Did you know your 401K account offers two distinct ways to save? Knowing which one to use depends on whether it makes more sense for you to delay paying taxes on your savings until retirement (Traditional) or paying them today (Roth).
A Traditional 401K is sometimes referred to as the pre-tax option. You are literally taking the income you decide to save and the tax that you should have paid on those dollars today and pushing both of them off to retirement. This has two significant impacts:
- Reduces your current taxable income to where you pay a smaller amount of tax THIS year.
- Delays your responsibility in paying ordinary income tax on those dollars when you use them in retirement.
What you won’t know is how much future tax you’ll have to pay on the dollars invested in a Traditional 401K. That tax bill will be at the mercy of whatever tax brackets happen to be in place when you start using your invested money during retirement.
The Roth option is sometimes referred to as the post-tax option because you pay taxes on the income you earn and then make the contribution into the Roth portion of your 401K. Because those dollars have already been taxed, you will not be responsible to pay taxes on them when you use them at retirement.
The bonus with the Roth option is that it’s not just the dollars you contribute to Roth that are tax-free, but also any gain that comes from the investment of those dollars. Perhaps determining which makes the most sense for you may be less of an involved process than you think!
Traditional vs Roth – how do I decide?
When deciding which option to invest in, look at your current tax obligations and try to balance those with what your future tax position may look like. If you typically owe on your taxes today, you want to utilize your Pre-Tax 401K contributions up to the $19,500 or $26,000 (age 50+) limit to reduce your current taxable income. This will significantly reduce your tax bill while simultaneously saving more dollars toward those retirement goals!
If, however, you are toward the younger end of things, it is incredibly important to recognize the power of the Roth 401K. This gives you the ability to pay tax on your income today and not be responsible to pay tax on any of those gains — which may be substantial over a 20, 30 or 40-year period of time. The younger you are and the lower your current tax rate, the more sense it makes to look at contributing Roth into your 401K.
Please keep in mind that you can use a combination of both the Traditional and Roth 401K, which personally is my approach. I put enough money into the Pre-Tax part of my 401K to reduce my current tax bill down to a point that I’m comfortable with it, and then everything else I can afford to save goes into my Roth. I have a need for a tax break today but love the idea of a tax-free bucket of money in retirement and all the flexibility that will provide. This strategy covers both of my wishes!
For questions about this and/or your specific strategy, please contact 401K Advisors Intermountain.
MJ Goss, Director Retirement Planning & Financial Wellness
401K Advisors Intermountain
Should you invest in a Roth or Traditional 401K?