By: Josh Koehnen, MsBA, CFP®
The road to an easy retirement can be plagued with difficult decisions but choosing the correct 401(k) plan does not need to be one of them. Selecting the type of 401(k) plan that will benefit you the most is crucial to a comfortable life post-work. Both the Roth 401(k) and the traditional 401(k) are options that will ensure you can save money for your retirement through contributions from your paychecks. They both also allow for a potential company match depending on where you work. These two plans both have a contribution limit of $19,000 per year or $25,000 if you are over the age of 50. The real difference maker is; are you going to pay more income tax now or later?
You can think of a traditional 401(k) plan as a pre-tax savings account. This means the contribution you make every month or year comes out of your paycheck before taxes are taken out. This pre-tax contribution makes your taxable income lower but also means when you begin taking distributions at age 59 ½, your withdrawals are taxed. The distributions you take become your income and the taxes you deferred while you were working, get paid at each withdrawal moving forward.
A Roth 401(k) is opposite of the traditional plan in the sense that it is an after-tax savings account. This means your contributions have been made after all necessary tax deductions have been made. In this format, your money will accumulate tax-free over time. When you retire, you will also receive tax-free withdrawals. While you will also be able to access your money at 59 ½, with a Roth 401(k), you must have had the account for over five years in order to receive distributions.
In order to decide which is best for you, ask yourself whether you think you will be in a higher or lower tax bracket once you enter your retirement years. If you are a younger investor who is just getting started in your career and your income is putting you in the lower tax brackets, you might be better off with more in the Roth. On the other hand, if you are a bit further along in your career and your income is putting you in the higher tax brackets, you might want to take advantage of the tax deduction today and therefore might be better off in the traditional.
Overall, both types of 401(k) plans have benefits and disadvantages, so it’s good to put thought into this now and decide which type is right for your situation. Or, better yet, maybe consider some combination of both the traditional and Roth 401(k) so you can have more tax flexibility when you start taking distributions in retirement.
Investment Advisor Representatives offering advisory services through Premier Wealth Advisors (PWA), a registered investment adviser. Securities and additional advisory services offered through Independent Financial Group, LLC (IFG), a registered broker dealer and a registered investment adviser. Member FINRA/SIPC. PWA and IFG are unaffiliated entities.