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Roth 401(k) Vs. Traditional 401(k)

You’ve likely heard of the Roth version of your 401(k), but how do you choose whether to put your 401(k) money in a Roth account or a Traditional account?

The only difference between the two is when you pay the taxes. If you invest in a Roth 401(k), you pay them now. If you invest in a Traditional 401(k), you get a tax break now but must pay taxes when you withdraw your money.

So how do you choose? Let’s use Lauren, a long-time wage laborer at a manufacturing company, as an example. She begins saving for retirement at the age of 30 and saves 5% of every paycheck until she retires at 65. While she works, she falls into the 25% tax bracket, but there is no way for her to know what kind of tax burden she will face in retirement.

Scenario 1

Suppose she is taxed at a higher rate, say 35%, on the distributions she takes in retirement:

Withdrawal Impact Roth 401(k) Traditional 401(k)
Annual Salary $45,000 $45,000
5% Annual Salary Deferral $2,979 $3,723
Taxable Income $45,000 $41,277
Annual Tax $7,021 $6,277
Total Additional Pre-Retirement Tax (Over 35 Years)$26,064 -
Paycheck After Salary Deferral $35,000 $35,000
Years of Saving 35 35
Investment Return 8% 8%
Tax Paid at Withdrawal (@ 35% Tax Rate) - $206,369
After-Tax Value of Account $575,957 $513,577

This higher tax rate has a large effect on Lauren’s income in retirement. If she puts all of her savings into her Roth 401(k), she doesn’t have to pay the higher 35% rate when she withdraws the money since she already paid the 25% rate when she deposited it.

If she puts all of her money in a Traditional 401(k), she has to pay 35% in taxes when she takes distributions in retirement.

In this scenario, having money in a Roth 401(k) really pays off for Lauren.

Scenario 2

Let's say Lauren is in the 15% tax bracket when she retires:

Withdrawal Impact Roth 401(k) Traditional 401(k)
Annual Salary $45,000 $45,000
5% Annual Salary Deferral $2,979 $3,723
Taxable Income $45,000 $41,277
Annual Tax $7,021 $6,277
Total Additional Pre-Retirement Tax (Over 35 Years)$26,064$0
Paycheck After Salary Deferral $35,000 $35,000
Years of Saving 35 35
Investment Return 8% 8%
Tax Paid at Withdrawal (@ 15% Tax Rate) $0 $107,992
After-Tax Value of Account $575,957 $611,954

For Illustrative Purposes Only

In this scenario, Lauren is better off putting her savings in a Traditional 401(k) and paying the lower 15% tax rate when she withdraws her money rather than the 25% rate when she deposits it.

Strategy

So what can you do with this information? The bottom line is that it is hard to predict what taxes will be like in 20 or 30 years. It is just as difficult to foresee what your personal financial situation will be.

A good strategy: put some in both! This gives you safety and flexibility in your retirement years. If you put your eggs in both 401(k) baskets, you can significantly reduce the tax risks you face.

On top of that, you will have two buckets to pull from: one that you have to pay taxes on (Traditional) and one that is tax-free (Roth).

Here’s an example of how this can be useful during retirement: Let's say you are planning an expensive vacation this year, and you will withdraw a large amount of money from your retirement account. As a result, you will be in a high tax bracket. If you withdraw from your Roth this year, you won’t have to pay these high taxes, since you already paid them when you put the money in.

Next year, you are planning to stay home and live a relatively inexpensive lifestyle. You won’t withdraw as much money from your nest egg as you did this last year. As a result, you will be in a lower tax bracket. Now you can pull from your Traditional 401(k) and pay taxes at the lower rate.

Vacation isn’t the only reason your expenses may be higher than usual. Having funds in a Roth can provide coverage against any unexpected medical expenses you may face in your later years.

A final important factor to consider is whether the tax break will help you more today or in retirement. The two scenarios for Lauren show how contributions to a Traditional 401(k) are tax deductible. For example, if you contribute $10,000 to your plan and fall into the 25% tax bracket, you can deduct this amount when filing your taxes and save $2,500 this year! You will still have to pay taxes when you withdraw your money, but some financial relief today could be more important to you than financial relief when you are retired.

Remember, your financial advisor or employer's Benefits Department is always available to provide educational support to help identify your retirement strategy.

This is intended for informational purposes only and should not be construed as investment, legal, or tax advice. Please consult with your financial professional regarding your specific situation.
Sources: taxfoundation.org, www.irs.gov, www.investopedia.com

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