Traditional 401(k) vs. Roth 401(k): Which is Right for You?

July 28, 2023
Estimated Reading Time: 5 Minutes
Making decisions about your retirement savings is no small matter. A question that often arises is whether to opt for a Traditional 401(k) or a Roth 401(k). The answer is nuanced and largely depends on your personal financial circumstances and future income projections.

Understanding the Basics:

Traditional 401(k):

    • Contributions: Made pre-tax, directly reducing your taxable income for the year they’re made.
    • Taxation at Withdrawal: When you withdraw in retirement, you'll pay income taxes on the amount.
    • Primary Benefit: You get a tax break now, when your current income might place you in a high tax bracket.

Roth 401(k):

    • Contributions: Made after-tax, not reducing your current year’s taxable income.
    • Taxation at Withdrawal: Provided you’ve held the account for a minimum of 5 years and are over 59.5 years, withdrawals are tax-free.
    • Primary Benefit: While you pay taxes now, your withdrawals in retirement are untouched by taxes, possibly an advantage if you expect to be in a higher tax bracket later.

Future Tax Bracket Predictions

A significant part of the decision depends on where you think your tax bracket will be in retirement.

  • Higher Future Tax Bracket: If you believe that your income in retirement will place you in a higher tax bracket than your current one, a Roth 401(k) can be more beneficial. You'll pay taxes at your current, presumably lower, rate and enjoy tax-free withdrawals later.
  • Lower Future Tax Bracket: If you anticipate being in a lower tax bracket come retirement, the Traditional 401(k) might be the way to go. You'll benefit from a tax break now and pay taxes on withdrawals when your rate is potentially lower.

Uncertainty about Future Tax Rates

With fluctuating economic scenarios and tax law revisions, predicting future tax rates becomes a challenge. For those uncertain about where tax rates are headed, splitting contributions between both account types might be a wise move. This strategy provides a hedge, helping you benefit from tax advantages now and in the future.

Legacy and Estate Planning

If you’re planning to leave assets to heirs, Roth accounts might offer an advantage. Beneficiaries of Roth accounts can also take tax-free withdrawals, making it a more attractive inheritance.

Diversifying Your Tax Exposure

Given the unpredictable nature of tax policies and the future economic environment, some financial advisors advocate for tax diversification. Much like you diversify investments to mitigate risk, diversifying your tax exposure can help you adapt to various tax scenarios in the future.

By balancing contributions between Traditional and Roth accounts, you're essentially hedging your bets. You'll benefit from immediate tax breaks while also establishing a tax-free source of income for retirement. This diversification can offer flexibility when devising withdrawal strategies in retirement.

Choosing between a Traditional 401(k) and a Roth 401(k) isn’t a one-size-fits-all answer. Your decision should be rooted in a careful evaluation of your current financial situation, retirement goals, and informed predictions about your future income and tax scenarios.

When in doubt, it’s always beneficial to consult with financial advisors or tax professionals. They can offer tailored advice based on your unique circumstances, ensuring you make a decision that will stand you in good stead when it’s time to retire. Contact Chicago Partners to set up an introductory meeting with one of our advisors.

Remember, the key is to start saving early and be consistent. Whether you choose a Traditional or Roth 401(k), or a mix of both, the most important step is to actively contribute and secure your financial future.

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