Traditional or Roth Contributions? Did You Think It Through for Future You
When deciding between traditional (pretax) and Roth contributions, the general rule is to think about whether you are likely to benefit more from a tax break today than you would from a tax break in retirement. Specifically, if you expect to be in a higher tax bracket in retirement, Roth contributions may be more beneficial in the long run.
If your employer-sponsored retirement saving plan allows traditional and/or Roth contributions, which type should you choose? It may help to compare the key features of these accounts.
Saving the traditional way
With traditional contributions, the money is deducted from your paycheck before taxes, which helps reduce your taxable income and the amount of taxes you pay now. In addition, any earnings made on pretax contributions grow on a tax-deferred basis. That means you don’t have to pay taxes on any gains each year. However, those tax benefits won’t go on forever. Any money withdrawn from a tax-deferred account is subject to ordinary income taxes, and if the withdrawal takes place prior to age 59 ½ (or in some cases, 55 or 50, depending on your plan’s rules), you may be subject to an additional 10% penalty on the total amount of the distribution.
Taking the Roth route
Contributing to an employer-sponsored Roth account offers different benefits. Roth contributions are considered “after-tax,” so you won’t reduce the amount of current income subject to taxes. Earnings grow on a tax-deferred basis inside the account, and qualified distributions down the road will be tax-free (under current tax laws).
A Roth distribution is considered qualified if the account is held for five years and the account owner reaches age 59 ½ , dies, or becomes disabled. (Other exceptions may apply.)
Non-qualified distributions are subject to regular income taxes and a possible 10% penalty tax.
However, because Roth contributions are made with after-tax dollars, if at some point you need to take a nonqualified withdrawal from a Roth 401(k), only the portion that represents earnings will be taxable.
