401(k) plans have many advantages; accounts can grow on a tax-deferred basis, potential employer contributions in the form of a match or non-elective contribution, the ability to contribute even after attaining age 70 ½, and protections from bankruptcy.
These benefits are consistent whether a one chooses traditional or Roth contributions, or even both! So, what makes the Roth and Traditional options different and what are the advantages and disadvantages of each?
Traditional 401(k) contributions, or those contributed on a pre-tax basis, have been the mainstay of the 401(k) plan since its inception. Traditional, or pre-tax contributions, are deducted from your paycheck before the application of federal and state income taxes. These contributions, along with any employer contributions and investment gains, remain tax-deferred until withdrawal. At the time of withdrawal, the participant will pay all appropriate income taxes due. If withdrawals occur before age 59 ½, disability, or death, an additional early withdrawal penalty of 10% will apply.
Roth deferrals are contributed on an after-tax basis with the employee paying all current federal and state taxes. Once contributed to, these accounts accumulate in the same fashion as Traditional 401(k) accounts until withdrawal. With a Roth account, your contributions and their investment earnings can be withdrawn tax-free, provided the withdrawal does not occur before age 59 ½, disability, or death. Even with an early withdrawal, only the investment gains and employer contributions will be taxed as income and subject to the 10% penalty.
What is the attraction of utilizing Roth 401(k)? It’s down to an individual participant’s tax situation. For those that are younger, income and tax rates may be lower, so paying the tax now makes sense. Chances are, their tax rates will be higher in the future. For those with many years to retirement, the power of compounding of investment gains will most likely make up a far greater percentage of their account than their contributions. Being able to withdraw those funds tax-free can be very attractive as well.
For those who are paying a high tax rate currently and might be closer to retirement, Roth may not be so attractive. One exception might be if the participant plans to leave the Roth as a legacy to their heirs, who can then stretch out the tax-free growth over their lifetime.
Another course of action is split deferrals by contributing some on a pre-tax basis and some on a Roth basis, thereby providing a hedge on what future tax rates might be.
Would you like help to determine which option is best for you? Simply request a call from a Bayntree financial advisor today.
Bayntree Wealth Advisors, located in Phoenix and Scottsdale, Arizona, provides comprehensive financial planning and wealth management. The Bayntree team specializes in all aspects of financial health, including retirement planning, risk management, investment advice, tax strategies, estate planning and insurance.
Bayntree does not provide specific legal or tax advice. Please consult with your tax advisor or legal professional for guidance with your individual situation.