Q: I’m contributing to my 401(k). Should I designate those as regular contributions or Roth contributions?
A: Depends. When do you want to pay your taxes?
Here’s a quick refresher on the tax consequences of Regular vs Roth contributions–and the timing of the payment of taxes.
Regular 401(k) contributions are tax-deductible and reduce the amount of income you must report on your income tax return in each year you make a regular contribution. In other words, part of your regular 401(k) contribution comes from tax savings.
When distributed, regular 401(k) contributions and earnings are taxed as ordinary income.
In the year you turn age 70 1/2, you are required to take a minimum distribution of the balance in your regular 401(k) account.
You cannot deduct a Roth contribution. The amount you contribute is made from after-tax dollars.
You are not required to take a minimum distribution from your Roth account (but your non-spouse beneficiaries must.)
When distributed, earnings on Roth contributions might* be tax-free AND your initial contribution is never taxed.
Some people decide to make a regular contribution versus a Roth contribution on tax consequences. The logic is if your tax rate in the year you make your 401(k) contribution will be…..
…..the same as the rate when you withdraw the money, it should make no difference if the contribution is regular or Roth.
…..lower than the tax rate when you withdraw the money, make a regular contribution.
…..higher than the tax rate when you withdraw the money, make a Roth contribution.
Do you know what your tax rate will be in retirement? (Bonus Question: Do you know your tax rate now?)
If claiming the tax deduction will materially impact your ability to make a larger contribution to your 401(k), make a regular contribution.
If you have a very low tax rate now, a Roth contribution can be a good choice–especially if you expect in future years to see your income grow with your career.
If the ability to postpone a distribution from your 401(k) account will be advantageous given your retirement income planning, then make a Roth contribution.
* What do you mean, “Earnings on Roth contributions might be tax-free?” To receive tax-free treatment of the distribution of earnings, the distribution must be “qualified”, i.e., occur after age 59 ½ AND the Roth account has been in existence for 5 years.