When 401ks came into being, all contributions were made tax-deferred. So, you don’t pay taxes today on the money you put into your 401k account each payroll. This can allow you keep more of your take home pay while you save for tomorrow. Your 401k savings will be taxed when you withdraw it in retirement.
Now, most 401k plans also offer a Roth 401k option. This is the exact opposite of tax-deferred. You make your contributions on an after-tax basis. By contributing some or all of your funds to the Roth, you pay taxes now, but these monies are not taxed again when you use them in retirement — earnings and all. Some like to call this retiring tax-free. See the chart below.
Fun Facts: If you receive an employer match, this money is required to be paid into your account tax-deferred. However, you as an employee can choose to contribute all tax-deferred, all Roth, or you can actually contribute to both!
Roth 401k versus Traditional 401k
|Roth 401k||Traditional 401k (tax-deferred)|
|Contribution Tax Treatment||You contribute after-taxes; there is no tax benefit in the current year.||You contribute before tax which lowers your current adjusted gross income. You’ll have more take home pay in the current tax year than if you made all Roth 401k contributions.|
|Withdrawal Tax Treatment||No taxes on your distributions in retirement. To be IRS qualified, you must have established the Roth 401k 5 or more years ago and you are taking the distribution on or after reaching age 59 ½ or due to disability or death.||Your distributions are taxed as ordinary income upon reaching retirement age (59 ½ years old). Note that if you take withdrawal before retirement age you will typically be subject to an added 10% penalty.|
Note that Roth 401(k) contribution limits are much higher than a Roth IRA and there are no income limits to use it.
Which Do I Choose?
Here are your top considerations that make this easy for you (go through all of these before you make a call as you will likely find multiple needs with different answers):
I want or need to lower this year’s taxes and maximize today’s take home pay while saving for retirement = Tax-deferred
I am just starting to climb the career ladder and expect to be at a higher tax rate in retirement = Roth
I don’t expect to be in a higher tax rate come retirement; in fact, my rate may be lower = Tax-deferred
I expect tax rates to be considerably more in retirement in general = Roth
I want flexibility to manage taxes in retirement = Roth
I expect to have wealth and will pass money on to heirs = Roth (You can roll your Roth 401k into a Roth IRA and pass to heirs with less tax consequences for them)
More Perspective – You May Want to Hedge Your Bets
No one knows what tax rates will look like 10, 20 or 30 years from now, and there is no guarantee on where you will be on your road to financial freedom. The Roth option can be used to hedge your tax situation when you’re ready to use your money in retirement.
A common strategy is to divide your contributions between pre-tax and Roth. This allows you to “hedge your bets” and provides you an extra option on how to use your savings when you reach retirement age. For instance, you can take money out of the Roth portion of your account in years when you need to spend more money (maybe a big trip or moving to that dream house on the beach) to keep taxes in check and use the traditional 401k monies at times when your spending will be lower.
Remember that all employer matching and profit-sharing is done on a tax-deferred basis. This means that only your personal contributions can be made towards a Roth 401k account. So, if you are hedging, you may want to consider how much you receive from your employer to determine what percent you want to contribute to Roth vs. tax-deferred to meet your goals.
As you look for new ways to pay yourself more and keep taxes in check, know that your 401k can be a big help. To ensure maximum tax benefits, the earlier you start the better. The savings benefits might just last you a lifetime. It’s always wise to check with your tax advisor for more insights and strategies for your specific situation.