Roth vs. Traditional 401(k)

Paul A. Ruedi

 When people are saving for retirement, one of the decisions that creates a lot of confusion is whether to contribute to a “traditional” or “Roth” 401(k). One is not definitively better than the other. The option that will be best for you depends on your personal situation, particularly your tax rate now versus your tax rate in the future.

When someone contributes to a traditional 401(k), contributions are made pre-tax, which lowers their taxable income that year. A traditional 401(k) then defers all the taxes on the assets, including any growth, until it is distributed in the future, at which point the taxes are paid on the entire amount of the distribution at their ordinary income tax rate.

Roth 401(k) contributions, by contrast, are made with after-tax dollars. You do not get a tax break in the year of the contribution. The benefit is your full account balance can ultimately be withdrawn tax-free (both the principal and growth) in the future, provided all the rules are followed.

To simplify, with a traditional 401(k) you lower your taxable income and save on taxes now; with a Roth 401(k) you pay taxes now and withdraw tax-free in the future. So naturally, the option that will provide you the most benefit depends on whether your tax rate is higher now, or in the future.

If your tax rate is higher now, it may be better to make traditional 401(k) contributions to lower your taxable income during your working years. However, if you expect a higher tax rate in retirement, you may want to contribute to a Roth 401(k) now, to save on taxes later.

Nobody can predict the future, so savers can only make an educated guess about their future tax rate. It can be tough to predict what your future income will be and Congress can always change the tax code. Just do the best you can with the information you have now.

A lot of people go in circles with this decision, so I like to remind investors that it is not a decision that will make or break a retirement. Things like choosing the appropriate asset allocation and sticking with your investments through temporary declines are considerably more important. That being said, it can’t hurt to put the wind at your back by getting this decision right. If you aren’t sure how to do that yourself, you may want to talk to a financial advisor.

Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.