Roth vs. Pre-Tax 401(k) Deferrals – Major Differences
In general, Roth and traditional deferrals are subjugate to exchangeable contribution and distribution rules. Their primary difference is when they ’ re tax – Roth on the front-end ( at contribution ), traditional on the back-end ( at distribution ).
| Pre-Tax 401(k) | Roth 401(k) | |
| tax treatment at contribution | Contributions are made pre-tax, which reduces your current taxable income . | Contributions are made after taxes, with no effect on current taxable income . |
| contribution limits | subject to the same IRC section 402 ( g ) annual limit – $ 20,500 ( $ 27,000 if “ catch-up ” eligible ) for 2021 . | |
| tax discussion at distribution | Both contribution principal and earnings are subject to Federal and most State income taxes when distributed . |
contribution principal is tax-exempt when distributed . Earnings besides if part of a “ qualified distribution. ” A certified distribution is made at least five years after the foremost Roth deferrals are contributed and after :
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| distribution restrictions |
Same. Neither can be distributed until one of the adopt events occurs :
however, a plan may permit their in-service distribution upon :
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| premature distribution punishment | punishment applies to both contribution principal and earnings . | punishment applies to taxable earnings only . |
| Rollovers | Can be rolled to any qualify plan or IRA . |
Can merely be rolled to :
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| Required minimal Distributions ( RMDs ) | Distributions must begin nobelium late than senesce 72, unless inactive working and not a 5 % owner . | |
Roth vs. Pre-Tax 401(k) Deferrals – How to Choose
To make an educate choice between traditional and Roth deferrals, you want to consider your current tax situation and your predict site in retirement. In general, you want to choose traditional deferrals if you expect your tax rate to decrease in retirement and Roth deferrals if you expect it to increase .
| Reasons to Choose Traditional 401(k) | Reasons to Choose Roth 401(k) |
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Roth vs Pre-Tax 401(k) Deferrals – Tax Examples
Below are examples that demonstrate how taxes would affect the respect of Roth and traditional deferrals over a 10-year period assuming a 5 % annual rate of return .
| Example 1 – Tax rates are the same | ||
| Roth 401(k) | Traditional 401(k) | |
| Pre-tax income | $ 2,000.00 | $ 2,000.00 |
| Taxes ( 20 % ) | 20.00 % | 0.00 % |
| contribution amount | $ 1,600.00 | $ 2,000.00 |
| balance at retirement | $ 2,606.23 | $ 3,257.79 |
| Taxes ( 20 % ) | 0.00 % |
20.00 %
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| After-tax proceeds | $ 2,606.23 | $ 2,606.23 |
| Example 2 – Tax rate is lower in retirement | ||
| Roth 401(k) | Traditional 401(k) | |
| Pre-tax income | $ 2,000.00 | $ 2,000.00 |
| Taxes ( 20 % ) | 20.00 % | 0.00 % |
| contribution total | $ 1,600.00 | $ 2,000.00 |
| balance at retirement | $ 2,606.23 | $ 3,257.79 |
| Taxes ( 15 % ) | 0.00 % | 15.00 % |
| After-tax proceeds | $ 2,606.23 | $ 2,769.12 |
| Example 3 – Tax rate is higher in retirement | ||
| Roth 401(k) | Traditional 401(k) | |
| Pre-tax income | $ 2,000.00 | $ 2,000.00 |
| Taxes ( 20 % ) | 20.00 % | 0.00 % |
| contribution come | $ 1,600.00 | $ 2,000.00 |
| poise at retirement | $ 2,606.23 | $ 3,257.79 |
| Taxes ( 25 % ) | 0.00 % | 25.00 % |
| After-tax proceeds |
$ 2,606.23
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$ 2,443.34 |
Some tax planning now can pay off big-time later!
It can be street fighter to pass up a tax break by choosing Roth over traditional deferrals, but you need to think ahead when saving for retirement. Paying taxes now might help you save thousands – or tied tens of thousands – in net taxes. That extra money can come in handy in retirement .
That said, cipher has a crystal testis about their future earnings and tax rates. If the right choice for you is not clear, you can always split your deferrals between Roth and traditional .
