Without extensive knowledge on the subject, finance can sometimes seem like alphabet soup with the many account names and acronyms that exist indicating so many different things. Even more than the names, the qualifying rules and implications of the many types of closely named aspects of finance can be quite confusing. When it comes to retirement accounts, while there aren’t as many options to choose from, the confusion can remain. Choosing between a Roth 401k and standard 401k is a good example of an important decision that can become foggy when delving into the minutia in the difference between the two. Ultimately, understanding the different implications of both types of accounts can help you to determine which is the better retirement account for you, and which will allow you to retain the largest amount of your assets, long-term.
While the two different types of accounts (Roth 401Ks and Standard 401Ks) have fundamental differences that are important to understand, it’s easier to understand the structure of both by beginning with a discussion of their similarities. Both are workplace retirement savings options. Set up with your employer, you’re able to deduct a certain agreed amount of money from your income that is automatically deposited into a specified account. One of the largest benefits to both variations of 401k accounts is that they offer employee match contributions. Under these circumstances, your employer agrees to ‘match’ your contributions to your account up to a certain percentage of your income: free money!
Understanding the fundamental similarities will help us to better determine the difference and hence, come to a conclusion on the best account-type for your needs.
One of the biggest distinctions of traditional accounts is that contributions made to the account are made on a pre-tax basis. This is great in the present because all of the money you’re contributing ends up in the account tax-free. An added benefit is that the growth on the account through your investments is tax-free as well. On the flip side, the money is taxed when you begin making withdrawals while in retirement.
You may not make withdrawals from your account before the age of 59.5 without facing an additional 10% tax penalty. Once you reach the age of 70.5 you are required to begin taking minimum withdrawals from your account. In terms of contribution limits, an individual under the age of 50 can contribute a maximum of $19,000 on an annual basis, while an individual over the age of 50 can annually contribute $25,000. Under either circumstance, if your company offers matches to your contributions, total contributions are annually limited to $56,000.
One of the more specific benefits to choosing this type of account is that if you’re at the peak income-earning point of your career, tax-deferrals can save you money in the present. This can become even more advantageous if the state that you live in has a high income-tax rate, or particularly progressive state income taxes. Ultimately, your decision on whether or not this account is right for you will have to do with how close you are to retirement, and therefore how realistic of a picture you have of your future taxable income, and tax situation.
On the other hand, Roth 401ks distinguish themselves in the fact that contributions to these accounts are made on an after-tax basis. This account is great for those with their vision set on the future because, after the initial contribution, the money that’s in the account stays there. Once you begin making withdrawals from the account in retirement, the only aspect that is taxed is the contributions by your employer. The account is free to grow and be withdrawn from tax-free.
Similar to the traditional 401k, you’re able to make withdrawals on the account beginning at the age of 59.5. However, one distinction between the two is that you must have had the account open for more than 5 years in order to make withdrawals. Therefore, for an individual nearing the age of retirement, it may not be as advantageous to open this type of account in order to ensure that you will have access to the funds if or when you need them in retirement. Despite the stipulation of needing the account to be open for at least 5 years, annual contribution limits are the exact same for traditional and Roth 401ks. Additionally, unlike traditional accounts, Roth 401ks don’t require minimum distributions starting at a certain age; this is a particularly valuable consideration for those with large estates since the money can continually grow.
This type of account is a great choice for individuals who would like to know exactly how much money they have in retirement. With proper planning, the issue of knowing exactly how much you’ll have in the account pre-taxes with a standard 401k shouldn’t be an issue. Although depending on the state you live in, once you begin withdrawing from the account taxes can take a significant toll on the amount of money you thought that you’d accumulated. An added consideration is that we have no way of knowing the ways by which tax brackets or percentages could change in the future (for the better or worse), and by making contributions to this account on a pre-tax basis, you could save yourself from potentially paying higher tax rates in the future.
Examining the Differences
By now, you’ve most likely deduced that the largest difference between the two types of accounts, is whether the account contributions are taken in advance to your retirement, or after. Depending on your specific financial journey, one account may be more advantageous to your success in retirement than the other. The decision should be made in a way that properly takes into account your current level of wealth, as well as how close you are to the point of retirement.
As a general rule of thumb, if you’re at an early point in your career, your tax rate will likely be higher once you reach the age of retirement. On the other hand, if you’re already in your high-earning years and/or getting closer to your desired age of retirement, your tax rate will likely be lower once you retire. This fact alone can help point you in the direction of choosing the account that might be better for your personal tax situation, so as to avoid the burden of accumulating taxes at certain points in your life where your income is higher.
