401k Comparison: Which is Best for You?: Analysis from Cabana Institutional

3 years ago

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A common question that we run into when working with businesses and their employees is “What is the difference in a Roth 401(K) and traditional 401(k) and which one is the best choice for me?” While there are a lot of advantages to Roth 401(k) contributions, there are many puzzle pieces and strategies to sort through before making a choice. We have helped lay out some of those for you below.

Know the Facts About Contributing to a Roth 401(k):

1. This option takes contributions from the employee’s salary after taxes have been paid on those amounts. Note that if there is an employer match on the account, this creates two “buckets”, one that is the after-tax contribution, and one that is pre-tax coming from the employer match. No matter what the employer matches, whenever a distribution is taken, it will be taxed exclusively on that portion. BUT the majority will come out tax-free, because taxes should already have been paid and it helps to diversity retirement income.

2. The investment earnings on the account will also come out tax free when you begin distributions, if the distributions are “qualified”, meaning that the account must be in existence for a minimum of five years since the first contribution was made and they must be made on or after turning 59.5 years old, or after death or disability. If a distribution is taken without meeting those requirements, the investment earnings on the account (including dividends, interest, and capital gains) will be taxed as ordinary income.

3. Roth 401(k)s do not have an income limit to be able to contribute. People over a certain amount of income (varies) are not able to contribute to a Roth IRA and therefore might benefit from contributing to a Roth 401(k) instead for retirement savings diversification.

Know the Facts About Contributing to a Traditional 401(k):

1. Money will come out of the employee’s paycheck on a pre-tax basis. Taxes will be paid as ordinary income on whatever amount is distributed at retirement or when money is taken out of the account (including employee and employer contributions, and investment earnings: dividends, interest, and capital gains). The amount deferred from paychecks will not count towards current income and will not be taxed during the current year or periods when contributions are being made.

2. Many people (especially high-earners) are currently in a higher tax bracket than what they might be in when they retire, since at retirement their income might be Social Security and retirement accounts only instead of a full salary. They might not be better off paying taxes now through the Roth option and could benefit from paying taxes at a lower rate in the future (assuming current and future tax rates are the same).

3. A traditional 401(k) might be less convenient when paying taxes on the sum withdrawn instead of currently on the sum contributed (which is potentially smaller) – especially if you think you will be in a higher tax bracket later or at retirement.

Now What?

Ideally it is good to diversify, and many people opt to open another retirement account like an IRA with the opposite strategy (Roth if their 401(k) is pre-tax or vice versa) or ask their employers if it is possible to contribute to both types within the same plan. Those who believe they are not making as much money as they might in the future, and might currently be in a lower tax bracket than later in life, could consider using the Roth option to pay fewer taxes now. This is common among young people who have a long career ahead of them. Those earning higher income might consider taking the tax deduction now (by choosing traditional), so that they could pay the taxes later when their tax rate might be lower. Those of you that want to diversify, and are currently at an income level that does not allow you to contribute to a Roth IRA, might consider using the Roth option for their 401(K) – and maybe diversify through a Traditional IRA that will grow tax-deferred.

Another smart thing to do when using a Traditional 401(k), is use the money being saved now on taxes to invest and grow it to pay for the taxes that will be charged on the distributions during retirement. Often, people decide to use the traditional option, but end up spending the money they save now by deferring taxes and find themselves having to take a big cut out of their distributions during retirement later. Therefore, those who believe they will not be disciplined enough to invest the tax deductions now, and that do not want to take a portion out of the money they withdraw at and during retirement, might be better off by paying the taxes now through the Roth option.

One more thing to keep in mind is that Roth 401(k)s, just as traditional 401(k)s have Required Minimum Distributions (RMD) which force account owners to begin taking distributions when they turn 70.5. But if the account is rolled over into a Roth IRA before that time comes, there will be no RMDs. Traditional IRAs also have RMD, just like any type of 401(k).

People wanting to save the trouble of paying taxes on their 401(k) distributions when they retire and are not worried about tax rates, or don’t want a portion of that income during retirement to be diminished by taxes and don’t plan on using the tax deductions they get when using a Traditional 401(k) to invest and pay for those taxes in the future, might want to opt for a Roth 401(k) option.

-Santiago Munoz, Dave Mersky and Adam Smith

 

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The views and opinions expressed are those of the authors do not necessarily reflect the official policy or position of Cabana or its affiliates. Any content provided by our bloggers or authors are of their opinion, and are not intended to malign any religion, ethnic group, club, organization, company, individual or anyone or anything.

Information presented is believed to be current. It should not be viewed as personalized investment advice. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a financial advisor before implementing any strategies discussed. Content should not be viewed as an offer to buy or sell any of the securities mentioned or as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation.

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