Since employers are increasingly including a Roth 401(k) option as part of their defined contribution plan, employees should consider potential benefits of using the Roth 401(k) option instead of contributing to a traditional 401(k).

Much like a Roth IRA, a Roth 401(k) can provide tax-free income during retirement. Roth contributions are made with after-tax dollars compared to traditional 401(k) plans which are funded with pretax earnings. It should be noted that the tax treatment of 401(k) options are designed to be tax-neutral which means the primary factor to consider when making a decision is the individual’s current tax rate compared to their expected tax rate in retirement.

Choosing Between a Traditional and Roth 401(k)

A traditional 401(k) plan is usually the best option for employees who expect their tax rate in retirement to be lower than their current tax rate. The goal in this situation is to avoid current tax on contributions and pay tax at a lower rate in the future.

On the other hand, a Roth 401(k) may make more sense since for an employee who expects to pay tax at a higher rate in retirement since Roth accounts allow individuals to pay taxes today at a lower rate and then later withdraw those funds at a zero-tax rate.

Potential Benefits of a Roth 401(k)

Since many employees expect to have lower taxable income during retirement, maximizing pretax contributions to a traditional 401(k) often makes sense; however, this strategy fails to consider other potential benefits of a Roth 401(k) including the following:

Conclusion

Determining an optimal retirement savings strategy should be based on an individual’s circumstances and financial goals. Using cash-flow based retirement planning which considers the variety of factors which impact results and working with a qualified financial planning professional can help you develop a road map to achieve financial freedom.