Shifting Tax Brackets
A more important distinction can be made, however. With Traditional 401ks, the taxing occurs when you make withdrawals in retirement. The taxation rate occurs at whichever income bracket you would be in, based on your annual withdrawals. A common rate of retirement savings is for individuals to accumulate enough money to take out 70-80% of their pre-retirement annual income, per year. With this in mind, a better understanding can be made for the income bracket you might be taxed in once you reach the point of retirement.
With Roth 401ks on the other hand, once the money is taxed on the current federal rate while entering the account, there will be (in the majority of circumstances) no money owed to the IRS ever again. Included in the amount of money that isn’t taxed, is the many decades of compounded growth that will generate over the length of your entire career.
Choosing An Account for High-Income Earners
With the potential for huge compounded growth, in tandem with the benefit of this money being untaxed, the Roth 401k could be a great choice for high-income earners. As stated previously, there are no required minimum distributions, which means that the money can stay within the account and grow for as long as you keep it in the account. These two factors combine make this account an attractive choice for those with well-established incomes.
Especially for individuals with successful careers, it is not unlikely that income could increase in the future with promotions or job changes. Taxing your income on the front end could be beneficial to remain in a lower bracket. With higher contributions to your retirement savings account, it is not unlikely that your tax bracket in retirement could be quite high, in combination with the growth of the money that occurred over its lifetime within the account.
An additional hindrance comes into play with Traditional 401ks when required minimum distributions kick in, which may force your taxable income into higher tax brackets, even if you don’t need to access the money. This also eliminates the possibility of continued compounding growth on the account.
Income Determinants, Social Security, and Insurance
In terms of social security, while you are receiving payment from the government, this money is still taxed. A married couple filing taxes jointly with an annual income of over $44,000 can expect up to 85% of their social security benefits to be taxable. For couples with income between $33,000 and $44,000, social security tax rates are set at 50%. This annual retirement income includes payments from Pensions, required minimum distributions from Traditional 401k accounts, income from taxable accounts, and any other sources of taxable income.
Income derived from your Roth 401k on the other hand, is not included in the income indicating the social security tax rate. In addition to the determination of social security tax rates, Roth accounts do not contribute towards income analyzed in determining how much you will need to pay for the health insurance portion of your Medicare coverage.
More recently, the SECURE Act was enacted which requires beneficiaries of an inherited Traditional 401k (and Traditional IRAs) who are not the individual’s spouse, to withdraw the entire balance of the inherited account within 10 years of the official transition of ownership. In turn, the individual must pay income tax on the amount of money inherited over the length of those 10 years, as the money is withdrawn. This particular issue is dodged with a Roth 401k, where the amount of money is received in full, and continues to grow in the account with a large amount of tax savings.
As you are probably aware, an important aspect of investment is diversification. By diversifying the investments in a portfolio, investors can soften the blow of bad market performance in a particular industry, instrument, or category by making up for it with investments that may be doing particularly well at the same time. Tax diversification can be viewed in a similar way to investment diversification.
While you may be able to determine the type of account that’s best for you based on your individual financial situation, the fact of the matter is that no one can perfectly predict the future. While you may think you’ll be in a lower tax bracket in the future, tax policies are continually changing, as are our incomes. A good choice could be contributing to both types of accounts in order to take into account the many factors that could change between now and the time that you choose to retire. This way, when a change occurs, you won’t end up with too many eggs in one basket. With multiple accounts, there is always the additional possibility of drawing from the accounts that have minimum required distributions and letting your Roth grow until the point in time where you need to make withdrawals.
Choosing the Right Account For You
Each individual’s circumstance is completely different. If you are making decisions on which type of account is better for your current financial situation and retirement goals, be sure to contact one of our financial advisors. Many important aspects of your current income or savings could be overlooked when non-professionals attempt to make this decision on their own. Your retirement is extremely important, you’ve been working toward it for a long time. When it comes time to enjoy the fruits of your labor, you will be happy that you made the best decision for your circumstances. Whether your goal is to utilize the money you’ve saved for so long by traveling, or you’re hoping to pass along some amount of wealth to your children, retirement is an exciting time that with proper planning can be lived out in the exact way you have planned out in your mind.
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