Whether you’re a new college graduate or an established professional, it’s never too early to start saving for your retirement. In fact, according to the University of Southern California, the United Nations predicts the number of people who are 65 years or older will increase 20 percent by 2050 and will most likely continue to gradually rise after that. This longer life expectancy is due in part to improvements in the healthcare field, expanded medical research and more globally-accessible insurance coverage.1 And as one might expect, the longer you live, the more resources you’ll need to sustain your lifestyle, so it’s always a good idea to start saving sooner rather than later.
The Differences Between a Roth 401(k) and Regular 401(k)
When saving money for your retirement, there are two common options to choose from inside of most workplace 401(k) plans -Traditional 401(k)s and Roth 401(k)s. There are several distinct differences between them and choosing the best option for your situation depends on your time-frame, tax rate, and distribution preferences. When reviewing the key differences, it’s important to ask yourself: “When is the most advantageous time to pay tax on my income?”
Traditional 401(k) contributions are made with pre-tax contributions – these contributions reduce your current income for that contribution year. The Traditional 401(k) money then grows tax deferred until retirement. Once you reach 59 1/2 years old you can start withdrawing funds however the money you withdraw will be treated as ordinary income and taxed at your tax rate in retirement. In addition, there are rules for required minimum distributions (RMDs), when an individual reaches 70 ½ years of age. These “Required Minimum Distributions” are a set percentage of your 401(k) balance each year as determined by the IRS, that must be withdrawn from your traditional 401(k) and would count as ordinary income and you would pay the taxes at that time. This requirement may make the Roth 401(k) option more appealing to those who do not want to be required to distribute their retirement assets before they’re ready.
Roth 401(k) contributions are made with after tax dollars -- meaning you will pay income taxes on Roth contributions at the time the contribution is made. The Roth 401(k) dollars grow tax free for the rest of your life. In addition, distributions from a Roth are not taxed so long as you meet certain criteria. You'll need to consider whether your tax rate during retirement will be lower or higher than your current income tax rate. Keep in mind, that with the Tax Cut and Jobs act of 2017, current tax rates are the lowest they've been in years-- so contributing part or all to the Roth 401(k) may be an excellent option.
Weighing Your Options
In 2019, the IRS increased the contribution limit for 401(k)s to $19,000 per year and up to $25,000 if you are over 50 years old2. What many people don't realize is that unlike Roth IRAs, Roth 401(k) contributions are not subject to IRS eligibility rules when it comes to your salary—this feature allows anyone with this retirement plan feature to participate. Another misconception about 401k contributions is that you have to choose to put all of your 401(k) contribution in either the traditional 401k option or all in the Roth 401(k) option -- that is just not true! You have the flexibility to put your money in both plans depending on your preferences. For example, you could contribute $9,500 to the Roth 401(k) and $9,500 to the Traditional 401(k), splitting your contributions into the after-tax option and the pre-tax option, while maxing out on the current IRS 401(k) contribution limits.
When weighing your options, keep in mind that if your workplace 401(k) plan has employer matching contributions or profit sharing, these contributions are made into the Traditional tax deferred 401(k). So you may have a portion of your retirement dollars in this tax deferred area.
If you are in a high tax bracket currently and believe you will pay lower taxes in retirement, then the regular tax deferred option, a traditional 401(k) may work best. However, if you feel tax rates will be similar or higher in retirement than your working years, the Roth could make a great selection. Unfortunately, we don't know what tax rates are going to be in the future, so having a mix of both Roth 401(k) dollars which are tax free in retirement and Traditional 401(k) dollars provides the most flexibility.
Education is Key
When it comes to choosing between a Roth 401(k) and a Traditional 401(k), there is no correct answer. Every individual is going to have a different preference and philosophy depending on when they want to pay their taxes, what tax rate they are in, and when they will begin their retirement distributions. Whichever decision you make, it’s important to understand that your needs are constantly changing, so be sure to not only think about your current preference, but also what you might prefer once you’re closer to retirement.
1 https://gerontology.usc.edu/resources/infographics/americans-are-living-longer/
2 https://www.irs.gov/newsroom/401k-contribution-limit-increases-to-19000-for-2019-ira-limit-increases-to-6000
This content is developed from sources believed to be providing accurate information, and provided by Criterion Capital Advisors LLC and Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.