More and more 401(k) plans are offering a choice on how you make your contributions. You can make deposits into the plan in the traditional way, which means that your money goes into the account before taxes are paid on that money. In recent years, many plans have begun offering another choice. If your plan allows, you can now make a Roth contribution, which means that the money goes into your account after-tax. Which option is best for you? As with most financial questions, the answer is “It depends on your personal situation.” I’ll try to help you decide which option is best for you in the paragraphs ahead, but first we need a little more detail about the choices.
Most people are familiar with the way that traditional contributions work. First, you decide how much you would like to have withheld from your paycheck, usually a percentage of your pay. That amount is deducted from your paycheck before income taxes are withheld. For example, if you make $75,000 per year and decide to contribute 10% of your pay, $7,500 goes into your account. Pre-tax means that, in this example, you would reduce your taxable income (before deductions) to $67,500 ($75,000 less the $7,500). So your traditional contributions result in a lower current tax bill. However, when you withdraw the funds, they are taxed as ordinary income.
Roth contributions work just the opposite way. Using the above example but making your contributions to the Roth option instead, your taxable income would be the full $75,000 you earn (less regular deductions). But when you withdraw the funds at retirement, they are tax-free. Contributing to the Roth option means that your current tax bill will be higher because you are paying tax on the entire amount of your income now, and you will receive tax-free income later.
Roth IRAs and Roth contributions in 401(k) accounts have been growing in popularity recently because of two reasons. First, the new tax law passed last year means that most of us will be in a lower tax bracket. That means that traditional, or pre-tax, contributions will be slightly less attractive. Shortly after the new tax law went into effect, Congress passed a $1.3 trillion spending bill, which results in a large increase in the national debt. That debt will eventually have to be paid, and most “experts” agree that it will mean higher taxes in the future. If that’s the case, your tax-free dollars will be worth even more.
It becomes a bit of a balancing act to determine whether you should make traditional or Roth contributions to your retirement plan. Do you take advantage of lowering your current taxable income by making contributions to the traditional option? Or do you pay a little more in tax now to have tax-free income at retirement? If you are just getting started in your employer’s plan, I say it’s a no-brainer—go with the Roth. If you’ve been in the plan for a while, you should consider redirecting at least a portion of your contributions to the Roth option.
Many people have been contributing to the traditional option for years and find it hard to give up that current tax break. After all, a dollar in your pocket now feels better than one in the future. There’s a good way to help you make the decision. Take the information from your 2017 tax return and run it through a 2018 calculator like this one, 2018 Tax Reform Calculator offered by the Tax Foundation, an independent tax policy nonprofit.
We’ve run the analysis for several of our clients and find that most will have a lower tax bill for 2018. We are recommending that they reduce their traditional contributions to the level that would keep their tax bill about the same, and start making Roth contributions with the tax savings. Over time, we recommend increasing the amounts going into the Roth. After all, tax-free is almost always better than tax-deferred.