Most 401(k) plans allow participants to contribute to the plan either on a pre-tax basis (Traditional) or an after-tax basis (Roth). Below are the tax considerations for each choice.
Pre-Tax Contributions Affect on Taxes
When you save in a traditional 401(k) plan, you are saving pre-tax, meaning you don’t pay taxes on your savings until you withdraw them from your 401(k). The money you save in the plan lowers your taxable income since your pre-tax contributions are deducted from your gross income before federal taxes are withheld. In practicality, this will result in a reduction in the total amount of taxes withheld from your paycheck.
So, you’ll owe less in taxes as you save. When you withdraw the money, which hopefully won’t happen until you retire, you’ll owe federal, state, and local income tax on your contributions and any earnings. Caution: If you withdraw any money before age 59½, you’ll owe a 10% federal tax penalty in addition to your regular taxes unless an exemption applies.
Roth Contributions Affect on Taxes
If your plan allows Roth contributions, you have a second way to save on taxes. You can pay taxes on your contributions now but take tax-free withdrawals in retirement. That means you never pay taxes on your earnings and have tax-free money in retirement.
More and more retirement plans offer Roth contributions. If yours does (check your plan rules), you can get tax-free income in retirement. Unlike traditional plan contributions which use pre-tax income, with a Roth, you make contributions with after-tax money, so you don’t get a tax break as you save. However, with a Roth, withdrawals of both contributions and earnings are tax-free as long as you meet certain conditions.
There are two conditions you must meet to qualify for tax-free withdrawals:
- You must be age 59½ or older when you withdraw the Roth earnings.
- You must make your first Roth contribution at least five years before you withdraw your Roth earnings.
Caution: If you don’t meet both requirements for a tax-free withdrawal, any earnings you withdraw are taxed at your federal, state, and local rates. You may also owe a 10% federal tax penalty.
Decide What’s Best For You
If your retirement plan allows both pre-tax and Roth contributions, you can decide whether to lower your taxes now or in retirement. Which one makes more sense for you?
Pre-tax might be better if…
- You’re behind on saving and expect Social Security to be the mainstay of your retirement income.
- Your pay spikes from time to time as a result of commissions or bonuses.
Roth might be better if…
- You’re well-prepared for retirement, with strong savings and benefits.
- You contribute the maximum allowed to your plan.
- You pay taxes at a low rate today (10% or 12%).
Note: I mean “better” in the sense that you’ll probably end up paying less in taxes over the course of your lifetime. That may not necessarily be your personal priority today. For some, the benefit of a tax deduction today outweighs the prospect of a tax break in the future.
You Can Contribute to Both
For most people, it’s tough to be sure whether pre-tax or Roth contributions will save you more in the long run. The good news is, you can make contributions to both. Splitting your contributions between pre-tax and Roth guarantees that at least some of your savings will receive the best tax advantage available to you.
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