Choosing between a traditional and Roth 401(k) or IRA means sifting through a number of variables.
But if you have to distill the decision down to one variable, it’s got to be taxes.
I'll take a brief look at traditional and Roth 401(k) contributions from a tax perspective. Then money expert Clark Howard will tell you whether you should contribute to a traditional or Roth 401(k) based solely on your income tax bracket. Feel free to skip ahead if you only want to know the answer.
Traditional 401(k) Accounts: Tax Perspective
When you contribute to a traditional 401(k), you’re putting in pre-tax dollars. In other words, if you make $100,000 this year but you put $10,000 in a traditional 401(k), you can adjust your taxable income to just $90,000.
However, the IRS has to get its cut at some point. So when you withdraw from a traditional 401(k) in retirement, every dollar of that money counts as taxable income.
The scary thing is that you don’t know what your tax rate will be in 20 or 30 years.
Plus, let’s say you invest the $10,000 you put into your traditional 401(k) account this year. By the time you retire, it grows into $100,000. When you’re ready to withdraw, you now have to pay income tax on the entire $100,000: a much larger tax bill.
Roth 401(k) Accounts: Tax Perspective
When you contribute to a Roth 401(k), you’re putting in post-tax dollars. If you make $100,000 this year and you put $10,000 in a Roth 401(k), you still get taxed on the full $100,000. That includes the $10,000 that you put into your retirement account.
The upside is that when you're ready to withdraw in retirement, you can take out every penny tax-free. That's the initial amount you invested plus all your gains. (You can take out your contributions at any point. But if you want to withdraw your gains tax-free, there are some rules you have to follow.)
So your $10,000 contribution to a Roth 401(k) this year would all count as taxable income. But if that money grows into $100,000 in retirement, it’s all yours. No need to pay the IRS.
Traditional vs. Roth 401(k) Decision Depends on Tax Bracket
According to Clark, you can distill your traditional vs. Roth 401(k) decision down to your tax bracket.
If your tax bracket is 24% or lower for 2022, contribute to a Roth 401(k), Clark says. If your tax bracket is 32% or higher, contribute to a traditional 401(k).
Which tax bracket are you in for 2022? Here’s a look at the federal income tax brackets based on your filing status.
On a recent podcast, Clark suggested that even if you're in the 32% tax bracket, you should still consider making contributions to a Roth 401(k).
Clark says that tax rates are at historic lows. Due to budget deficits and other reasons, Clark believes that taxes will increase significantly in the future. So even if your income is lower in retirement than it is now, you could pay the same or more in taxes.
Taxes are the clear No. 1 factor. But there are other points of comparison for the traditional vs. Roth decision beyond taxes.
Ultimately, if you're setting aside significant money into a 401(k) plan, especially if you're taking full advantage of any company match, you're doing a nice job of saving for your retirement.
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