According to a recent Gallup survey, only 43% of Americans believe they will have enough money to retire comfortably.
As a financial coach, I’ve taught thousands of students how to save more for retirement based on my own experience in investing enough money in my 30s. Don’t overlook this one key difference between traditional and Roth options in choosing your employer sponsored 401(k).
Traditional 401(k)s Help You Save On Taxes Today
Unlike a general investment account on apps such as Robinhood, both traditional and Roth 401(k) contributions are tax-deferred. The difference is when you get the tax benefit. The easy way to remember is their first letters: T = traditional = today and R = Roth = retirement.
A traditional 401(k) provides tax savings today by lowering the amount of income you are being taxed on in a given calendar year. This is also known as a tax deduction. Other tax deductions you might be familiar with are mortgage interest, contributing to charity and health insurance payments.
So, if your annual income is $70,000 and you contribute $10,000 to a traditional 401(k) this year, your taxable income for this year is considered to be $60,000. The $10,000 you put in your 401(k) is not taxed.
When you take funds out during retirement, you will owe income taxes on the withdrawal based on your income and tax bracket at that time, including all of the earnings your 401(k) grew over the years.
A Roth 401(k) Helps You Save Taxes In Retirement And On Your Investment Growth
About 88% of 401(k) plans offered a Roth account in 2021, almost doubling from a decade earlier, according to the Plan Sponsor Council of America.
Roth 401(k) contributions require you to pay the taxes now at your current tax bracket. Using the same numbers as before, if your income for the year is $70,000, and you contribute $10,000, you will still pay taxes on your total $70,000 salary now, assuming no other deductions.
However, when you do withdraw funds in retirement with a Roth option, you won’t owe taxes on any of the money. More importantly, and what most people misunderstand is that you also won’t pay taxes on the earnings accrued since your original contributions.
To clarify, if the $10,000 you contributed in a traditional 401(k) grows to $30,000 when you retire, you will pay taxes on the entire $30,000 as you withdraw, including the $20,000 of growth. But if you contribute it to a Roth 401(k) you will not pay taxes on the $20,000.
This means that income earned on the account, from interest, dividends, or capital gains, is tax-free, according to the U.S. Securities and Exchange Commission.
Consider How Much You Can Afford Now Versus Later
Not every employer offers a Roth option, so it’s important to do your research on the particular plan that’s available to you.
Whether you contribute into a Traditional 401(k) versus a Roth 401(k) also depends on how much money you need for other current expenses, particularly if you are carrying high interest credit card debt, saving to buy a home, or are paying off student loans.
If you were to contribute the same amount to your 401(k) via Traditional or Roth options, your take-home pay will be higher if you choose Traditional contributions.
However, both options have specific withdrawal rules that include potential tax implications and penalties if you need the cash sooner than later.
Having more disposable cash may now be more important for you depending on your current budget and long-term financial plans. Planning a simple monthly budget can help you find extra dollars to contribute to your retirement investing.
But if you do have a Roth 401(k) option available and can accommodate contributing more toward it, you can save the headache of taxes farther down the road.
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