Do you think taxes will be higher or lower by the time you’re ready to retire?
Without a time machine, none of us know how the tax system will shift during our years before retirement. We do, however, have choices on how we handle our taxes today.
Taxes are important to consider when deciding whether a traditional 401(k) or Roth 401(k) is right for you. Nextep’s 401(k) gives you the ability to choose. Here’s a rundown.
Traditional 401(k): Pay Taxes Later
Let’s say your annual income is $35,000, and you contribute $3,000 into a traditional 401(k). Your 401(k) contributions are deducted from your paycheck before any taxes are taken out. When you file your taxes, you have reduced your taxable income from $35,000 to $32,000.
Reducing your taxable income allows you to pay less in taxes during your working years. However, if you don’t pay taxes on your 401(k) contributions when you put them into your account, the IRS will require you to pay taxes as you take them out.* Withdrawals in retirement will be taxed like working income, whether those dollars are what you contributed or are investment earnings.
Traditional 401(k) Pros | Traditional 401(k) Cons |
|
|
Roth 401(k): Pay Taxes Now
A Roth 401(k) works differently. Let’s take the same $35,000 annual income and contribute $3,000 into a Roth 401(k). This contribution will be deducted from your paycheck after your taxes are paid. When you file your taxes, your taxable income will still be reported as $35,000.
There aren’t tax savings during your working years for contributions into a Roth 401(k). The benefit of a Roth is enjoyed in retirement. Because taxes are paid on Roth contributions upfront, you will be able to take qualified distributions in retirement tax-free*— including investment earnings.
Roth 401(k) Pros | Roth 401(k) Cons |
|
|
Since none of us know what the future holds, you might consider splitting your savings between traditional and Roth contributions. Essentially, you would have two buckets of money within your 401(k) account that would give you the freedom to choose how to withdraw money in the most tax-efficient way. Just like investors diversify their investment strategies, you can diversify your tax strategies.
Keep in mind, if your employer offers a company match, employer match dollars in your account will always be traditional, and their pre-tax contributions will be taxed at retirement.
Check out this Roth vs. Traditional calculator to compare the plans and choose which one may be right for you.
Your Nextep 401(k) team is here to help! Our 401(k) has a financial advisor who can help you look at all the factors to consider when deciding if a traditional 401(k) or a Roth 401(k) is right for you.
We would love to partner with you in creating a retirement savings plan! Reach out to us at 401k@nextep.com.
*Early withdrawal penalties and income taxes may apply if you withdraw from a 401(k).
