The debate rages on when it comes to saving for retirement, should you choose a Traditional 401(k) or a Roth 401(k)?
Why a Traditional 401(k):
Many financial professionals will quickly point out that with a Traditional 401(k) you will save in taxes today and they are spot on.
Traditional 401(k)’s work by taking dollars from your pay check and investing them before those dollars get hit with a tax.
The other advantage with the Traditional 401(k0 is that the dollars you invest today will not be hit with a tax until you take the money out and you don’t have to take any money out until you are at least 73.
Unfortunately, with a Traditional 401(k) there is a required minimum distribution that you ust make on annual basis once you reach age 73.
This RMD will continue to get larger each year until the account no longer has any value.
With a Traditional 401(k) you get lower your taxes today and in retirement you will have, hopefully, more money late on, which of course you will have to pay taxes on.
Why a Roth 401(k):
Unlike a Traditional 401(k) a Roth 401(k) uses after tax dollars when investing.
This means your entire pay check will get hit will taxes and then you will invest a percentage of your remaining pay into a Roth 401(k).
Financial professionals will be quick to point out that with a Roth 401(k) you will not be able to save as much while your are working and this will mean you will have less in savings for retirement.
However, the key to Roth 401(k) is that because you pay taxes immediately when you do take money out in retirement that it is all tax free.
The choice is yours and you must ask your if you want to:
- Avoid pay taxes while you are young, working and can afford to or
- Pay taxes later on when you are no longer working and need the money?
Before deciding let’s throw a curve ball at you and bring up what really happens in retirement with taxes.
Reality of Retirement
In retirement there are 5 rules that many people seem to neglect to factor when planning for the future and they are:
- To receive any Social Security benefits you must enroll into Medicare.
- Medicare is not free and there is a tax on your income through the Income Related Monthly Adjustment Amount (IRMAA). The ore income you have the higher your Medicare Premiums will be.
- Social Security benefits are subject to tax if you make too much money. The more taxable income you have the less Social Security you are going to receive.
- You pay for your Medicare premiums and that IRMAA tax through your Social Security benefit. The more taxable income you have the higher your Medicare premiums will be and the less Social Security benefits you are going to receive.
- The income that creates IRMAA and also makes your Social Security taxable comes directly from Traditional 401(k)’s. With a Roth 401(k) you can have as much income from it as you will like without the worry of any taxes.
The difference between Traditional 401(k) or Roth 401(k):
The biggest decision when choosing a Traditional 401(k) or a Roth 401(k) is whether or not you want to pay more in taxes and lose more of your Social Security or not.
With a Traditional 401(k):
The Pros:
- You will be able to lower your taxable income from working.
- You will be able to invest more today which will may create a greater nest egg later.
- There will be no taxes to pay on your investments until you retire.
The Cons
- You will have to take money out of your investment at some point (RMD).
- This money will count as income and you will pay tax on it (tax #1).
- This income will count towards the taxation of your Social Security benefit and you will lose more of that benefit (tax #2.)
- This income along with your now taxable Social Security benefit will increase your Medicare premiums through IRMAA (tax #3).
- With higher Medicare premiums (IRMAA) you will have even less Social Security benefits (tax #4).
Notice that the Cons outweigh the pros with a Traditional 401(k)?
With a Roth 401(k):
The Pros:
- You never have to make a withdrawal…ever.
- If you make a withdrawal there are no taxes.
- Withdrawals will never count as income towards Social Security or IRMAA.
- You will never reach IRMAA.
- Your Social Security will never taxable at the fullest rate.
- You will keep more of your Social Security benefit
- You will keep more of your income.
The Cons:
- You will have to pay taxes while you are young, working and generating money.
- Because you will pay taxes on your income today you will not have as much to invest today.
- Your nest egg at retirement should be smaller when comparing to what a Traditional 401(k) will be.
Even with the Roth 401(k) having less in terms of a nest egg than the Traditional 401(k) because taxation never becomes a factor you will have more with the Roth 401(k).
Conclusion to which should you pick a Traditional 401(k) or Roth 401(k)?
If you want to save taxes today while you are young and working then go with a Traditional 401(k) for your retirement savings.
Though, if you want more income, more of your Social Security and the obligation of taxes while you are in retirement then the Roth 401(k) is a better option.
