People today have many different options for saving for retirement. One of the most popular is the employer-sponsored retirement plan, otherwise known as the 401k or 403b that you can participate in through your job. Many companies are adding another plan – a Roth version of their retirement plan. If you are a young person just starting out, or a crusty old veteran who hasn’t been offered a Roth 401k before, how should you choose between the two?
401k basics
The traditional 401k is a retirement plan where your employer withdraws money from your paycheck before taxes are assessed and sends it to a third-party brokerage or insurance company where you can invest it for retirement. Many provide a company match, a percentage bonus based on the amount you contribute (for instance, a company may match your contributions 50 cents on the dollar up to the first 6% you defer, meaning that if you contribute 6%, they will give you 3% more). Most financial experts agree that one of the biggest benefits to a traditional 401k is that contributions are tax-deferred and reduce your current tax bill. You are taxed on your withdrawals.
Roth 401k basics
The Roth 401k is similar to the traditional, in that your employer withdraws money from your paycheck and sends it along to a brokerage or insurance company for you to invest. The big difference is that your contributions are made after taxes have been assessed on your paycheck, so there’s no decrease in your current tax bill. Similar to the traditional 401k, your employer may offer a match. Recent Federal legislation allows companies to invest that match in the Roth 401k (before the match was invested in a traditional 401k). However, the big benefit for Roth 401ks is that your withdrawals in retirement will be tax-free.
When should you pay taxes?
In a sense, much of this discussion revolves around when you want to pay taxes on your retirement income. Do you want to pay today, or do you want to pay in retirement?
The argument for paying taxes during retirement by investing in a traditional 401k plan. The simplest way to look at this is to try to determine your tax rate today versus your expected tax rate in retirement. However, this can be something of a crapshoot. You have to assume that tax brackets will stay relatively stable in the future, so how far you are from retirement will have a large effect on how well you can estimate. Many financial professionals recommend that people who are later in their careers and earning at their highest levels contribute to a traditional 401k because the assumption is their tax rate will be higher today than at retirement. Their current income – and therefore their tax bill – will be reduced today while their earnings are higher.
The argument for paying taxes today by investing in a Roth 401k plan. While people at the top of their expected salary levels may want to defer taxes until they retire, younger workers just starting out may choose to invest in a Roth 401k. They will pay taxes today at hopefully lower rates than they will experience in 40 years when they retire. But they will gain the benefit of withdrawing their money tax-free at retirement.
When is it more comfortable to pay taxes?
Most advice I’ve seen focuses on the numbers: your tax rate today versus your tax rate in the future. And while that is important, it’s also important to consider when you might feel more comfortable paying taxes. For some, paying taxes while they have a steady income makes more sense than hoping that some future retirement scenario works out perfectly. They may want to contribute to a Roth knowing that while it may not be the best plan for maximizing every dollar, they can afford the tax burden today because they have a steady job.
Other Roth IRA advantages at retirement
In addition to tax-free distributions at retirement, Roth IRAs offer a couple of other advantages you should be aware of.
Required minimum distributions (RMDs). Some retirees consider those three words to be swear words. Why am I forced to take out money I don’t need? Both plans required retirees to take out RMDs annually. However, starting in 2024, RMDs are no longer required for Roth 401ks.
Inheriting money in a Roth 401k. Your heirs would pay no taxes on money left to them in a Roth 401k (provided it’s been open for at least five years).
It’s okay to change over time
Since Roth 401ks are relatively new, people are still determining the best way to use them. One idea is to start off by investing in the Roth 401k when you’re early in your career. As you receive raises and move up the corporate ladder, consider moving some or all of your contributions to a traditional 401k. This allows you to take advantage of a longer period of time to build up the Roth while also potentially lowering your tax bill later in your career by using the traditional.
Divide and conquer
Most companies allow you to choose one or both plans. If you can’t decide what to choose, put the majority of the money in the account you feel most comfortable with, potentially up to 70 or 80%, then contribute the remainder to the alternate plan. As you grow older and move closer to retirement, you may be better able to predict the advantages of one over the other and match your contributions to your new reality.
Unfortunately, there’s no time machine where you can go 40 years into the future to ask your older self what you should be doing with your money. Much of financial investing is to use the best advice and products available, then reevaluate along the way. Whatever you decide, start investing immediately. Don’t let the question of one plan or the other keep you from saving for retirement.