By Jane Young, CFP, EA
A tax advantaged 401(k) retirement plan, if available through your employer, is a great way to save for retirement especially if your employer matches your contributions. Over the last few years many employers have begun offering employees the option to invest in a traditional 401(k) or a Roth 401(k). The primary difference between a traditional and Roth 401(k) is when you pay taxes.
In 2021 the total amount you can contribute to a 401(k) is $19,500 plus a catch-up contribution of $6,500 if you are 50 or older, regardless of the type of plan you choose. Contributions to a traditional 401(k) are made with pre-tax dollars which reduce your taxable income when the contribution is made. However, distributions are taxed as ordinary income. There is a 10% penalty if distributions are made before 59 ½ unless you qualify for an exception.
Contributions to a Roth 401(k) are made with after tax dollars and can be distributed tax free at age 59 ½ if the account has been open for at least five years. You must take a required minimum distribution from both a traditional and Roth 401(k) when you reach 72. However, the distribution from the Roth is tax free and you can rollover your Roth 401(k) to a Roth IRA to avoid the requirement to make annual distributions.
The employer match to a 401(k) is always treated as a pre-tax contribution and distributions are taxed as ordinary income regardless of the type of plan selected for the employee contribution.
When deciding on the best option for your situation consider the long term. The decision depends on your current tax rate and your anticipated tax rate in retirement. It is difficult to predict future tax rates, but you can make a rough estimate of your projected income in retirement. Run some retirement planning scenarios to determine your future tax bracket in comparison to your current bracket.
The decision between a Roth and traditional 401(k) is easier when you are on the extreme end of the income spectrum. Individuals who are young or expect their income to dramatically increase will usually benefit from a Roth 401(k). Alternatively, if you are in your prime earning years and in a high tax bracket a traditional plan may be best. If you are in between and unsure if your tax bracket in retirement will be lower than today, consider splitting your contribution between a Roth and a traditional plan.
Investing in a Roth account will result in a lower required minimum distribution from your traditional 401(k). Lower income in retirement can reduce the portion of Social Security that is taxable and can lower Medicare premiums.Also consider the benefit of tax diversification in your retirement portfolio. It is beneficial to have some tax-free Roth money to cover large periodic expenses in retirement and avoid getting bumped into a higher tax bracket.