference between a traditional and a Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your money—both contributions and earnings—grow tax-deferred until you withdraw them. At that time, withdrawals are considered to be ordinary income and you have to pay Uncle Sam his due at your current tax rate. (With certain exceptions, you'll also pay a 10 percent penalty if you're under 59½.)
With a Roth 401(k), it's basically the reverse. 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, as long as you've held the account for five years.
So it all comes down to deciding when it's better for you to pay the taxes—now or later. And that depends a lot on what the future may look like for you.
Weighing now versus later
A tax deduction now can seem like a pretty good deal, but you have to think ahead. Come retirement time, every $100,000 you withdraw from a traditional 401(k) could be 25 or 35 percent less depending on your tax bracket. (And who knows if tax rates will go up?) That's not going to feel so good when you're trying to put together your paycheck in retirement.
If you're young and are confident that you'll be earning more and in a higher tax bracket in the future, the Roth 401(k) is an easy choice. But even if you're in your 40s, 50s or 60s, you might want to take a look at the Roth option.
Consider that even if you end up in a lower income tax bracket when you retire, large withdrawals from your traditional retirement accounts could potentially kick you into a higher tax bracket, increasing your tax bill and reducing your disposable income. So giving up the tax deduction now may be well worth having tax-free withdrawals later on.
Hedging your bets
The good news is that when it comes to a traditional vs. a Roth 401(k), you don't necessarily have to make an all-or-nothing choice. You can have both, and decide year-by-year where you want to make your contributions. If your employer's plan allows it, you may even be able to split your contributions 50-50 between the two types of accounts.
Having both types of 401(k) would give you the flexibility to vary your contributions. It would also allow you to more effectively control your tax situation in retirement by balancing taxable and tax-free withdrawals to minimize your income tax bill.
A couple of added thoughts
Like a traditional 401(k)—and unlike a Roth IRA—you do have to take a required minimum distribution (RMD) at age 70½ from a Roth 401(k) unless you're still working. However, it's possible to roll over your Roth 401(k) into a Roth IRA, eliminating that requirement. But before you make that decision, you should carefully consider others factors such as fees, investment choices, distribution options, legal protection, loan provisions and other particulars of each account.
If you're thinking even farther ahead to estate planning, such a move would be good news for your heirs because they wouldn't have to pay income taxes on the distributions from an inherited Roth.
It's great that you have a choice—and the best choice of all may be to invest in both types of accounts. Whatever you decide, you're already planning and saving for retirement. And that's the best decision of all.