How to Know If You Have the Best Type of 401(k) to Plan for Your Retirement
Q: My employer lets me choose between a regular 401(k) and a Roth 401(k)? What’s the difference between these two types of retirement accounts, and which one should I use?
Both a traditional and Roth 401(k) have a place in your retirement nest egg, and you needn’t choose between them. In fact, the best move may be to hedge your bets if your employer is one of the 50% of plan sponsors that offer both.
The differences between these 401(k) plans are similar to the differences between regular and Roth IRAs: the timing of taxes.
With a Roth 401(k), you pay taxes up front. In other words, you contribute to your retirement account with money from your paycheck after it has already been taxed. Once in the account, your money grows tax-sheltered. Then at retirement, qualified withdrawals come out tax free.
By contrast, contributions to traditional 401(k)s are made with pre-tax dollars. The money is allowed to grow tax sheltered. But when it comes time to tap the account in retirement, withdrawals will be taxed as ordinary income.
Annual contribution limits for both types of accounts are $18,000 in 2016, plus $6,000 more if you’re over 50. And required minimum distributions begin for retirees at 70 1/2.
Each type of 401(k) can provide a path to a safe and secure retirement, but there are different considerations to take into account.
The Case for Using a Traditional 401(k)
Your decision comes down to a basic question: When do you want to pay taxes, and what’s your tax rate going to be?
“It’s a tax play,” says Bethlehem, Penn. financial planner and president of Educated Wealth Strategies Eric Nichols. “Will you be in a higher or lower tax bracket in retirement relative to where you are now?”
If you think your tax rate when you retire will be lower than it is now, go with the traditional 401(k). That way, you’ll avoid having to pay taxes on your contributions now, when your tax rate is high.
Then, when you start to withdraw at retirement, between ages 60 and 70, you’ll pay the applicable income taxes on that money when your income tax bracket is presumably lower.
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The Case for a Roth 401(k)
In a Roth, you use income that’s already been taxed from your paycheck and contribute to the account. But once inside, the cash grows tax free and isn’t subject to income taxes when you start taking money out in your 60s.
If you’re in a low income bracket now — for instance, if you’re young and just starting out — and think you’ll be in a higher tax bracket at retirement, a Roth can make a lot of sense. After all, you’d be paying taxes up front at a time when the actual tax bill will be small.
One major advantage of a Roth — besides the tax play — is that you can tap a large portion of your Roth 401(k) in retirement to pay for, say, a medical emergency without incurring the tax bill you would have with a traditional 401(k).
Roth investors are also making a bet that tax rates will roughly stay where they are. Young workers may be attracted to the Roth option since you lock in low tax rates up front. But they’d be hurt if overall tax rates were actually lowered in 30 years in favor of, say, a value-added tax.
“It’s a gamble on where you think taxes are going to be in the future,” says Nichols.
The Case for Both
Rather than making an affirmative decision, why not bet on both?
Just as you diversify the stocks and bonds in your retirement portfolio, there’s a strong case for diversifying your tax exposure in retirement.
By using both a Roth and a traditional 401(k), you’d lower at least a portion of your current taxable income, maintain a diversified retirement plan, and give yourself some cover if future tax rates change.
Keep in mind, though, you’ll still be capped at $18,000 a year for total annual contributions.
If your employer doesn’t offer a Roth 401(k), and you’re eligible, consider contributing to a Roth IRA in addition to your traditional 401(k). On top of potential tax benefits, there’s another advantage: You can withdraw your original contributions (not your gains) to a Roth IRA tax and penalty free — which you can’t do with a Roth 401(k).
“The best thing is to hedge your bets and get some tax diversification,” says Nichols. “I have no idea what taxes will look like in the next administration, let alone 30 years into the future. You should run far away from anyone who says they do.”