“When you cease to make a contribution, you begin to die” – Eleanor Roosevelt
The year 2020 has definitely been very surreal. You may be looking forward to celebrating the New Year and if one of your resolutions is to take a deep dive into your finances, you might want to review how you are saving for retirement. If your company offers a 401k plan, chances are they also allow you to make Traditional and/or Roth contributions to your plan account. One of the most common questions we get from clients is, “Which option is the best for me?” And the answer, well it depends.
Define the difference
The difference is very simple, it is about taxes and when you make the choice to pay them.
Traditional 401k contributions allow you to get a deduction on your taxes now and allow the money to grow tax-deferred. However, you will pay taxes on the funds when you take them out to fund your retirement.
Roth 401k contributions are taxed in the current year and then allowed to grow and be distributed to fund your retirement tax-free. The tax-free option makes the Roth contribution very attractive but before you go and make all your contributions, here are a few other decision points to keep in mind.
What does your CPA or Tax Advisor have to say?
Good tax counsel also involves helping you to pay the lowest amount of taxes over your lifetime, not just this calendar year. It never hurts to check with them to get their opinion on the best option for the short and long term.
Would you prefer to pay taxes on $5,000 or $25,000?
Well, we would all be happy to pay taxes on the lower amount of income so let me rephrase the question. If you contribute the same amount of money this year, those funds will grow inside your 401k plan the same way. So if you contribute $5,000 in 2021 and it grew to $25,000, which would you rather pay taxes on now?
What if there is an unexpected hardship?
If you had an unforeseen disruption in your finances, taking money out of your 401k prior to age 59 ½ will be subject to a penalty. Early distribution penalties impact both contribution types. However, there may be some financial hardships that the IRS allows to avoid the 10% penalty. However, traditional contribution dollars withdrawn will add to the taxable income you have to pay taxes.
As with anything today, moderation makes the most sense. You may want to be weary of anything in excess and instead use both contribution sources. Ideally, you want your portfolio to have three equal buckets of money saved by the time you retire. The equal amount of Roth, Traditional, and Regular Taxable dollars gives you plenty of options to help minimize your long term future tax bills.