Does everyone dread selecting annual benefits? Benefits are nice to receive, but making choices can be a little daunting. This article focuses on which commonly offered retirement savings vehicle to choose.
Deciding between contributing to a Roth 401K and a Traditional 401K (or Pre-Tax 401K) involves weighing your current financial situation against your expectations for retirement, primarily regarding your income tax bracket. Both plans allow your investments to grow without current taxation of the income. The IRS places annual limits on the amount you may contribute to both types of plans. By contributing some to either or some to both, you will most likely be eligible to receive a contribution from your employer. If you don’t participate, you could forfeit potential additional savings from your employer. Furthermore, some employers allow you to direct their contribution to be invested in the alternative to the choice you make with your own contributions. Inquire about this before making your decision.
Here’s a reference to help you make an informed decision:
| Roth 401K | Traditional 401K | |
| Contributions | Made with after-tax dollars (no current benefit) | Made with pre-tax dollars (reduces your taxable income when contributing) |
| Withdrawals | Qualified withdrawals are tax free | Every dollar distributed is taxable. Penalties may apply to withdrawals made before age 591/2 |
| Best for individuals who… | Believe they will be in a higher tax bracket in retirement. | Anticipate being in a lower tax bracket in retirement than they are currently. |
| Income Limits on contributions | None | None |
| Required Distributions | None during lifetime. | Required Minimum Distributions (RMDs): You generally must start taking withdrawals when you reach age 73 (born 1951-1959) or age 75 (born 1960 or later) |
**Please note that IRAs have different rules than 401Ks**
Generally speaking, younger individuals may benefit more from a Roth 401K as they may be in a lower tax bracket now and have a longer time for their investments to grow tax-free.
If you anticipate a lower tax bracket in retirement and you are at the height of your earning potential, a traditional 401K could be a better choice as it offers a current reduction in taxable income.
How much impact does this choice have on my current paycheck? Here’s an example:
| Roth 401K | Pre-Tax or Traditional 401K | |
| $100,000 Gross Salary, 26 pay periods | $3,846 | $3,846 |
| 10% 401K Contribution | -$385 | |
| Wage Base | $3,846 | $3,461 |
| 10% 401K Contribution | -$385 | |
| FICA & MC 7.65% of Gross | -$294 | -$294 |
| Local, 2.2% of Gross | -$85 | -$85 |
| FED & State, 19% of Base | -$731 | -$658 |
| Net take home pay | $2,351 | $2,424 |
The example above is hypothetical, for illustration only. No individuals will have the same results based upon benefits and elections.
While there isn’t a huge variance between take-home pay in the illustration above, by contributing to the Pre-Tax or Traditional 401K, the hypothetical employee reduces annual taxable income by more than $10,000. The more you save, the more you will reduce taxable income when contributing to a Pre-Tax or Traditional 401K.
If your employer’s plan permits, it’s often possible to contribute to both a traditional 401K and a Roth 401K, as long as the combined contributions don’t exceed the annual maximum allowed by the IRS. Additionally, some plans permit employees to contribute to the Traditional 401K (for the immediate tax break) and designate the employer portion to be contributed to a Roth 401K. This may be attractive to employees who want a current tax benefit from their contributions but also wish to build a fund that will be tax-free in the future. Keep in mind, however, if your employer makes contributions to a Roth 401K, they are considered taxable income in the year they’re made. Employer contributions to a Pre-Tax/Traditional 401K are not currently taxable income to the employee, but will be taxable when withdrawn in retirement.
TAKEAWAYS
- Whether you choose to save for retirement in a Roth 401K or a Traditional 401K, save at least enough to maximize your receipt of employer contributions.
- If you don’t know if your income will be higher in retirement than now, your Glenview Planning Professional can help.
- Traditional 401K contributions reduce taxable income now but will be taxable when withdrawn.
- Roth 401K contributions do not reduce taxable income now but will be tax-free when withdrawn during retirement.
- Finally, the most important takeaway is to start saving early in your career so that you will benefit from years of contributions and growth of your investments.