How to Save Money by Choosing between a Roth 401k and a Traditional 401k

How to Save Money by Choosing between a Roth 401k and a Traditional 401k

Summary: Employers are opening the playing field for retirement planners when it comes to the kinds of 401(k) plans they allow. We look at two key cases and consider the pros and cons that come with each.

When we talk about 401(k) plans and retirement, the recipe is almost always familiar: save tax-free now and then pay the IRS when you start to withdraw incurring a penalty if you take distributions before reaching the retirement-age threshold that's been set.

Now, however, employers have in increasingly begun to offer 401(k)s with a twist: they're known as Roth 401(k)s and they, in effect, reverse the process when it comes to how you apply taxes to your investment.

Read on to see how the traditional 401(k) and the Roth version stack up on your own list of pros and cons. It's a fine time to revisit your plan, as new employer flexibility gives you even more control over how you save.

Which Option Makes More Sense for You?

Just a few years ago, according to Aon Hewitt research, only about 11% of employers provided the Roth option to their 401(k) participants.

That's not the case anymore. Fully 50% currently allow their employees to plug into the plans, and 27% further allow their workers to make Roth in-plan conversions in other words, roll your non-Roth 401(k) savings into a Roth 401(k).

But should you? That depends on many factors, but what follows is a list of major considerations when it comes to the two instruments for retirement investing and planning.

Traditional 401(k):While you're still working, you pay no income tax on the contributions you make to a traditional 401(k) unless you withdrawand then, you take out funds at a penalty. In the course of growing this kind of account, contributions are taken directly from your paycheck, meaning that your taxable income is actually less than it would be without the 401(k)and that can be advantage depending on how it affects your current tax bracket. That is, contribute enough, and you might pay smaller percentage. At the end of your career, when you start to withdraw from the fund, taxes are applied according to ordinary income parameters: in other words, if you're a single filer and you're taking $35,000 annually from your 401(k), you're probably in the 15% tax-rate category.

An important consideration, however: your savings have grown in the time they've been in the 401(k), but those growth-related earnings have been tax-deferred. That means that your income at the time of withdrawal will include those earnings. Finally, under traditional plans, at age 70-1/2, you'll be required to take a minimum distribution.

Roth 401(k):Under these plans, you pay your income tax on earnings along the way, which means contributions to the 401(k) are made after tax to which your income-bracket tax rate applies in the same way it does to all other applicable pay. When you withdraw at the time of retirement, however, you pay no taxes on the funds not even on the growth. There are a couple of stipulations involved. First, qualified distributions start after age 59-1/2. Second, put simply (and there are some exceptions and additions to this rule), five tax years must pass from the time of your first Roth 401(k) contribution until you can withdraw from it, penalty-free. There are some Roth 401(k)s that come without required minimum distributions at age 70-1/2.

The upshot of the decision-making process, when it comes these two types of plans, comes down to what is largely a matter of income expectations.

Do you suspect your tax bracket will significantly dip once you retire? In that case, the traditional 401(k) would allow you to potentially pay less in taxes on the income from which you're deferring a government bill during your working years. In other words, if your bracket is 25% now, but only 15% after you retirement you come out ahead, tax-wise to go with a traditional 401(k).

On the other hand, if you're expecting a larger amount of money to come your way upon retirementfrom other investments, other retirement instruments or maybe you're one of the fortunate few still on the books for a pension then plugging into a Roth 401(k) can mean protecting your savings against that tax-bracket increase at the time of withdrawal. Pay taxes at your lower tax-rate now, and then keep all your contributions safe from a higher rate after retirement.

So, if you're looking to create some Roth assets in your retirement portfolio, but your earned income keeps you out of the running for a Roth IRA, the 401(k) version of the plan can be a helpful workaround.

As with any retirement-savings scenario, the type of 401(k) you choose comes down to an individual-by-individual assessment but the good news is that employers are increasingly offering the choice. When it comes to maximizing your savings, and controlling how taxes influence them, it is worth your time to evaluate how the 401(k) options can work for you. Also, check out these 3 tips to maximize your 401k returns, regardless of whether you choose a Roth 401k or a traditional 401k.