401k vs Roth: Understanding the Best Way to Save for Retirement
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If you want to get any personal finance nerd riled up, just ask them if you should contribute to your 401k or a Roth. 🙃
In all seriousness, though, it is an important question to ask because it can greatly impact your retirement income.
Before we dive into 401k vs. Roth, let's back up and make sure we're on the same page regarding how the two main retirement account types work:
How a 401k works:
Note - I often colloquially refer to 401ks as a traditional retirement account, but that's not actually correct. Rather, a 401k is a type of traditional retirement account.
It's kind of like how you may call all bandages band-aids.
A traditional retirement account is a retirement account that allows you to contribute pre-tax dollars and watch them grow tax-free until retirement. Most for-profit corporations offer a 401k plan as part of their employee benefits package. Other variations include the 403b, 457b, or TSP, which government or nonprofit employers typically offer.
By contributing to a 401k, you can lower your taxable income and potentially benefit from being in a lower tax bracket during retirement.
However, withdrawals from a 401k are subject to income taxes and may impact your tax liability in retirement.
Here’s how a Roth works:
On the other hand, the Roth retirement account offers tax advantages that are the opposite of a traditional 401k. Unlike a 401k, a Roth account consists of after-tax dollars, meaning taxes have already been paid on the contributions. The contributions and earnings in a Roth account grow tax-free, and withdrawals in retirement are tax-free as well.
Factors to Consider in Deciding Between 401k and Roth:
While it’s not true that there’s a noticeable “better” choice between a 401k or Roth, one may be more advantageous to you, depending on your circumstances. Here are three key questions to ask oneself:
1. Is there a difference in current and future tax brackets? If you live in a high-tax state or city, you might opt for a 401k to reduce your taxable income. Conversely, prioritizing a Roth account could be more advantageous if you anticipate living in a lower tax bracket during retirement.
2. What is your income level, and where do you see it in the future? For higher earners, maximizing contributions to a 401k can provide significant tax benefits, while lower-income folks may benefit more from a Roth account.
3. Are there specific life events or career changes expected? If you plan for sabbaticals, career transitions, or temporary income changes, you might benefit from the flexibility of a traditional retirement account, such as converting funds to a Roth during a lower-income year.
No Clear Winner: The Importance of Diversification
To be clear, there’s no one-size-fits-all approach to choosing between a 401k and a Roth. Due to the unpredictability of future tax rates, inflation, and personal circumstances, diversification is critical. A strategy that balances both accounts lets you take advantage of each option's strengths and tax benefits.
Your Action Plan:
Planning for retirement involves carefully considering various factors, and choosing the right retirement account is essential. While 401k and Roth accounts have distinct advantages, no definitive winner exists. You can make informed decisions by understanding the differences and assessing your income, career trajectory, and tax considerations.
Of course, if your employer offers a match, that is ALWAYS the first place to put your money. This conversation around Roth vs. 401k only comes into play once you meet your match.
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