How to Choose Between a Traditional vs Roth 401(k)

Does your workplace offer both traditional and Roth-style 401(k) plans? Traditional plans (i.e., money is taken out of your paycheck pre-tax) have been the industry standard for several decades now. However, Roth-style plans (i.e., money that gets saved on a post-tax basis) have become very popular given that they provide accountholders with tax-free income when they retire.

So how does someone choose between a traditional vs Roth 401(k) plan? Here’s what you need to ask yourself.

What is Your Tax Bracket Now vs Later?

Stop for a minute and imagine your future self. What does life look like for you? 

Do you plan to be living the life of luxury enjoying more money than you have right now, or do think your days will be similar to the way they are right now? 

This exercise may seem silly, but it’s an important one to do because it helps you to better understand what your tax situation will look like in the future relative to now.

Generally speaking:

  • Most of the money you earn today from your job is taxable
  • Likewise, when you’re retired, if your income is coming from “pre-tax” accounts like a traditional 401(k) or IRA, then these will also be taxable

From that perspective, the question to ask yourself is: How much do I really need to live comfortably during retirement?

For instance, let’s say you and your spouse are currently earning a combined $150,000 per year. If you’re relatively modest and expect to have some of your major expenses paid off (such as your mortgage), then you might only need $100,000 when you retire. All things being equal, this means you’re probably in a higher tax bracket right now and a traditional 401(k) would be the better option.

If for some reason you thought you’d need $200,000 per year when you retire, then one could argue that you’d probably be in a higher tax bracket. Therefore, a Roth might be the better option.

The best way to determine this is to go through your budget now and make a list of what you’d anticipate your expenses to be in the future. Don’t forget to include things like:

  • Out-of-pocket taxes (since they’d no longer be withheld like they are now with your paycheck)
  • Inflation
  • Healthcare
  • Travel
  • Daily activities (clubs, sports, etc.)

If you’re unsure what your expenses are now, try using a budgeting app like Buxfer to capture them.

Do You Think Tax Rates Will Go Up?

Another way to approach the traditional vs Roth question is to predict where tax rates will be in the future. In other words, if your income was equal now and in retirement, is there a possibility that the government might raise rates and you’d have to pay for the same amount of income?

This is of course a very loaded question because it involves you trying to guess what the future will hold. Although no one really knows, you could make a case either way.

On one side of the equation, tax rates for everyone up through the upper middle class have gone down over the years. Economists and politicians recognize that taxing the wealthy and businesses produce far more income for the IRS.

Taking the other side of the argument, recognize that tax rates have historically been higher than they are right now. This means there’s a good chance that they could always be raised – especially when you consider how much national debt we have and the fact that the Social Security trust will soon be running out of funding by 2034.

Again, it’s anyone’s guess what will or won’t happen. However, if you strongly feel one way or the other, then this will impact whether you’d want to go with a traditional or Roth 401(k).

Do You Want to Avoid Taxes in the Future?

While taxes withheld from your paycheck or paid out of pocket are essentially the same thing, from the perspective of a retiree, they’re not. In fact, having to manage and pay your own taxes at retirement is one of the expenses that people look forward to least after they separate from work.

This is because managing these taxes can be a headache. The IRS doesn’t want to wait until the end of the year to be paid, and so depending on how much you owe this could be thousands of dollars every quarter. Unless you’re diligently setting money aside every month, then this could be a very daunting task.

This is why some people choose to skip the hassle altogether and go with the Roth plan. Retirement is all about having peace of mind, and receiving tax-free income will definitely help with that.

Lower Social Security Taxes and Medicare Premiums

If you’re younger, you might not be thinking about Social Security and Medicare. However, something to think about is how your taxable income can influence these two benefits.

When it comes to Social Security and income taxes, there are basically three tiers depending on your tax filing status. For instance, as of 2023, someone who files a joint return can expect that:

  • If their taxable income is less than $32,000, then their Social Security benefits are tax-free.
  • If their taxable income is between $32,000 and $44,000, then 50 percent of their Social Security benefits are taxable.
  • If their taxable income is more than $44,000, then 85 percent of their Social Security benefits are taxable.

Medicare Part B premiums, the healthcare plan offered by the government that everyone is required to sign up for at age 65, have similar exemptions based on taxable income.

If you’d like to get your taxable income down as low as it will go so that you can get the most out of these benefits, then it will make sense to contribute to a Roth. However, if you feel like you’ll already exceed these limits, then it won’t make a difference if you go with the traditional plan instead.

Do You Want to Avoid Required Withdrawals?

Did you know that when you reach a certain age, the IRS will penalize you if you don’t withdraw enough from your retirement accounts? This is because they’ve waited long enough, and they’d like to finally collect the taxes they’re owed. 

These are called RMDs (required minimum withdrawals), and they start at age 73 (as of 2023). The penalty for not complying is a hefty 25 percent of whatever amount was not taken out.

Again, this is not something a younger person is probably thinking about now. But as you get closer to retirement and age, it will become increasingly important. This is yet another reason why contributing to a Roth-style account might have its advantages. Money saved inside of a Roth retirement plan is not subject to RMDs. This allows you to manage your money any way you want.

Which One is Right for You?

As you can see, there are a lot of factors that go into deciding between a Roth and a traditional one. Questions about your current vs future tax rates, Social Security, and even RMDs can all have an impact. No matter which path you choose, the important thing is that you’re diligently saving your money, monitoring your budget, and preparing for what comes next.

Featured image credit: Pexels

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