By Bob Rall, CFP®
More 401(k) retirement plans are starting to offer two ways to make your contributions. You can still make deposits into the plan in the traditional way, which means your money goes into the account before taxes are paid on the amount; or, you can elect a Roth option, which means your contribution is made with after-tax dollars. The option that is best for you—traditional contributions or Roth contributions—depends on your personal situation.
Traditional 401(k) Plan Contributions are Pre-Tax
The traditional way to contribute to a 401(k) plan is familiar to most people who have had an employer-sponsored retirement plan: You decide how much you would like to contribute, which is usually a percentage of your pay, and that amount is deducted from your paycheck before income taxes are withheld and put into your 401(k) account.
For example, if you make $75,000 per year and decide to contribute 10% of your pay, $7,500 goes into your account over the course of the year. Because these contributions are made with pre-tax dollars, your taxable income is reduced. In this example, your taxable income would be $67,500 ($75,000 minus $7,500).
Traditional contributions to a 401(k) result in a lower current tax bill. However, when you withdraw the funds, they are taxed as ordinary income.
Roth 401(k) Contributions
With a Roth 401(k), your contributions are treated the opposite way. If you make $75,000 per year and decide to contribute 10% of your pay to a Roth, your taxable income would be the full $75,000 you earned, but when you withdraw the funds at retirement, they are tax-free. In other words, with Roth contributions, your current tax bill is higher because you are paying tax on the entire amount of your income now, but you won't have to pay taxes on the income when you need it in retirement. (For related reading, see: Tax Tips on Roth and Regular 401(k)s.)
Why These Contributions Are Becoming More Popular
There are two reason Roth contributions to 401(k) accounts have been growing in popularity recently. First, the Tax Cuts and Jobs Act (TCJA), which was passed in 2017, resulted in most people being in a lower tax bracket. That means traditional, or pre-tax, contributions are less attractive because people will already be paying less income tax on their current income.
Shortly after the new tax law went into effect, Congress passed a $1.3 trillion spending bill, which has resulted in an ongoing increase in the national debt. That debt will eventually have to be paid, which many experts speculate will result in a large debt burden on future generations. If this is the case and your income tax rate increases in the future instead of decreasing, which is normally what happens, the tax-free dollars in your retirement account from your Roth contributions will be worth even more.
Which Type Is Right for You?
It's a balancing act when determining what kind of contributions you should make to your retirement plan. There are a couple of things to consider:
- Should you take advantage of lowering your current taxable income by making contributions to your 401(k) account using the traditional option?
- Or do you pay a more in taxes now, then expect to have tax-free income in retirement using the Roth option? (For more from this author, see: How to Replace Your Paycheck When You Retire.)
If you are just getting started in your employer’s plan, the traditional pre-tax option is a good choice. However, If you’ve been contributing to a 401(k) plan for a while, you might consider redirecting at least a portion of your contributions to the Roth option, even though you may find it hard to give up the current tax break.
Use a Tax Calculator to Help You Decide
If you're not sure which option is best for you, take the information from your 2017 tax return and run it through a calculator like the 2018 Tax Reform Calculator offered by the Tax Foundation, an independent tax policy nonprofit. If the analysis shows you will have a lower tax bill for 2018, it might be a good idea for you to reduce traditional contributions to your 401(k) account, but only to the level that will keep your tax bill the same in 2018, and use the remainder to make a Roth contribution.
Over time, increasing your Roth contributions will result in more tax-free income in retirement, which can help offset the taxes you will be paying on your traditional contributions that are helping you save on your income taxes today.
(For more from this author, see: Maximize After-Tax Returns With Asset Location.)
This article was originally published on Investopedia.