It might seem too early to think about your retirement but it’s considered good practice to start preparing for it already. We’ll never know what the future holds for us so it’s wise to be prepared for anything that might come our way.
To help in planning for retirement, there are a number of retirement plans offered by the government and other private institutions. Two of the most popular are Roth 401(k) and the regular or traditional 401(k) plans.
What are these plans and what are their differences? Presented here are some of the basics that could help you choose between them.
What is a Roth 401(k)?
A Roth 401(k) is a kind of retirement savings plan that combines the advantages of a Roth IRA and a traditional 401(k) plan. Under this plan, employers can contribute funds to their retirement account on a post-tax basis. It means that the contribution is taxed before being added into your retirement account.
Upon withdrawal of savings, there won’t be any tax applied to it since you’ve paid it already during contribution.
What is a traditional 401(k)?
A 401(k) is also another type of retirement savings plan. Its main difference with a Roth 401(k) is the way tax is applied to your contributions.
In a traditional 401(k), contributions can be exempted from federal income taxes the year the contribution was made. When you withdraw your contributions that is when taxes will apply. Ordinary income taxes will be deducted from the savings as if it’s normal income.
Tax brackets are important factors to consider in determining the best retirement savings plan. Experts say that income taxes will continue to rise, making one retirement plan favorable over the other.
Going into a higher or lower bracket or staying in the same one you’re in now, would have a significant effect on the choice you’ll make. Think of the worst and best case scenarios possible and start weighing your options.
Advantages and disadvantages
Both plans have their own strengths and weaknesses. It’s up to you to decide which would be the most advantageous for you.
With Roth 401, you’ll be able to withdraw your retirement savings without worrying about taxes. The catch is that contributions are taken from your net income, reducing the total money you can take home.
Experts say though that the benefits of having a Roth 401(k) outweigh all the hassle associated with it. More money could be saved in the long-term from paying taxes every contribution.
With traditional 401(k), taxes won’t be deducted from every contribution which means more money will be stored in your retirement plan. However, when you withdraw your savings, taxes are compounded and you’d be getting a smaller amount in return.
To help you visualize things, let’s take this situation as an example:
You’re in a 28% tax bracket and you plan to put $10,000 in your retirement plan. If you have a traditional 401(k), you’ll be adding the whole $10,000 into your savings. With a Roth 401(k), you could add the whole $10,000 too but you’ll have to pay tax on top of that, making a total of $12,800.
After a number of years, you’ve saved enough to be able to withdraw $50,000 a year for the next years you’d live. You retired being in the 28% tax bracket. Withdrawing on your Roth 401(k), you get the whole $50,000 without any tax deductions. Getting from a traditional 401(k), you’ll receive $36,000 a year since the $14,000 (28%) is the amount of tax deducted from the $50,000 total.
The best plan for you
The best plan depends on your income projection. How much you’ll receive in your retirement savings plan is based on guesses regarding tax rates.
If you think you’ll belong to the same tax bracket that you’re in now upon retirement, either plan won’t affect your savings. Whether you choose a traditional 401 (k) or a Roth, the benefits of either retirement plan would just cancel out.
Choose a plan that would be most suitable for your current financial situation. But of course, it’s better if you can plan ahead and estimate which would be best in the long-run.