“The future belongs to those who give the next generation reason for hope.” – Pierre Chardin
401(k) vs. Roth 401(k) – Which is better?
First, a quick refresher on their differences.
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- A traditional 401(k) allows an employee to defer a portion of their salary before taxes into a 401(k) and then defer the income taxes on the growth of that account until retirement and/or penalty-free after the age of 59 ½, withdrawals are subject to income tax.
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- The Roth 401(k), on the other hand, does not provide an immediate tax deduction but instead uses an employee’s after-tax salary to fund the Roth 401(k) and subsequent tax-free withdrawals on the growth of the account at retirement, or after the age 59 ½, provided that you’ve had the account for at least 5 years (IRS.gov).
For both a traditional and Roth 401(k) plan, early withdrawals can lead to a 10 percent bonus penalty.
Fun Fact: Roth 401(k) plans are on the rise, too. According to the PSCA-Plan Sponsor Council of America, 28% of workers participating in a 401(k) plan made Roth contributions in 2021, up from 18% in 2016.
So, which is the better choice?
Well, that depends on a few factors.
First, if you or you and your spouse are in a high marginal bracket, it may make sense to reduce your income now and lower tax bill by funding a 401(k) pretax.
Second, if you expect your income to be lower in retirement where the withdrawals will be taxed at a lower tax rate, then the 401(k) could the better option.
Finally, what do you expect future tax rates to look like when you enter retirement. Unfortunately, predicting anything into the future, especially when it involves congress is a fool’s game.
Like Yogi Berra said, “It’s tough to make predictions, especially about the future.”
For younger employees just starting their careers, utilizing the Roth 401(k) could be a better choice. In this case, most employees are not yet at their peak earnings years, so making pretax contributions may not save that much on taxes. However, paying a lower tax rate on the after-tax contributions could allow 30+ years of tax-free growth to retirement. The growth is dependent on many factors, including the types of investments and market conditions, and is not guaranteed
Side benefit: While traditional 401(k) plans require minimum distributions beginning at age 73, beginning in 2024, there are no minimum distribution requirements for ROTH 401k or Roth IRAs.
As younger employees’ career evolves and they find themselves earning more and moving to a higher tax bracket, they can always switch to the pre-tax 401(k) option during those peak years prior to retirement.
One additional advantage of the Roth 401(k):
Recent changes to inherited IRA rules require future beneficiaries to withdrawal the entire retirement account over a 10-year period. It could make a big difference to your beneficiaries if those withdrawals are taxable (traditional 401k) or tax-free (Roth 401k).
As always, consult your tax advisor for more guidance on your specific situation.
On the lighter side, my lovely wife, Iren, left to see her parents in Bulgaria. Elliott and I will join her for a couple of weeks in mid-July.
Hope all is well with you and your family,
Jeremy,
Finger Financial Five – 5 points in 5 minutes or less – is to provide you with a weekly shot of useful financial information. My intention is to share principles so that you will have more clarity that help you make better financial decisions.
Investment advice is offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and Riverview Wealth Management are separate entities.
The information presented in this newsletter is the opinion of the writer and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes only and should not be construed as an investment recommendation.
Past performance is not necessarily indicative of future results, and there is no assurance that the investment objective will be achieved or that the strategies employed will be successful. All investments involve risk and, unless otherwise stated, are not guaranteed.
The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
