What Are They?
For years, individuals participating in a 401(k) could only contribute in a traditional fashion. It wasn’t until 2006 when many 401(k) plans adopted a Roth contribution feature. This was a game changer for many people and we will walk through those benefits. But first, let’s walk through the differences between Roth and traditional contributions.
How Are Roth and Traditional Contributions Different?
A traditional contribution into your 401(k) is tax-deferred which means you receive a tax deduction in the amount of your contribution. The earnings on those contributions are also tax-deferred. You pay taxes on the contributions and earnings when you take a distribution.
A Roth contribution into your 401(k) is after-tax which means you pay the tax up front. The earnings on those contributions are tax-deferred (just like earnings on a traditional contribution). However, qualified withdrawals are tax-free! A qualified withdrawal requires holding the account for five years and reaching the age of 59 ½.
The table below illustrates how traditional and Roth contributions impact your paycheck. The slight tax savings traditional contributions provide result in retirement savings being taxable. Roth contributions receive no tax savings up front but result in retirement savings being non-taxable.
Roth vs. Traditional Contributions: Which One Should I Do?
If you expect your tax rate to be higher in retirement than it is now, Roth contributions could benefit you. Committing to pay the tax at a lower tax rate allows you to not pay taxes at your higher rate when you take qualified distributions.
If your tax rate is higher now than you expect it to be in retirement, traditional contributions may be the option for you. Delay paying the tax until retirement when you’re subject to a lower tax rate.
Roth vs. Traditional Contributions: Other Things to Consider
- Do I make too much money to contribute to a Roth IRA?
- Do I plan on using my 401(k) in retirement?
- Possibility of higher tax rates through legislation in the future
Make sure to always consult with a tax professional to make the most impactful and tax-advantage decision for your retirement savings.
