By David Horwedel, EA
There are two main types of 401(k) plans-traditional and Roth.
Below is an overview of both types and their tax implications, so you can make an informed decision.
A traditional 401(k) allows you to set aside a portion of your salary pre-tax through paycheck withholding. Taxes on your contributions are deferred, and you will pay taxes when you withdraw funds from the account.
A Roth 401(k) is funded with after-tax dollars, which means you will pay taxes on the amount you contribute each year, and qualified withdrawals of contributions and earnings are not taxed.
Employer contributions can help grow your retirement savings, and both plan types can give your money a tax shield while your account grows.
The main differences between traditional and Roth 401(k) s is when you pay taxes. Contributions to traditional 401(k)s are pre-tax, reducing your taxable income. In contrast, contributions to Roth 401(k)s are after-tax, meaning they do not reduce your taxable income. However, qualified withdrawals of contributions and earnings from a Roth 401(k) are not taxed.
For both types of plans, there’s no tax impact as your investment grows and remains in the 401(k) account.
Let’s assume that you withdraw funds as intended for retirement and are following the rules so you incur no penalties. When you withdraw funds from a traditional IRA, the entire income is taxable. When you withdraw funds from a Roth IRA, nothing is taxable. (Both types of plans have penalties for premature withdrawals, which we are not covering here.)
So in a traditional 401(k) your tax is deferred until you withdraw funds. In a Roth IRA, the tax has been paid up front.
Now, if you are making 150k a year now and when you retire your income drops to 30k, then the traditional 401(k) looks pretty good. You are taxed at a lower tax rate, or, if your income is low enough, not at all. This is the long-standing argument for a traditional 401(k)
You also may be able to contribute more money as you did not have to pay the up-front tax. Besides, everyone likes to pay less tax now!!
The Roth advantage is that you are NEVER taxed on rising tax rates. Let’s say you pay tax on a $5000 contribution. 20 years later, at a 10% annual rate compounded monthly you have $36,640 dollars you can withdraw TAX-FREE.
If taxes go up and inflation is high, it tends to favor the Roth as it increases the rate of return on your investments. Increasing taxes also favor the Roth as it could mean a higher tax rate on withdrawal for the traditional 401(k). Moreover, if you have planned to maintain your income in retirement, then this is a further Roth advantage. (If your retirement income is low and you drop into a lower tax bracket, this favors the traditional IRS.)
So if you expect inflation and higher taxes, the Roth is probably a better bet.
It’s important to note that both traditional and Roth 401(k)s require minimum distributions starting at the age of 72 or when you retire from the company sponsoring the plan, if later and if allowed by the plan. However, under recent legislation, if you turn 72 after 2022, your required minimum distributions don’t start until age 73, and after 2023, RMDs will no longer be required for Roth 401(k)s.
The contribution limits for both Traditional and Roth 401(k)s in 2022 are $20,500 for employees under 50 years old and $27,000 for those over 50 years old. These amounts will increase in 2023. Employer contributions do not count towards employee contribution limits, and the company match does factor into an overall cap on contributions.
At Torchlight Tax, our purpose is to save your tax dollars by doing your taxes the right way without cheating or putting at you at risk. We also have the purpose of making the tax process as pain-free as possible. 401(k)s are a valuable tool in this regard.
Also, please be aware-tax laws can change. I cannot guarantee that Congress and the President may come up with additional ways to tax your 401(k) in the future.
If you have tax questions and would like assistance having more after-tax dollars, give us a call at 1-877-758-7797 or email us at firstname.lastname@example.org. You can also fill out the free consultation form with this article.