With a traditional 401(k) account, contributions are made on a pretax basis: an employer takes money out of a paycheck and transfers it in the employee retirement plan before withholding taxes. When the employee begins to take distributions, he/she will pay normal income tax on those distributions, and the income tax will be based on the employee’s tax bracket at the time of the distribution.
Roth 401(k) contributions are made after an employer withholds taxes. Because the employee already paid taxes, he/she will not owe taxes on distributions. (However, if an employee receives a company match on a Roth contribution, the company match is a pre-tax contribution. The funds that result from company matches and the associated growth will be subject to regular income tax when distributions are drawn at retirement.) It is noteworthy to mention that employees never owe capital gains taxes on any kind of 401(k) investments.
Here is a simple breakdown of the difference between a Roth 401(k) and a traditional 401(k):
- Traditional 401(k) = income taxes on distributions
- Roth 401(k) = income taxes on contributions
Determining which form of 401(k) contribution is preferable requires an investor to do some retirement planning. Without consideration for other financial issues the employee might face, the goal is to pay less in taxes. So an investor needs to determine when he/she will be in the highest tax bracket and avoid paying taxes on contributions or distributions during that time.
For example, most people will be at the height of earning capacity as they near retirement, which means this is the time they will be in the highest tax bracket. People who fit this description will earn less in retirement than they did in their final years of employment. If that is the case, it makes more sense to pay taxes during retirement than during high-earning years immediately preceding. So generally advisers recommend that people contribute exclusively to a traditional 401(k) during the years leading up to retirement.
Conversely, people at the beginning of their careers are usually earning less than they will earn in the future, so they are in a lower tax bracket. For these employees, it is most logical to pay taxes at the time they make contributions, while they are in a low tax bracket. So generally advisers recommend that people make some portion of contributions during their early career on an after-tax basis to a Roth 401(k) account. The caveat is that traditional 401(k) contributions lower an employee’s annual taxable income – possibly taking that person into a lower tax bracket. For that reason, accountants might recommend some kind of split between Roth and traditional 401(k) contributions.
At this time there are no income restrictions for Roth 401(k) contributions. According to IRS guidelines, single tax filers whose taxable income is more than $120,000 and married-filing-jointly tax filers whose taxable income is more than $177,000 cannot contribute to a Roth IRA. Despite that rule, retirees can rollover funds from a Roth 401(k) to a Roth IRA without concern for income restrictions.