When it comes to 401(k) plans and retirement savings, the process is simple: save pre-tax income for retirement and then pay the IRS when you start to withdraw that money at a designated age (currently 59-1/2 years).
However, employers have increasingly begun to offer 401(k)s with a twist. They're known as Roth 401(k)s, which essentially reverse the taxation process of a traditional 401(k).
As more employers offer the Roth option, giving you more control over how you save, it's a fine time to revisit your plan. Read on to see how the traditional 401(k) and the Roth version stack up.
How traditional and Roth 401(k)s compare
Just a few years ago, according to Aon Hewitt research, only about 11% of employers provided the Roth option to their 401(k) participants.
That's not the case anymore. Fully 50% of employers currently allow their employees to plug into the plans, and 27% allow their workers to make in-plan Roth conversions -- that is, to roll their non-Roth 401(k) savings into a Roth 401(k).
But should you opt for the Roth? That depends on many factors. Here are some major considerations when it comes to the two instruments for retirement investing and planning.
While you're still working, you pay no income tax on the contributions you make to a traditional 401(k) unless you withdraw -- and then you take out funds at a penalty. In the course of growing this kind of account, contributions are taken directly from your paycheck, meaning that your taxable income is actually lower than it would be without the 401(k) -- and that saves you money in income taxes. At the end of your career, when you start to withdraw from the fund, those withdrawals will be taxed at your ordinary income tax rate.
Finally, under traditional plans, starting at age 70-1/2, you'll be required to take a minimum distribution each year. For every year in which you do not withdraw the required amount, the government assesses a penalty of 50% of the amount you were short.
With a Roth 401(k), your contributions are made after income tax, so there is no upfront tax break. When you withdraw at the time of retirement, however, you pay no taxes on the withdrawals. There are a couple of stipulations involved. First, qualified distributions start after age 59-1/2. Second, put simply (and there are some exceptions and additions to this rule), five tax years must pass from the time of your first Roth 401(k) contribution to the time of your first withdrawal from it, unless you're willing to incur substantial penalties. There are some Roth 401(k)s that come without required minimum distributions starting at age 70-1/2.
Which plan is right for you?
This question mostly comes down to your income expectations.
Do you expect to be in a lower tax bracket once you retire? In that case, the traditional 401(k) would allow you to potentially pay less in taxes altogether. For example, if your bracket is 25% now but will only be 15% when you retire, you'll save money with a traditional 401(k) because the income taxes you pay in retirement will be lower than the upfront taxes you deferred during your working years.
On the other hand, if you're expecting a larger amount of money to come your way upon retirement from other investments, other retirement instruments, or, if you're lucky, a pension, then plugging into a Roth 401(k) can mean protecting your savings against that tax-bracket increase at the time of withdrawal. If you pay taxes at your lower tax rate now, you can keep all your contributions safe from a higher rate after retirement.
As with any retirement-savings scenario, the type of 401(k) you choose comes down to an individual-by-individual assessment -- but the good news is that employers are increasingly offering the choice. When it comes to maximizing your savings and controlling how taxes influence them, it is worth your time to evaluate how the 401(k) options can work for you.
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