When you start a new job, one of the first decisions you may encounter is the choice between Roth and traditional contributions for your 401(k). This decision can have a significant impact on your tax liability and the amount of income you can enjoy in retirement.
Before you make this choice, you need to fully understand each option and how it could impact your retirement goals. That begins with learning what sets these types of contributions apart from one another.
Why Is the Choice Between Roth and Traditional Contributions Important?
The wrong choice between Roth and traditional can cause you to pay a much higher amount of tax over the course of your life. These tax consequences compound over years, which means it is vital to make the right choice as early as possible.
About 90% of employer sponsored retirement plans now offer a choice between Roth and traditional contributions. Due to the growing availability of Roth, you will likely encounter this type of retirement account at a future job. Therefore, it makes sense to start the decision-making process by learning about this type of account and how it differs from traditional.
What is a Designated Roth Account?
A designated Roth account is a feature available inside most modern 401(k) plans. It is a separate account within your employer sponsored plan that holds retirement funds that have already been taxed.
Roth 401(k) contributions don’t qualify for tax benefits in the year you contribute. Instead, your contributions and investment returns are tax-free when you take a distribution during retirement – pending you meet certain criteria.
In general, you must be at least age 59 ½ and you must have maintained the Roth account for more than 5 years to take a tax-free distribution. Although, there are exceptions to these rules, such as in the case of death or disability.
A designated Roth account doesn’t prevent you from maintaining a pre-tax 401(k) account. In fact, you can generally designate a portion of your salary deferrals to a traditional account in your 401(k) and another portion to your designated Roth account. You may also be able to change which type of account you direct your funds to mid-year if your plan sponsor allows those changes.
What is the Difference Between Traditional and Roth 401(k) Contributions?
Many factors remain the same whether you contribute to a traditional or Roth 401(k) account. However, there is one major difference between these two types of contributions – taxes.
Unlike a Roth account, contributions to a traditional 401(k) typically qualify for a tax deduction in the year you contribute. Then, the funds grow based on your investment choices until you reach retirement age and begin to take distributions from your account. At that time, any amount you withdraw from your traditional 401(k) is taxable as income – including both the original amount you contributed and any earnings.
Which Should I Choose – Roth or Traditional 401(k)?
Choosing between a traditional account and a designated Roth account often comes down to a decision between current and future tax benefits. Your progress toward savings goals, anticipated investment returns, and income are all important factors that can influence this decision.
Who Can Benefit from Roth 401(k) Contributions?
You may benefit from a Roth 401(k) if you have lower income while saving but expect to have higher income during retirement. This is due to the progressive tax system in the U.S. For example, if you pay 10% tax on your income currently but expect to pay 18% during retirement, it makes sense to pay the taxes on your contributions now while your effective tax rate is lower.
If you expect to accumulate significant investment gains, you may also benefit from a designated Roth account. That’s because investment gains are tax-free when you make a qualified distribution from a designated Roth account but taxed as income when you take a distribution from a traditional 401(k).
Who Can Benefit from Traditional 401(k) Contributions?
Those who expect to have a lower effective tax rate during retirement than during their working years may benefit from a traditional 401(k). Depending on your current and expected tax rates and investment returns, the current tax benefits of a traditional 401(k) could outweigh the possible future tax benefits of a Roth account.
Also, individuals who are investing for a shorter period of time may find traditional 401(k) contributions more beneficial. For people who plan to begin taking distributions in the next few years, the current tax savings from traditional 401(k) contributions may outweigh the potential future tax benefits from maintaining a designated Roth account.
The choice between traditional and Roth contributions can also vary based on the year. If your income is variable, you may benefit from making traditional 401(k) contributions in years where your income is higher and Roth contributions in years where you don’t earn as much.
Similarities Between Traditional and Roth 401(k) Contributions
There are many similarities between pre-tax and Roth 401(k) contributions. Some of the most common are eligibility criteria, annual limits, matching, and investment options.
Eligibility Criteria Do Not Vary Between Roth and Traditional 401(k) Accounts
Eligibility criteria vary by employer but can include things like being over a certain age, earning over a certain salary, or meeting a minimum length of service. These requirements are not affected by your choice between a traditional or Roth 401(k).
401(k) Contribution Limits Are the Same for Roth and Traditional Accounts
If you are eligible to participate in your company’s 401(k) plan, the amount you can contribute is the same whether you have a Roth or traditional account. For 2024, the maximum contribution amount for employee salary deferrals is $23,000 plus an additional $7,500 catch-up contribution for those over age 50.
Employers Generally Match the Same Percentage of Roth or Traditional Contributions
If your employer matches your contributions, the match rate is not affected by your choice of traditional or Roth designation for your salary deferrals. After the SECURE Act 2.0 took effect in 2023, your employer may offer the option of designating matching contributions to Roth as well as salary deferrals.
Traditional and Roth 401(k) Contributions Typically Have the Same Investment Options
The available investments in your 401(k) are chosen by your employer, and there are generally no differences between the options available for traditional and Roth accounts. Therefore, you will have the same investment options and potential earnings whether you choose to designate your contributions as traditional or Roth.
Since so many factors remain the same whether you choose traditional or Roth, it is important to focus on the difference between them when deciding how to set up your account. In particular, you should work with an experienced financial advisor to weigh the immediate tax benefits of a traditional 401(k) and the possible future tax benefits of a designated Roth account before deciding which type of account is right for you.
Get Help Choosing Between Roth and Traditional 401(k) from Meld Financial
To determine which 401(k) savings strategy could help you achieve your retirement goals, speak with an experienced financial advisor at Meld Financial. Our team of financial, legal, and tax professionals can help you analyze your current financial situation and choose the right type of account for your situation.
In our 40 years managing our clients’ wealth, we have developed a unique financial planning process called Financial Fingerprint®. This is a comprehensive wealth management plan that is quick to assemble, easy to understand and simple to modify as your circumstances change. With this plan and a partnership with an experienced advisor, you can stay on the right path to achieving your retirement goals.
To get your Financial Fingerprint®, contact us today.
