Pay Taxes Now or Later? Traditional 401k vs. Roth 401k

/ evensky
Katherine Sojo

Katherine Sojo, CFP® Financial Advisor

If your employer offers you a traditional 401k and a Roth 401k, you might find yourself wondering what the difference is and why it matters. Traditional and Roth 401ks have several similarities such as that they are only offered by employers, the contribution limits are the same ($18,000 for 2017 plus $6,000 if you are over the age of 50), and the employer match is always pretax regardless of which option you choose. The biggest difference between a Traditional 401k and a Roth 401k is the timing of payment of taxes. In a Traditional 401k, your contribution is termed as pre-tax dollars; you receive an upfront tax break, reduce your taxable income, and pay the taxes when you take the funds out during retirement. The money withdrawn at retirement from a Traditional 401k is taxed as ordinary income using your tax rate at that time. A contribution to a Roth 401k is termed as after-tax dollars; this means you pay taxes on the contribution now, at your current tax rate, and therefore during retirement you withdraw the money and the earnings tax-free.

How do I decide? Ask yourself the following questions:

  1. Do I want to pay taxes now or later? What is my tax rate differential? If you believe you are in a lower tax bracket today and will be in a higher tax bracket during retirement, then paying the taxes now by funding a Roth 401k is a good option. If you believe you are in a higher tax bracket today and will be in a lower tax bracket during retirement, then funding a Traditional 401k and paying the taxes later is a good option.
  2. Can you afford to pay the taxes now? Knowing what the actual tax dollar benefit of a pre-tax or after-tax contribution means for your pocket is also a deciding factor (your tax advisor can help with this calculation). If you pay the tax now (Roth 401k), then your paycheck will decrease; therefore, you will have less money to cover expenses and/or less money for additional outside savings. A traditional 401k provides for a current tax deduction that results in some extra cash in your pocket now.
  3. Do you distrust future tax regulations? Do you believe taxes will increase in the future? If so, then taking advantage of a lower tax bracket now will signify contributing to a Roth 401k. Do you believe taxes will decrease in the future? If so, then hold off on paying taxes on the contribution until retirement and utilize a Traditional 401k.

There is also an argument for using a combination of both a traditional 401k and a Roth 401k to diversify your tax exposure. A combination of the two can provide some upfront tax benefit and also some protection on any tax rate changes in the future. It is not a simple decision, but truly thinking about your answers to the questions above can help you make the best decision possible for your retirement planning.

Feel free to contact Katherine Sojo, CFP® with any questions by phone 305.448.8882 ext. 243 or email: KSojo@EK-FF.com.