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Your 401k: Is the Roth Option Better Than the Traditional?

Traditional 401k plans are pretty common these days, but did you know that almost 70% of employers now offer a Roth 401k option? 

So if you’ve got the choice, how do you decide which one may be better? 

Let’s do a little comparison first. The 401k contribution limit applies to both the Roth and traditional: for 2021, that’s 100% of your pay up to $19,500, or $26,000 if you’re age 50 or older. You can also contribute to both categories in the same year, as long as you keep your total contributions under that limit. 

Where the Roth 401k and the traditional are different is in the taxation of your contributions and distributions. 

In a traditional 401k, contributions are pre-tax, which reduces your current adjusted gross income (AGI). With a Roth, they’re after tax, with no effect on your AGI. Any matching contributions made by your employer, though, must go into a pre-tax account, and you’ll pay taxes on those when they’re distributed. 

When you are eligible for withdrawals, all distributions from a traditional 401k are taxed at ordinary income rates. With the Roth, you won’t pay any taxes at all on your “qualified distributions”. 

But there are rules for withdrawals in both accounts. With a traditional 401k, withdrawals of contributions and earnings are taxed, and you might be penalized if you take the funds before age 59 ½, unless you meet one of the IRS exceptions. With the Roth, qualified withdrawals of contributions and earnings are not taxed at all.  But to be qualified, you must have held the account for at least five years, AND you have to be age 59 ½ or older, or have taken the withdrawal due to a disability or the death of the owner.  

Okay, so which may be better for you?   

It starts with taxes. If you think your income and tax rates will be higher in retirement than they are now, then the Roth may be better. On the other hand, if you think your income and tax rates will be lower in retirement, so lowering taxable income today is more beneficial, then the traditional 401(k) may be the better option. 

Keep in mind that future tax rates are unknown, but even if you believe that tax rates are generally going up in the future, that doesn’t mean your specific income and tax rates will. This is one of the benefits of projecting your future cash flows for years into the future as we do with our Bucket Strategy planning. It allows you to estimate how your income might change over time and infer what the impact to your taxes might be.   

While taxes are important, there are other factors to also consider when thinking about traditional vs Roth 401(k) contributions: 

Access: If you make too much to qualify for a Roth IRA, the Roth 401k has no income limits, giving you access to the Roth’s tax-free investment growth potential.   

Future Withdrawals: Qualified withdrawals from a Roth won’t increase how much of your Social Security benefits are taxable and won’t increase your Medicare premiums. In addition, you won’t have required minimum distributions at age 72 from a Roth. 

Flexibility: On the other side, the Roth 401(k) is less flexible than a traditional 401(k) in some ways, because of that five-year rule. Even if you’re age 59½, your distribution won’t be qualified unless you’ve also held the account at least five years. That’s something to keep in mind if you’re getting a late start. And even if you’ve met the 5 year rule with the 401(k), if you transfer it to a new Roth IRA and don’t have any other Roth IRAs, you start a new 5-year clock. 

And hey: if, after all this, you still can’t decide what’s better for you, you can always split the difference and contribute to both types of accounts. If your income varies from year to year and your plan allows for it, you can switch back and forth throughout your career or maybe even during the year. Doing this will diversify your tax situation in retirement, which in my opinion is generally a good thing. 

It all comes down to planning. Here at Lucia Capital Group, we help our clients with decisions like these every single day. Just give us a call to schedule your free, retirement income review. We’re here to help! 

Important Information:

The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

No client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.

IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

Examples cited are hypothetical, are for illustrative purposes only, are not guaranteed and subject to potential federal and state law amendments. There is no guarantee that you will achieve the results discussed or illustrated.

Diversification strategies do not ensure a profit and cannot protect against losses in a declining market.

Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.

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