If your employer offers you a choice between a traditional 401(k) and a Roth 401(k), how do you choose?
The simplistic answer
If you believe your income tax rate is higher in your working years than it will be in your retirement, choose the 401(k); otherwise choose the Roth 401(k).
A better answer
If you can, do both. In retirement, this will give you the flexibility to make withdrawals that are the most tax efficient given your financial circumstances at that time.
And some good advice
These rules can be both complicated and confusing. You are ecouraged to seek advice from a financial advisor or retirement tax expert to make sure your assumptions are valid before making major decisions.
Cash flow implications
With a traditional 401(k) plan, you get an immediate tax benefit as the before-tax contributions are not subject to tax until later when they are withdrawn. With a Roth 401(k) you don’t get an immediate tax benefit as the funds are contributed with after-tax money, but you do get a later tax benefit as there is no tax assessed when the funds are withdrawn when they are considered to be qualified withdrawals.
Note this means that your take-home pay will be somewhat higher with a traditional 401(k) compared to a Roth 401(k) as you will not pay taxes now on a portion of it. Also note that if you do not expect to pay any federal taxes because of the individual standard deduction of $12,950, then a traditional 401(k) which allows you to defer taxes when you won’t owe any isn’t helping you.
Because contributing to a traditional 401(k) reduces your taxable income in the year in which the contribution is made, the lowered income may improve your eligibility for tax credits and allowable deductions. It’s therefore important to estimate your income and taxes before choosing one plan over the other.
Contribution limits and required distributions are different
While there are contribution limits ($23,000 0r $30,500 if you’re at least age 50) for both traditional 401(k)s and Roth 401(k)s, there are no income limits for eligibility to contribute to Roth 401(k)s. These contribution limits apply to the aggregated total of your Roth 401(k) plus any pre-tax deferrals such as a 401(k). Note Roth 401(k) contribution limits are not aggregated with IRA or Roth IRA contribution dollar limits.
With traditional 401(k)s, RMDs (Required Minimum Distributions) need to be taken beginning at age 72 (73 if you reach 72 after December 31, 2022). For Roth 401(k)s, RMDs are not required beginning in 2024.
Note that Roth 401(k)s can be rolled over to Roth IRAs without incurring any tax liabilities since the dollars that went into the Roth 401(k) were after tax dollars.
Employer matches and rollovers are different
Employer matches work differently with the Roth 401(k). Employer contributions to a traditional 401(k) go directly into your traditional 401(k). Employer matches to a Roth 401(k) go into a pre-tax account that is tracked separately from your employee contributions. From the IRS viewpoint this makes sense because the employer’s contribution has not yet been taxed, but this fact complicates the issue of deciding which plan to choose.
Rollovers are taxed differently with the two plans. Rollovers from a traditional IRA to a Roth IRA are taxed at the taxpayer’s marginal tax rate. Rollovers from a Roth 401(k) to a Roth IRA are not taxed.
Why might you want to do a rollover from a Roth 401(k) to a Roth IRA? One reason might be the custodian of the Roth IRA may have significantly better investment options and lower fees than your options with your employer’s Roth 401(k) plan.
Summarizing the important factors
Making smart choices now can save you thousands of tax dollars later. Here is a summary of factors that should be taken into account when deciding between traditional 401(k) plans and Roth 401(k) plans:
- Whether your employer contributes to your retirement plan and, if so, at what rate.
- Current and assumed future tax rates.
- The taxable income effect on your choice as it relates to income-based eligibility cutoffs and other phaseouts for federal tax liabilities. Examples of these are the Saver’s Credit, the Earned Income Tax Credit (EITC), and the Premium Tax Credit (aka the Obamacare subsidy).
- Future assumed social security benefits.
- Your current salary and your salary growth potential.
- Whether you have a defined benefit plan.
- Whether you are able to put aside current and future funds for savings and retirement.
- Investment options and fees for your traditional 401(k) versus a Roth 401(k).