Choosing Between Roth and Traditional 401(k)

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Deciding between a Roth 401(k), a traditional 401(k), or a combination of both is a common yet critical question for retirement savers.

A traditional 401(k) allows pre-tax contributions, reducing taxable income for the year. For instance, saving 10% of a $50,000 salary means taxes are only paid on $45,000, with the $5,000 growing tax-free until retirement. Upon withdrawal, both contributions and earnings are taxed.

A Roth 401(k) involves post-tax contributions. Using the same example, a saver is taxed on the full $50,000 income, but withdrawals in retirement are tax-free, including earnings.

Who Should Choose a Traditional 401(k)?

Traditional 401(k)s are popular due to the immediate tax break, making them ideal for those in higher tax brackets or those struggling to save. The upfront tax reduction can encourage saving, which is crucial given the low savings rates in the U.S.

Who Should Split Between Roth and Traditional?

Cary Carbonaro, a CFP Board ambassador, advises many clients to split their contributions between Roth and traditional accounts. This approach leverages both tax scenarios, providing flexibility in both working and retirement years. For instance, a saver with a 6% employer match contributing 3% each to traditional and Roth accounts effectively has 9% in traditional and 3% in Roth.

Who Should Choose a Roth 401(k)?

Younger savers and high earners may benefit more from a Roth 401(k). Younger savers can take advantage of the tax-free growth over time, while high earners may be ineligible for Roth IRAs due to income limits. For these individuals, a Roth 401(k) offers a valuable tax-advantaged savings vehicle.

SECURE 2.0 Act and Roth Matching

Starting in 2023, the SECURE 2.0 Act allows plans to offer Roth matching contributions. This means employer contributions can also benefit from the Roth tax treatment, though not all plans may adopt this feature.

Withdrawal and Inheritance Planning

For withdrawal strategies, it’s advisable to use Roth funds last to maximize tax-free growth. Roth accounts are also advantageous for inheritance, as heirs can benefit from tax-free withdrawals over an extended period.

Choosing between Roth and traditional 401(k)s depends on individual circumstances, including age, income, and tax considerations. Balancing contributions between both types can provide a diversified approach to retirement savings, optimizing tax benefits and financial security.

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