Dear Carrie,
I’ve been contributing to a regular 401(k) for 8 years but my employer just started offering a Roth 401(k) plan as well. How can I decide which is best? —A Reader
Dear Reader,
The sheer number of retirement accounts can make anyone's head spin. Once you've opened a specific type of account—for instance a traditional 401(k)—it's tempting to just figure you're set. But with more and more employers now offering a Roth 401(k) as well, it's smart to take a step back and consider the potential benefits of each. So thanks for bringing this up.
You'll often hear that a Roth account, whether an IRA or a 401(k), may be a good option for young investors. That's because they are typically currently in a low income tax bracket, and the up-front tax deduction of a traditional retirement account is less valuable at that time than the tax-free withdrawal of a Roth down the road.
Lately, however, financial advisers have been pointing their older clients toward Roth accounts as well. Unlike a Roth IRA, there are no income limits on a Roth 401(k), so the door is wide open for older, higher-earning employees to get the benefits of tax-free withdrawals later on.
So how do you decide? Let's start with the basics.
It's a question of when you pay the taxes
The basic difference between a traditional and a Roth 401(k) is when you pay the taxes. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your money—both contributions and earnings—grows tax-deferred until you withdraw it. At that time, withdrawals are considered to be ordinary income and you have to pay Uncle Sam his due at your current tax rate; there may be state taxes due as well. (With certain exceptions, you'll also pay a 10 percent penalty if you're under 59½.)
With a Roth 401(k), it's basically the reverse. You make your contributions with after-tax dollars, meaning there's no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free at age 59½, as long as you've held the account for five years.
So it mostly comes down to deciding when it's better for you to pay the taxes—now or later. And that depends a lot on your timeframe as well as what the future may look like.
Weighing now versus later
A tax deduction now can seem like a pretty good deal, but you have to think ahead. Under today's tax rules, every dollar you withdraw from a traditional 401(k) could be reduced 25 or 35 percent (or more!) come retirement time, depending on your tax bracket. That's not going to feel so good when you're trying to put together your income in retirement.
If you're young and confident that you'll be earning more and in a higher tax bracket in the future, the Roth 401(k) may be a good choice. But even if you're in your 40s, 50s or 60s, you might want to take a close look at the Roth option.
Why? Because even if you end up in a lower income tax bracket when you retire, withdrawals from your traditional retirement accounts could potentially kick you into a higher tax bracket. That could increase your tax bill—including potential taxes on Social Security benefits—and may reduce your disposable income. Higher taxable income could also increase the costs of your Medicare B premiums in retirement. So giving up the tax deduction now may be well worth having tax-free withdrawals later on.
Hedging your bets with both
The good news is that when it comes to a traditional vs. a Roth 401(k), you don't necessarily have to make an all-or-nothing choice. You may be able to have both, and decide year-by-year where you want to make your contributions.
If your employer's plan allows it, you may even be able to split your contributions between the two types of accounts. In 2017, you can contribute a total of up to $18,000 to a 401(k). That goes up to $18,500 in 2018. (Plus you can add an additional $6,000 if you're 50 or older.) So, for example, depending on your plan rules, you could decide to put $9,000 in your traditional 401(k) and $9,000 in your Roth in 2017—enjoying the benefits of both.
A couple of added thoughts
Like a traditional 401(k)—and unlike a Roth IRA—you do have to take a required minimum distribution (RMD) at age 70½ from a Roth 401(k) unless you're still working for that employer. However, it's possible to roll over your Roth 401(k) into a Roth IRA, eliminating that requirement. But before you make that decision, you should carefully consider others factors such as fees, investment choices, distribution options, legal protection, loan provisions and other particulars of each account.
If you're thinking even farther ahead to estate planning, inheriting money in a Roth could be good news for your heirs because, provided the Roth 401(k) is at least 5 years old, they wouldn't have to pay income taxes on the distributions from an inherited Roth.
It's great that you have a choice—and the best choice of all may be to invest in both types of accounts. Whatever you decide, you're already planning and saving for retirement. And that's the best decision of all.
Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article.
For more updates, follow Carrie on LinkedIn and Twitter. This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
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