Last updated on May 16th, 2017 at 02:40 pm
The answer to this question is, “it depends.” In other words, the choice of a 401k plan is based on the particular life stage of the employee. There are several advantages to both, but those can be negated by circumstances. Is a Roth or traditional 401k better for you? In the simplest terms, here is what you need to consider to make your decision.
- Traditional contributions to a 401k plan are made on a pretax basis. That means that they reduce your taxable income for the year. Better yet, the money you invest is tax deferred as it grows and you only pay taxes when you withdraw the money at retirement. At that time, you will pay ordinary income tax on all the contributions you have made over the years to the plan.
- On the other hand, contributions to a Roth 401k are made on an after-tax basis. This means that your contribution will not reduce your current taxable income, but the advantage here is that you will not pay taxes when you retire and begin to take distributions from the plan. Under this scenario, you pay taxes on your income as it is earned, rather than at the end of your career.
- It is also important to note that one big disadvantage is the obstacle to early withdrawals from a traditional 401k. (Distributions generally must begin at 70 1/2.) For Roth accounts, you can pass them onto your heirs without taking distributions and they can take it out over their lifetime if they choose, which will help them generate wealth over time.
Is a Roth or Traditional 401k Better?
When I speak with clients of our firm, we take into consideration where they are in their earning years. People who are at the peak of their careers can benefit from traditional contributions, which help to lessen their taxable income — and in some instances, this can be a reduction that results in considerable savings.
Younger workers who are still in their 20s often have smaller incomes and contributions. This means that the tax consequences are smaller as well. The earlier in your career that you are, the less essential it is to try to manage your tax bracket.
If you think that your tax rate is lower today than it will be when you retire, the Roth 401k may be more attractive to you — whereas if you believe your tax rate is higher today than it will be at retirement, the traditional 401k is likely to be more beneficial. This is an especially prevalent perspective for middle-income employees who expect Social Security to comprise a substantial portion of their income during their retirement years.
What’s a good course of action?
The first thing I would suggest is that you speak with your adviser, who is aware of your current financial situation, as well as your short and long-term goals, so that you make a decision based on the bigger picture. Regardless of the details, one common sense piece of advice that seems to resonate with almost everyone is tax diversification. In this case, you can divide your contributions between both a Roth and a traditional 401k, adjusting the percentage allocated based on your personal situation and comfort level. In the final analysis, putting your money in both plans balances your tax burden.
Keep in mind that once your money is in a Roth 401k, it cannot be transferred to a traditional 401k. But, if you begin with a traditional plan you can convert to a Roth IRA. Although the conversion is complicated, it is possible to achieve.
- “Am I more comfortable paying taxes now or later?”
- “Am I willing to take the risk that the benefit of not paying taxes in the future during my retirement years will outweigh taking advantage of a beneficial tax situation right now?”
Ken Bagner is a member of Sobel & Co. LLC. He is a member of the American Institute of Certified Public Accountants and the New Jersey Society of Certified Public Accountants. Plymouth Rock Assurance is proud to partner with NJCPA to bring you valuable tips for about your financial health. Qualified members of the NJSCPA can receive a discount on their car insurance through Plymouth Rock Assurance New Jersey.