Benefits of Roth Contributions in a 401(k) Plan
Enrolling in (and starting to contribute to) your 401(k) plan can seem like a daunting task—especially if you aren't overly familiar with the inner workings of the financial industry. Luckily, participating in a 401(k) plan is a great first step towards retirement readiness—but before you reach the retirement of your dreams, you'll have to make a variety of decisions to help you get there.
Deciding how much to contribute to your 401(k) plan won't necessarily be the only financial decision you'll have to make regarding your retirement savings; you may also need to decide how you’ll defer those funds to your account: in a Roth contribution or a traditional contribution.
What is a Roth 401(k)?
Simply put, a Roth 401(k) is a retirement account offered by your employer that’s funded with money from your paycheck that has already been taxed. The contributions grow tax-free and can be withdrawn tax-free in retirement with a qualified distribution—when you’ve held the account for at least five years and reach age 59½, most commonly.
However, there are a variety of differences between Roth contributions to your 401(k) account and traditional contributions, and it’s beneficial to understand both options to determine which makes the most sense for your personal situation and retirement goals.
It’s also important to note that not every 401(k) plan allows for Roth contributions—so make sure to check your plan document to determine what your contribution options are.
What are the differences between Roth contributions and traditional contributions?
When looking at the key differences between traditional and Roth contributions, it really comes down to pre-tax and post-tax, respectively. Traditional 401(k) contributions are not taxed up front, but they are taxed on distribution—whereas Roth contributions are taxed before they arrive into your 401(k) account and can be withdrawn tax-free upon qualified distribution.
Let’s break it down a little further.
Roth vs. Traditional contributions in a 401(k) plan
In a Roth 401(k) account, you pay taxes on your contribution before it goes into your account. As a result, your take-home pay will be smaller when contributing to a Roth 401(k) than a traditional 401(k), as the taxes on the contribution amount have been paid up front.
Let’s say your compensation for the pay period is $1200. When you choose to defer ten percent of your salary into your 401(k), disregarding any complex definitions of compensation, the contribution—whether pre-tax or Roth—would be $120. If the contribution is made on a pre-tax basis, you would have $1,080 in taxable income for the pay period. Conversely, if the contribution was made as Roth, the full $1200 is taxable for the current pay period.
Alice makes $1,200.00 gross pay biweekly. She wants to know the difference between a pre-tax deferral and Roth after-tax deferral. This example uses a rate of 10%.2
2This example assumes $91.80 was deducted from the Employee’s paycheck for Social Security, Medicare, and income taxes for a Single individual.
|Roth After-Tax Deferral
|Amount subject to income tax
|Social Security and Medicare
|Pay after taxes
|Roth (after-tax) deferral
- The deferral amount is the same: $120.00 per paycheck
- The net paycheck difference is $11.80, which is the difference in taxes paid.
The benefit of paying taxes on your contributions up front with Roth contributions is obvious: you can withdraw funds tax-free at retirement age (if you’re at least 59½ and have held the account for five or more years) because the taxes have already been paid, which essentially eliminates one key retirement planning variable: trying to predict your future tax rate to align your decumulation strategy with maximizing tax advantages.
Participants may also want to consider Roth 401(k) contributions because they:
- Are beneficial for savers who are currently in low tax brackets but anticipate moving into higher tax brackets in the future
- Offer flexibility so employees can align their retirement planning strategies with their individual financial situation and retirement goals
- Eliminate the stress of trying to estimate future tax rates on qualified withdrawals
- Safeguard participants from paying higher tax rates on contributions in retirement if the government makes significant changes to income tax brackets
- Decrease the risk of Social Security funds becoming taxable because Roth contributions don’t count as taxable income while concurrently taking Social Security payments
- Are a great way to do estate planning and planning for beneficiaries
On the flip side, traditional 401(k) contributions are made pre-tax, which reduces your current adjusted gross income, and by extension, lowers your annual taxes at tax time. The Internal Revenue Service (IRS) only taxes the funds that are contributed to your traditional 401(k) account when they are withdrawn from the plan, and qualified distributions are taxed as ordinary income.
As such, your distributions will seem smaller when you receive them than when you request the distribution. For example, if you withdraw $75,000 from your traditional 401(k) account, you may actually receive less than $75,000 in distributions because the distributions could still need to be taxed before you receive them.
Retirement savers may want to consider traditional 401(k) contributions because:
- Taxes are only paid when the funds are withdrawn, so they are contributed tax-free and grow tax-free until they’re taken out of the account
- They are beneficial to savers who are currently in a high tax bracket and anticipate moving into a lower tax bracket in retirement
Am I better off using Roth or Traditional 401(k) contributions?
Determining which contribution option will benefit you the most is highly dependent on your individual situation and retirement goals. It really comes down to how you want to put your money in and take your money out of the account—and when you want to pay taxes on that money. With Roth, you pay taxes now and get them out of the way. With traditional, you don’t have to pay taxes on the contributions until they’re taken out, potentially years down the road.
That being said, younger workers may benefit more from Roth contributions because they tend to be in the lowest tax bracket of their career when just starting out. With an increased earning potential throughout their lifetime, they may bump into higher tax brackets as time goes on—and by extension, pay higher taxes on future Roth contributions than they would early on in their career. Plus, younger workers have more time to benefit from compounding interest and make up returns on their contributions—since as we mentioned earlier, funds contributed to a Roth account will have a larger impact on your paycheck and take-home pay than a contribution of the same amount to a traditional 401(k) plan.
On the other hand, traditional contributions may be a better option for older workers with less time to make up returns, high earners, or those who plan to be in a lower tax bracket in retirement than they are during their career.
All that being said, if allowed by the 401(k)’s plan document, retirement savers can consider splitting their contribution types between traditional and Roth to maximize the benefits of their retirement saving strategy. Consult with your financial advisor or a trusted financial professional to determine which type of contribution option will benefit you the most.
Regardless of which contribution type you choose, saving for your retirement is the first step in helping you get there.
Check out our Retirement Saving Resources for additional tools to help you prepare for a financially-secure retirement, or contact our customer care team at 888-652-8086 if you have any questions about which type of contributions are allowed in your Ascensus retirement plan.