07 Jul Which 401(k) is right for me?
Q. I started using a Roth 401(k) last year but it meant I had to pay more in taxes. Should I go back to the traditional 401(k)?
A. This is a common question, so let’s start with the differences between the two types of accounts.
The basic difference between a traditional and a Roth 401(k) is when you pay taxes on your contribution, said Chip Wieczorek, a certified financial planner and investment adviser with Tradition Capital Management in Summit.
“With a traditional 401(k), contributions are made with pre-tax dollars, helping to lower your income tax bill in the current year,” Wieczorek said. “Your contributions and earning grow tax-deferred then at retirement withdrawals will be taxed as ordinary income.”
With a Roth 401(k), contributions are made with after-tax dollars and there is no current tax deduction, Chip Wieczorek. Just like a traditional 401(k), contributions and earning grow tax-deferred until you withdraw them in retirement.
Wieczorek said withdrawals of both contributions and earnings are tax-free at age 59½, as long as you’ve held the account for five years. In addition, he said, once rolled to a Roth IRA, there is no Required Minimum Distribution (RMD) requirement after age 70 ½ as there is with a 401(k).
He said for most 401(k) plans, you don’t necessarily have to make an all-or-nothing choice, so Wieczorek recommends that clients contribute a portion to both accounts.
“It is worth paying some taxes now to more effectively control your income tax bill in retirement by balancing taxable and tax-free withdrawals,” he said. “Likewise in the current year, having both types of 401(k) will give you the flexibility to vary your contributions depending on bonuses, commissions, stock vesting or any other variable compensation.”
If you have variable income, Wieczorek said, in a low income year you can allocate more to your Roth 401(k) and in a high income year, you can allocate less or none.
If you find that you need the tax deduction for the 401(k) contributions now, you should go back to making the contributions pre-tax, said Vicky Tomaro, an Investment Advisor Representative with Tomaro Financial Group in Wall.
“The Roth IRA is very good long-term if you can afford to make the contributions after-tax as your money will come to you tax-free when you need to start withdrawing,” she said.
Tomaro recommends you discuss your options with your financial advisor and your accountant to see the best scenario for you.
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This post was first published in July 2016.NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.