Roth vs. Pre-Tax 401(k) Deferrals – How to Choose

The most expensive thing you ’ ll credibly buy during your life is retirement. possibly you ’ ve never thought of “ buy ” retirement, but that ’ s precisely what you do when you participate in a 401 ( kilobyte ) plan – you are saving now to buy retirement income by and by. When you consider that income may need to end 10, 20, even 30 years, it ’ mho easy to understand why retirement is then expensive. however, by following a childlike 4-step design during your working years – save early, lend regularly, invest appropriately, minimize explanation fees – you can reduce the out-of-pocket cost of your retirement by a lot !
You may be able to reduce your retirement ‘s price even further by contributing Roth deferrals to your 401 ( kilobyte ) report rather of traditional deferrals. While traditional deferrals are contributed pre-tax and then taxed upon withdrawal, Roth deferrals are the diametric – contributed after-tax and then tax-exempt upon withdrawal. Taking the tax hit on Roth deferrals now could save you a lot in taxes in the long-run .
not all 401 ( thousand ) plans permit Roth deferrals, but if your design does, making an inform decision about the best deferral option for your 401 ( potassium ) history can be well worth your time. not certain how to choose ? Below is a comparison and factors to consider .

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 :

  • Attainment of age 59½
  • Death or disability
distribution restrictions Same. Neither can be distributed until one of the adopt events occurs :

  • Termination of employment
  • Death or disability
  • Plan termination

however, a plan may permit their in-service distribution upon :

  • Age 59 ½
  • Hardship
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 :

  • another Roth 401(k) account
  • a Roth IRA
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)
  • You expect to be in a lower tax bracket in retirement
  • You want maximum rollover flexibility.
  • You want to do an in-plan Roth rollover later. 
  • You expect to be in a higher tax bracket in retirement.
  • You’re young and expect your income to grow throughout your career.
  • You want to minimize your Social Security taxes and/or Medicare B premiums in retirement.

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 %

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

$ 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 .

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