When it comes to making decisions about your 401k, one of the biggest questions you may face is whether to contribute on a traditional pre-tax basis, or Roth after-tax basis.
Let’s talk about the why behind a 401k: If your company offers a 401k plan, this is one of the best personal financial tools to minimize taxes over your lifetime and build wealth for your future.
When you have a small portion of your paycheck withheld on an automated basis and diverted directly into a 401k plan, you are saving money for your future when you no longer can or want to work. And you get potentially huge lifetime tax savings for doing so.
Now, when you set up this paycheck withholding to make a 401k contribution, there are two main choices: Traditional pre-tax or Roth post-tax.
First, let’s talk about Traditional pre-tax:
Any money you contribute to your 401k in this category does not get included in your taxable income and does not get taxed now. Once in your 401k account, these funds can grow and earn income tax-deferred, which just means that you don’t pay taxes on those funds while they are protected by the 401k.
However, in the future at the time you remove a portion or all of those funds from your 401k, whatever amount you withdraw is taxed at that time. And, if you do so before age 59.5, there is also a 10% penalty on what you remove...though there are some helpful exceptions to the penalty.
So, to summarize the traditional 401k category, no taxes now and no taxes along the way, but all of what you withdraw in the future is considered taxable income.
If you are married and have a household income of more than $120,000 or single and have an income of more than $60,000, then it may make sense to lean towards Traditional pre-tax contributions.
Next, let’s talk about Roth post-tax:
Any money you contribute to your 401k in this category DOES get included in your taxable income and gets taxed now. Once in your 401k account, these funds can grow and earn income tax-deferred, which just means that you don’t pay taxes on those funds while they are protected by the 401k.
The good news is that in the future if you are over age 59.5 and have held the account for at least five years at the time you remove a portion or all of those funds from your 401k, whatever amount you withdraw is not included in your income and is not taxed. Keep in mind that if you are not 59.5 and make a withdrawal from Roth 401k funds, a portion of the withdrawal may be subject to taxes and a 10% penalty...though there are some helpful exceptions to the penalty.
So, to summarize the Roth 401k category, pay taxes now, but no taxes along the way, and all of what you withdraw in the future is considered tax-free if you wait until after age 59.5.
If you are married and have a household income of less than $120,000 or are single and have an income of less than $60,000, then it may make sense to lean towards Roth post-tax contributions.
Now, there are a few other important details to note:
For example, the same IRS maximum contribution limits, including the over age 50 catch up contribution, apply to both Traditional and Roth contributions.
And, as long as you stay within those total maximum 401k contribution limits for the year, you can contribute in any combination of Traditional and Roth! For example, you could do 50% Traditional and 50% Roth...or 25% Traditional and 75% Roth.
Also, if your company offers a match, then either Traditional or Roth counts as your employee contribution in order to qualify for the match.
Now that you know the difference between Traditional pre-tax and Roth post-tax 401k contributions, login to your 401k portal and find the link or tab that allows you to make changes to your contributions today!
The content and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax, or legal advisor with regard to your individual situation. The information has been obtained from sources we believe to be reliable, but we cannot guarantee its accuracy or completeness. Past performance is no guarantee of future results. The opinions and views expressed here are for informational purposes only. Please consult with your tax and/or legal advisor for such guidance. Investment advisory services offered through Catalyst Wealth Management, LLC doing business as Ridgeline Private Wealth. Catalyst Wealth Management, LLC and Ridgeline Wealth, LLC are not affiliates.