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An employer-sponsored 401(k) is one of the most valuable saving vehicles available to those who want to grow their money for future financial security. A 401(k) comes with a number of unique features, such as pre-tax contributions, employer matching, automatic rebalancing, and purchases via dollar-cost averaging, all of which benefit you as a saver and investor.
While using a 401(k) may feel like a no-brainer, what’s more difficult to determine is whether you should use a traditional 401(k) or a Roth 401(k) if your plan offers the choice. Here’s how to choose between the two.
The biggest difference is taxes
The main difference between a traditional 401(k) and a Roth 401(k) is how the money contributed to each is taxed now and in the future.
Traditional 401(k)s lower your current taxable income because you fund this type of plan with pre-tax contributions. You fund Roth 401(k)s, on the other hand, with post-tax dollars. You won’t pay taxes on qualified withdrawals in the future, but the trade-off is Roth contributions don’t lower your present-day taxable income.
Therefore, you need to understand your tax situation before you can determine which kind of tax break will best benefit you. Are you in a high tax bracket right now, or finding yourself writing big checks to Uncle Sam every year? Then the tax breaks of a Traditional 401(k) might be right for you.
In contrast, forgoing pre-tax contributions and saving to a Roth 401(k) might be a better option if you find yourself in a low tax bracket or always receive a friendly refund check every year.
While the idea of future tax-free withdrawals sounds too good to pass up, that doesn’t make the Roth 401(k) the automatically superior choice.
I recently sat down with a new client who was 30 years old, single, with $175,000 in annual earnings. They contributed $19,500 per year to the Roth portion of their 401(k) because of the blanket advice they were following.
I educated the client on how contributing to the traditional 401(k) instead could lower their marginal tax rate from 32%. Because they had no other above-the-line tax deductions, simply switching from the traditional to Roth option in their 401(k) saved this client about $6,240 in taxes.
If you’re in a similar boat with a high income but no deductions to take like business losses, capital losses, health savings account deductions, or student loan interest deductions (capped at $2,500), traditional 401(k) contributions can create a big tax savings for you, too.
Watch your cash flow
Being in a low-income tax bracket is one reason to consider saving into a Roth 401(k), but you can’t ignore your cash flow when making this decision.
If you live paycheck to paycheck, saving pre-tax to a Traditional 401(k) will allow you additional funds for spending due to the tax break. For example, let’s say your paycheck is $1,000 every two weeks. That is $26,000 annually, and this will place a single person in the 12% marginal tax bracket.
If you contribute 10% of your $26,000 salary to a 401(k), you’d see a $100 difference in your check when contributing to a Roth 401(k) and an $88 difference contributing to a Traditional 401(k). In both cases, you’re contributing $100 to your 401(k), but it only actually costs you $88 to do so if you contribute to a traditional 401(k) rather than a Roth.
Although the savings in this example might not be a lot, every little bit counts when you’re fighting to increase your disposable income.
Get around IRS income limits for Roth IRAs
In general, both a Traditional 401(k) and Roth 401(k) have the same annual contribution limits. In 2021, those limits are $19,500, or $26,000 if you’re over the age of 50.
But the Roth options may be especially appealing for those who make too much to contribute to Roth IRAs.
The Roth 401(k) doesn’t come with income limits; the IRS starts limiting how much you can contribute to a Roth IRA once you earn $198,000 for married couples filing taxes jointly and $125,000 for single or head of household filers.
Before Roth 401(k)s became an option for those over the income limits, they were forced to complete Backdoor Roth IRA contributions. While this strategy is helpful, it only allows you to get $6,000 to a Roth IRA, which is much less than the Roth 401(k)’s limit of $19,500 per year.
As more and more people take advice online, we need to keep in mind that financial decisions are personal, and the strategies you implement to solve your financial problems should be, too.
Malik S. Lee, CFP, CAP, APMA, is a financial expert with nearly two decades of experience and is the founder of Felton & Peel Wealth Management.