Recent studies have shown that very few employees are opting for the Roth 401(k) which is a huge mistake on their part. It’s been almost 10 years since the 401(k) plans were able to offer a Roth version. If your company offers both plans, it’s time to consider the benefits of a Roth.
Today, there are about 50 percent of plans that currently give employees the option of saving through a Traditional 401(k) or a Roth 401(k). However, many people do not know the difference between the two different plans. You may hear that the Roth account is better for young investors due to their low income tax bracket and up-front tax deduction. But, financial advisors are now starting to point their older clients toward the Roth as well because unlike a Roth IRA, there are no income limits on a Roth 401(k) making the door wide open for older, higher-earning employees to get the benefits of tax-free withdrawals later on.
So what’s the difference between a Traditional and a Roth?
Traditional 401(k) compared to the Roth 401(k)
The Traditional 401(k) offers an upfront tax break unlike the Roth. Every dollar you contribute to the Traditional account reduces your taxable income for that year, but the money you put into a Roth is made with after-tax dollars, so there is no “upfront” tax break.
Although the upfront break can be tempting, you need to realize the long-term impact and tradeoff of that decision. All money withdrawn from a Traditional 401(k) will be taxed at your ordinary income tax rate, while there will be no tax on withdrawals from a Roth 401(k) Understand that that no taxes in retirement on your retirement withdrawals could be very rewarding. What you can do to decide if this benefits you or not is consider if your expected tax rate in retirement will be lower than your tax rate today- if so, go with the Roth.
The only issue that you face is not knowing where tax rates will be in 20 or 30 years from now. Also, even though your income will likely be less in retirement, you don’t know which tax bracket you will fall under. Take for example a married couple in 2014 filing a joint return with taxable income of $125,000 in the 25% federal income tax bracket. If their income in retirement is $85,000, guess what? They are still in the 25% federal tax bracket, based on current tax rates.
In conclusion, for those of you who have been saving in a Traditional 401(k) for years, it may be time to switch your future contributions into a Roth 401(k), if your plan offers it. That way when you retire you will have tax flexibility, with some of your retirement income being tax-free and only some being taxable.