401(k) Contributions – Regular or Roth?

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Published by Jake Dungey, Qualified Plan Relationship Manager, Registered Representative

More and more employers are offering the Roth 401(k) option alongside the traditional 401(k), but should you take advantage of the Roth option? Let’s look at aspects of the Roth and traditional and you can see if one makes more sense for you.

If you’ve heard the term “401(k)”, and most people I’ve talked to have, then I imagine you’ve also heard the term “Roth”. But, have you heard of what exists when you combine those two terms? Yes, I mean “Roth 401(k)”. Surprisingly, a lot of those same people that I’ve spoken to hadn’t heard of a Roth 401(k) and they tend to confuse it with a Roth IRA. They function the same from a tax perspective, which means contributions come out of your paycheck after-tax and any gains, and therefore distributions, are tax-free.

 

How They’re The Same

Before we examine what’s different, let’s look at what’s the same. 401(k) contribution limits, regardless of Roth or traditional, are set annually by the IRS. For 2020, an employee can contribute up to $19,500 and if over 50 years old, an employee can contribute an additional catch-up contribution of $6,500 for a total annual contribution of $26,000. You can even split your contributions between Roth and traditional contributions as long as you don’t go over the $26,000 limit. It’s also important to note that any contributions received from your employer don’t count against the $26,000 limit!

 

How They’re Different

So if contribution limits are the same, you might ask how are they different? The difference between a Roth 401(k) and a traditional 401(k) is the tax treatment of contributions and distributions.

  Traditional 401(k) Roth 401(k)
Tax treatment of contributions Contributions are made pre-tax, which reduces current adjusted gross income Contributions are made after-tax and have no impact on current adjusted gross income. Employer matching dollars MUST go in pre-tax and are taxed upon distribution
Tax treatment of withdrawals Distributions in retirement are taxed as ordinary income Qualified distributions in retirement have no tax
Withdrawal rules Withdrawals of contributions and earnings are taxed. Distributions prior to age 59 ½ may be penalized unless certain IRS requirements are met

Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by IRS regulations. To be considered “qualified”, the account must have been held for at least 5 years and a distribution must be:

·       Due to disability or death

·       On or after age 59 ½

Note, unlike a Roth IRA, contributions can’t be withdrawn at any time

 

Which Is Best For You?

This decision comes down to your personal situation, how you want to put the money in and how you want to be able to take the money out.

If you’d prefer to pay taxes now and get them out of the way, or if you feel your tax rate will be higher in retirement than it is now, then the Roth 401(k) may be for you. By paying taxes today you’re helping to guard yourself against from potential tax increases in retirement, though your own taxable income may drop. You’re also giving yourself access to a bigger pot of money. $100,000 in a Roth 401(k) is worth $100,000, while $100,000 in a traditional 401(k) is worth $100,000 less taxes owed on each distribution.

If you’d prefer to reduce your taxable income today or put off taxes until retirement because you think you may be in a lower tax bracket, then a traditional 401(k) may be the solution you’re looking for.

Some people might say, “I’ll just open a Roth IRA in addition to my traditional 401(k) and get the best of both worlds!” While some people may be able to take advantage of this strategy, Roth IRA’s have income limits where Roth 401(k)’s do not. So if you make too much money to contribute to a Roth IRA, the Roth 401(k) could be a solution for you.

One last thing to consider is passing assets on to your heirs. Roth assets, whether in a Roth 401(k) or Roth IRA, passed on to heirs are taxed the same way as if you would have taken a distribution during your lifetime; i.e., tax-free. With the passing of the SECURE Act, estate planning is more important than ever and tax-free income to your heirs could help them quite a bit.

If you are interested in how making a few small changes can affect your investments, please call us to schedule a meeting with one of our advisors.

 

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