If you are US citizen and thinking of or planning to save for your retirement, then it is highly likely that the Roth plan and 401k traditional plan are not new terms to you. When making a choice between the Roth plan or the Traditional 401 (k) plan, your decision comes down to answering the following questions; what tax rate do you want to use? When do you want to pay your taxes?
Therefore, if you are making any retirement plans, it is vital that you familiarize yourself with both retirement plans, get to know their differences, pros, and cons before making a choice on which one to go with. This will save you on taxes either now or in the future.Partaking in your employer’s 401 (K) plan is a good first step towards attaining your retirement plans and goals. Both of these plans offer attractive tax advantages either in the present or future. The choice on either will depend on your individual situation or your personal retirement goals.
Traditional 401 (k) Plan.
The traditional 401 (k) plan is sponsored by the employer and it provides an employee with a variety of investment options. This employee’s contributions to the 401 (k) plans together with any earnings that they make from the investments are normally tax – deferred. The individual gets to pay their taxes on their earnings and contributions during the time of withdrawing their savings. Additionally, any income taxes on an employee’s matching funds are deferred until they withdraw their savings.
Roth 401 (k) plans.
The Roth 401 (k) plan is somewhat similar to the traditional 401 (k) plan in that they are both employer-sponsored. However, for the Roth plan, the employee’s contributions are not tax deferred but they are made after taxes, with the tax benefit coming later. In simple words, you need to pay the tax upfront. Once the money is in your account, it grows tax-sheltered, and comes out tax free. Any of the employee’s benefits including their income earned from dividends, capital gains or income earned on the employee’s account may be withdrawn at a tax-free rate on retirement. The Securities and Exchange Commission (SEC) does not oversee or regulate any retirement plans.
401 (k) Traditional vs. Roth
Making a choice on which retirement plan suits you best will be greatly influenced by when you intend to pay your taxes, and whether you will be in a higher or lower tax bracket at the present or later during retirement.
If after your considerations, you foresee that during your retirement your tax rate will be presumably lower than it is at the moment, then the traditional 401 (k) will work best for you. The income could decrease in the future due to various reasons such as; you are planning to retire soon, taking some time off, or planning to leave a particular job. Through this, you wisely avoid paying taxes on your contributions momentarily when your tax rate and bracket is high. In the case for the Roth plan, one uses income that has already been taxed straight from the paycheck to contribute to the Roth plan. However, once inside the account, the money is left to grow at a tax free rate without being subject to any tax charges at the time of retirement when you start making your withdrawals.
Therefore, if at present you are at a low income bracket say, you are newly employed, and you foresee yourself being in a higher tax bracket during retirement, for example due to job promotions, raised income through attaining additional degrees, or switching to a higher paying job in the near future, then it would make more sense for you to use the Roth plan. This is mainly because you will be paying your taxes upfront during a period when your tax liability will be minimal.
Besides the tax play advantage, another major advantage of using the Roth plan is that it is possible for you to tap a big portion of your Roth 401 (k) during retirement to pay for other expenses like a medical emergency without actually incurring the tax fee you would have otherwise incurred were you using the traditional 401 (k) plan.
Notably, Roth investors tend to make a gamble that the tax rates will approximately stay as they are. It is often to find young employees opting for this plan the main attraction being locking low tax rates upfront. Things could go very badly for them if for instance tax rates were to be lowered in years to come in favor of other types of taxes like value-added tax.
The general rule that should be applied is:
Choose the traditional plan if your current tax bracket is higher than your foreseen future tax bracket during retirement.
Choose the Roth plan if your current tax bracket remains the same or is lower than your expected bracket during retirement.
Other factors to consider.
Besides taxes, there are other factors that one needs to consider before deciding on what retirement plan to go with. They include;
Employer’s match. In some cases, some employers may match a portion of their employees’ contribution up to a certain percentage of your salary. This is common for the Roth plan. Ideally, this means that your employer will be contributing a certain amount to your account as a way motivating you to contribute to your plan. Therefore, if a particular option is matched by the employer unlike the second option, it is likely to see an individual preferring to take up the option matched up by their company.
Fees charged on a particular retirement option can be a huge drag on one’s savings. If say, your 401 (k) charges particularly high fees, this could eliminate or greatly reduce the savings you would have made from its tax benefits.
Contribution limits. The limits vary between different accounts and age and are continually adjusted for inflation. Before choosing a particular plan, it is important to be up to date with any recent laws and limits
Diversifying your tax exposure during retirement.
Just like it is possible to diversify your investment in stocks and bonds from your retirement portfolio, it is also not only possible, but highly encouraged to do the same for your tax exposure during retirement.
By taking up both the Roth plan and the traditional 401 (k) plan, an individual is able to maintain a diversified retirement plan, lower a portion of their current taxable income and shield themselves from large losses in the future in case the tax rates change.