What Should I Contribute to? A Roth 401(k) or a Traditional 401(k)?

When it comes to saving for retirement, most employees have a choice between contributing to a Roth 401(k) or a Traditional 401(k). The choice largely depends on your individual financial situation and long-term goals, as both options have their advantages and disadvantages.

Considerations When Funding Your Retirement

Traditional 401(k) accounts provide a tax deduction by reducing your taxable income, while Roth 401(k) contributions do not provide a tax deduction. However, Roth 401(k) withdrawals, under current law, are made tax-free.

It is also important to consider whether your employer offers a matching contribution to your plan, as matches are provided pre-tax – meaning, you will owe taxes when funds are distributed. Essentially, a Roth 401(k) provides two accounts for your retirement.

The Benefits of a Roth 401(k) Plan

Roth 401(k) plans feature qualified tax-free withdrawals, which means that money contributed and any earnings accumulated over the years can be taken out of a Roth 401(k) with no tax implication. This is unlike a Traditional 401(k), where savings are taxed upon withdrawal. If you expect to be in a higher tax bracket when you start to withdraw 401(k) funds, a Roth 401(k) plan might save you from owing taxes on those funds.

Another benefit of a Roth 401(k) is the lack of Required Minimum Distributions (RMDs). Without an RMD, money can be left to grow for as long as you wish. Under a Traditional 401(k), current law states that RMDs are taken at age 73 if you are no longer working. Should you pass away before Roth 401(k) funds are distributed, your account is transferred to a beneficiary.

A Roth 401(k) allows for contributions to be withdrawn at any time without fees or penalties (however, generated earnings cannot be withdrawn). This is helpful in an emergency, as fund sources can be taken out as needed.

Disadvantages to be Aware of

One of the biggest trade-offs when contributing to a Roth 401(k) instead of a traditional account is that take home pay is reduced, as contributions are made with after-tax dollars. In comparison, a traditional account can provide a tax deduction that would increase your take home pay.

Taking the Next Step

Saving for retirement has clear benefits, regardless of the plan you choose to invest in. Depending on your specific financial situation, choosing a Roth 401(k) over a Traditional 401(k) can offer significant benefits. The tax-free withdrawals, absence of RMDs and tax diversification also make it a compelling option for many individuals. Nonetheless, the retirement account you choose should align with your long-term goals and tax considerations. Many individuals opt for a combination of both the Roth 401(k) and traditional account to maximize tax diversification and financial flexibility. Consulting with a financial advisor can help you make the best choice based on your unique circumstances.

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Sikich Financial does not provide tax or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are based upon publicly available information and are provided for general information and educational purposes only. Although the information contained herein has been compiled from data considered to be reliable, the information is unaudited and is not independently verified, and therefore we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.