In this new year, you may have the opportunity to reevaluate your employer-sponsored retirement plan. Most companies will give you the option to choose between a Traditional and Roth 401(k). Chances are, this decision will require a little research to ensure you’re making the right choice for you. We’ve done what we can to compile the basics, and help you understand exactly what you need to know about your 401(k).
In a Traditional 401(k), contributions are made with pre-tax dollars, which allows an up-front tax break and a lower current income tax bill. The money grows at a tax-deferred rate until it’s withdrawn. However, when it is withdrawn, it is seen as ordinary income and is paid at the individual’s current tax rate.
Inversely, Roth 401(k) contributions are made with after-tax dollars. Because of this, withdrawals become tax-free at age 59 ½, as long as the account has been held for five years. While traditional 401(k)s provide the instant gratification of an up-front tax break, come retirement, every dollar you’ve saved away could become worth 25-35% less, depending on your tax bracket.
How to choose?
If you’re earning the most money you’ve ever earned and you’re closing in on your retirement years, the traditional 401(k) will probably be the wisest option. Because your income will probably be lower in retirement, you may be paying less in taxes as you withdrawal than you would
However, if you’re just getting started in a career and expect a higher wage in the years to come, the Roth option is probably more in your interest. While you will pay an up-front tax, you’re also in a lower tax bracket than you’ll find yourself later in life. Paying the taxes now will allow you the luxury of tax-free withdrawals once you hit retirement age.
Okay, now what?
Here’s why you might choose a Roth 401(k) –
- You’re a young investor or not a high earner
- You’ll have to give up initial tax breaks on contributions, but if you’re in a lower tax bracket, you’ll be okay
- You’ll get to avoid 401(k) taxation when you’re
retired,because you’ve already paid it!
Here’s why you might choose a Traditional 401(k) –
- The instant gratification of making tax-free contributions to your account
- You’re in the highest-earning tax bracket you’ve ever been in
- Your money will continue to grow, tax-deferred!
Ultimately, the decision boils down to whether you want to pay taxes now or later. This truly depends on what your financial future looks like, and where you see yourself headed.
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