Traditional vs. Roth 401(k): Why You Might Want Both
February 25, 2022
Traditional vs. Roth 401(k): Why You Might Want Both
February 25, 2022
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There is one key factor to consider when deciding which type of 401(k) to contribute to: tax implications—both now and later. Retirement planning involves balancing saving now with tax implications in the future. While you may only have one type of 401(k) available via your employer, if you do have a traditional and Roth 401(k) available, it may be wise to contribute to both.
Differences Between a Traditional 401(k) and a Roth 401(k)
A traditional 401(k) allows you to make pre-tax contributions directly from your paycheck, meaning your total taxable income is lowered and you pay fewer taxes right now. However, when you withdraw money from your 401(k) in retirement, you’ll pay taxes on those distributions in the future. Contributions to a Roth 401(k) are made with after-tax dollars, meaning your contributions have already been taxed and distributions will not be taxed in retirement—this includes any returns/growth in your account, too. Roth 401(k) contributions have no implications on your current taxes, so you can’t take a deduction or reduce your taxable income using this method. Keep in mind that even if you contribute to both, your combined contributions cannot exceed the IRS’s limit (currently in 2022, the limit is $20,500).
While no one can predict future tax rates, especially if you’re young and have many years of earning and saving before your retirement, but it’s a good bet to plan on your income continuing to rise throughout your career. With that being said, when you’re younger and your income puts you in a lower tax bracket, a Roth 401(k) may be a good idea since you’re likely not as concerned with reducing your taxable income. This gives you many years of tax-free growth in your Roth account. Also, if you expect your income tax bracket to be high in retirement, a Roth becomes even more advantageous because your withdrawals are tax-free. Lastly, if you’re great saver and plan to max out your contributions every year, a Roth may be the best fit for you since you’ll probably have a hefty nest egg that would enjoy tax-free withdrawals.
A traditional 401(k) might be best for high income earners, when reducing your taxable income and keeping more money in your pocket now may be more important. Your contribution timing may be a factor to consider also; sometimes, the “sting” of contributing to a retirement account is felt more when it’s made after-tax, as this reduces your take-home pay more so than a pre-tax contribution. Keep in mind that if offered, your employer can match either Roth or traditional 401(k) contributions, but they must put their matching funds into a pre-tax account; you will pay taxes when you withdraw your employer matches.
Benefits of Diversifying Your Taxes
However, the ideal mix may be contributing to both a Roth and traditional 401(k) if they are available to you. This helps diversify your tax strategy and spread out your tax implications on retirement account withdrawals. You are required to make required minimum withdrawals on most retirement accounts at the age of 72, so how those distributions will be taxed is an important factor in your retirement income planning. Spreading out taxable and tax-free distributions between accounts can help ease your tax burden in retirement.
Additionally, you may have the option to roll over both 401(k) accounts into a Roth IRA, which does not require required minimum distributions until after the original account owner’s death (if desired). There are also other options for rolling over your accounts, which tax and financial professionals can elaborate on.
Lastly, if you plan to utilize both accounts to build your current tax strategy, you may consider figuring out how much you need to contribute to each to maintain your current tax bracket or avoid moving into a higher tax bracket. For example, say your current salary is $100,000, which puts you in the 24% tax bracket for 2022. You plan to utilize your employer-sponsored Roth and traditional 401(k) for tax and retirement planning and max out your annual contributions. You need to contribute at least $10,925 to your traditional 401(k) to reduce your tax bracket to the 22% marginal rate. You can then contribute the remaining $9,575 to your Roth 401(k).
There is no one universal answer as to which type of account is best for you. It depends on your finances, current and possible future tax situation, overall retirement planning, and your goals. However, contributing to both 401(k)s, if available, has many benefits and may be an effective way to hedge your future taxes. Financial professionals, including an investment advisor and tax professional, can help you make the best decision for you by taking into account your full situation.
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Bahney, Anna. (November 30, 2018). Why you might want both a traditional 401(k) and a Roth. CNN Money. https://money.cnn.com/2018/05/10/pf/401k-vs-roth-retirement-accounts/index.html
FINRA. (n.d.) Traditional and Roth 401(k)s. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/traditional-and-roth-401ks#:~:text=The%20good%20news%20is%20that
Internal Revenue Service. (November 10, 2021). IRS provides tax inflation adjustments for tax year 2022. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2022
Internal Revenue Service. (n.d.) Retirement Plan FAQs on Designated Roth Accounts. https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#:~:text=Yes%2C%20your%20employer%20can%20make,on%20your%20designated%20Roth%20contributions.