Many companies who provide 401K retirement plans are now starting to offer a Roth 401K option. How do you know which one to choose? Both savings vehicles allow you to make voluntary salary deferrals of the lesser of 100% of your pay or $18,000 (the limit in 2016) per year. And if you are 50 or older, you can typically contribute an additional $6,000. While the limits are the same, the deferrals and retirement distributions are taxed differently in the two plans.
A traditional 401K allows for pre-tax deferrals, meaning that they are deducted from the taxable income that is reported on your W-2 at the end of the year, reducing your taxable income and the income tax due in that year. As the investments grow, no tax is due on any gain until you withdraw money from the plan. At that time, you will pay ordinary income tax on all withdrawals (plus a 10% federal penalty if you are not at least 59½, or in the event of a few other less-common situations). You make pre-tax deferrals but receive taxable distributions.
A Roth 401K, named for the late Senator William Roth, requires that deferrals be made with after tax–dollars. This means that you will not save any income taxes at the time of the contribution. Similar to the traditional 401K option, the investments grow free of taxation. However, while traditional 401K withdrawals are taxable, all qualified distributions from a Roth 401K are income tax-free. Qualified distributions are those in which the account is at least five years old and the distribution is made due to disability, death or upon reaching age 59½. So your contributions are taxable but your distributions are generally income tax-free.
Which Option Is Better?
The answer is actually quite simple. If you are in a higher tax bracket when making contributions than the tax bracket you are in while taking distributions, you should choose the traditional version. If, however, you are in a lower tax bracket when making contributions than the one while taking distributions, you should choose the Roth version. If the tax rates are identical pre- and post-retirement, then it makes absolutely no difference.
When comparing the two options, it is necessary to adjust the contributions for taxation. Since the Roth contributions are after tax, for comparison purposes, the deferral must be reduced by the income taxes paid before the contribution is made. So an $18,000 contribution to a traditional 401K plan would be compared to a $15,300 contribution to a Roth 401K plan if the taxpayer is in the 15% tax bracket (15% X $18,000 = $2,700, and $18,000 – $2,700 = $15,300). Essentially, both contributions required $18,000 of gross pay. Upon retirement, the traditional 401K balance must be reduced by taxes due on distribution, while the Roth 401K balance is paid tax-free.
The chart below compares an $18,000/year-contribution for a traditional 401K to an after-tax contribution of $15,300/year to a Roth 401K, assuming a 15% pre-retirement income tax rate. It illustrates the after-tax retirement balances using 10%, 15% and 20% post-retirement tax rates. The investments are assumed to earn a hypothetical rate of return of 7% per year.
Notice that when the pre-retirement tax rate of 15% is higher than the post-retirement rate of 10%, the traditional 401K plan has the advantage. When the pre-retirement rate of 15% is lower than the post-retirement tax rate of 20%, the Roth 401K is a better choice. However, when the pre- and post-retirement tax rates are equal at 15%, the net for the Roth and the Traditional 401K plans are identical.
So if you expect your income tax rate to decrease in retirement, choose the traditional 401K. If you expect taxes to increase during retirement, choose the Roth 401K. If you are not comfortable guessing what your tax rates will be at that time, then split your contributions evenly between the two options.
Remember, no matter what you’ve planned for retirement, it pays to know where your credit score stands and how everyday habits are affecting your credit. You can check your scores, updated monthly, for free on Credit.com.
More Money-Saving Reads: