When investing in a 401(k), it important to determine whether making Traditional (Before-Tax ) or Roth (After-Tax) contributions would be more beneficial to your long-term retirement strategy. When you retire and begin withdrawing money from your 401(k), the type of contribution you made to your account determine what, if any, tax you pay on these distributions. If you make Traditional contributions, you will have to pay income tax on withdrawals. If you make Roth contributions, you will not pay income taxes on these distributions.
When it comes to determining whether Traditional or Roth Contributions would be better for you, there are calculators to help you with this decision. Many financial companies, mutual fund providers, and banks have these calculators on their website. These calculators are easy to use and require you to input a few numbers. Once this done, a report can be generated letting you know whether Traditional or Roth contributions would be better for you. Below are two examples:
Client #1
Based on the information you entered, a Roth account may be worth more than a traditional account.
| Traditional 401(k) | Roth 401(k) | |
| Total contributions | $108,000 | $108,000 |
| Total before taxes | $463,504 | $463,504 |
| Value of investing tax savings | + $54,711 | + 0 |
| Taxes for 401(k) at retirement | - $69,526 | - 0 |
| Value at retirement (age 65) | $448,689 | $463,504 |
| A Roth 401(k) may be worth $14,815 more than a traditional 401(k). | ||
| Annual contribution* | $3,000 | Current age | 29 |
|---|---|---|---|
| Years until retirement | 36 | Age of retirement | 65 |
| Expected rate of return | 7% | ||
| Current tax rate | 15% | Retirement tax rate | 15% |
Client #2
Based on the information you entered, a traditional account may be worth more than a Roth account.
| Traditional 401(k) | Roth 401(k) | |
| Total contributions | $108,000 | $108,000 |
| Total before taxes | $463,504 | $463,504 |
| Value of investing tax savings | + $77,990 | + 0 |
| Taxes for 401(k) at retirement | - $69,526 | - 0 |
| Value at retirement (age 65) | $471,968 | $463,504 |
| A traditional 401(k) may be worth $8,464 more than a Roth 401(k). | ||
| Annual contribution* | $3,000 | Current age | 29 |
|---|---|---|---|
| Years until retirement | 36 | Age of retirement | 65 |
| Expected rate of return | 7% | ||
| Current tax rate | 25% | Retirement tax rate | 15% |
As you notice, the results were different. Client #1 found Roth Contributions more beneficial while Client #2 benefitted more from Traditional Contributions. Client #1 would have a larger estimated value from Roth Contributions due to the tax savings in retirement. Client #2 would have a larger estimated value from Traditional Contributions due to the tax savings they generated.
One final note in this example. Even though the contributions and expected rate of return were the same, the clients were in different income tax brackets. Your tax bracket, both now and the future, are major determiners in the Traditional vs Roth Contribution decision. Therefore, it important to both make good use of this type of calculator every time you have a change in income and discuss the results with your tax professional before implementing.
Disclaimers
- I.F.S.G. is a fee-based registered independent advisory specializing in investments and life insurance solutions.
- I.F.S.G. does not give tax advice. You should consult your tax professional before making any financial decisions.
- Securities provided by Trade PMR. Fixed income products provided to Trade PMR by Advisor Asset Management, Crew & Associates, and JBB Financial.
- Investing Money in securities exposes investors to risks including loss of principal and past performance is not an indicator of future returns. Investors should carefully consider investment risks, objectives, charges, and expenses.
Matt Dressel is the Owner of the Independent Financial Solutions Group. If you have any questions about this article, he can be reached at 252-515-0242 or matthewdressel.ifsg@gmail.com
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