Traditional vs. Roth: Which 401(k) is right for me?

Whether you've just changed jobs or you're a soon-to-be grad about to start your first job, one of the most important benefits is saving for retirement with a 401(k). Let's explore the power of your 401(k) (it may surprise you!), and which kind of 401(k) to use.

When you contribute to your 401(k) plan, you defer money from your paycheck into an investment account before payroll, and income taxes are deducted. Already, this is a powerful advantage for savers, and many employers also offer a free match of your 401(k) contribution, meaning you get a 100 percent return on the amount you contribute when your employer adds that amount to your account balance.

But as Albert Einstein purportedly said, "The greatest invention of all time is the power of compounding." The 401(k) offers that in spades; over time, your investment will grow because you will earn returns on your returns. And because this process repeats, the sooner you get started, the more your money can grow. A simple example may surprise you.

Now this example uses bigger numbers to make a point, but it works no matter how much you contribute. If you save $20,500 a year in a bank account earning 0 percent, over 35 years you would have saved $717,500. But if you invest that money in a combination of high-quality stocks and bonds earning an average of 7 percent per year, it could grow to more than $3 million. This is possible because your balance grows from your continual contributions and those contributions generate interest, dividends and capital appreciation.

Once you understand the power of compounding over time, the next step is determining which type of retirement account to invest in — a Traditional 401(k) or a Roth 401(k).

Traditional 401(k)

This option is familiar to most investors. With a Traditional 401(k), you can automatically defer pre-tax money from your paycheck into a 401(k) up to a maximum of $23,000 for 2024. If you're over 50, you can also use a catch-up contribution of $7,500 for a total of $30,500.

From a tax perspective, the amount you contribute to your 401(k) will not be subject to payroll and income taxes, and it will therefore lower your tax bill. What is more, your 401(k) investments will grow tax-free with no income or capital gains taxes on the balance until you start to withdraw money during retirement. At that time, any distributions will be taxed at your ordinary income-tax rate.

Roth 401(k)

Some employers also offer a Roth 401(k) in addition to a Traditional 401(k). This lets you defer the same amounts into your 401(k) as a Traditional 401(k), but it uses after-tax dollars. This means you will pay income tax on any contribution in the year it is made. If these aren't pre-tax contributions, you might ask why you'd choose a Roth 401(k). The answer is while both Traditional and Roth 401(k)'s let your investments grow tax-free, they treat distributions differently. While you pay income tax on Traditional 401(k) distributions, any distributions from a Roth 401(k) during retirement are income tax-free. Roth 401(k) contributions are, in essence, prepaying the taxes on any growth in the account and reducing your future income tax liability.

Which one is right for me?

When deciding between a Traditional or Roth 401(k), think about taxes and time. If you are in a lower income tax bracket now but expect you'll be in a higher bracket during retirement, the Roth 401(k) contribution may make more sense since you pay income taxes now at a lower rate than you will in the future.

Your investment time horizon is also important to consider. The more time you contribute to a 401(k) and for those investments to enjoy tax-sheltered growth before retirement, the more appealing it is to pay the income tax on those contributions now. This lets you withdraw the growth on those contributions tax-free throughout your retirement years. This is especially attractive if you expect tax rates to increase in the future. However, as we always advise, you should consult with your tax preparer before deciding.

If you're not sure what the future will hold, you may be in luck since many 401(k) plans allow you to split your contributions between both types of 401(k)s. This lets you prepare for either scenario in retirement and, as your circumstances change, you can make changes in how you contribute to your 401(k). We always recommend an annual checkup to ensure your financial plan meets your needs. With just a little planning and steady investing over time, your future retirement may be bright, indeed.

Eric Kauders is president and chief executive officer with Old Point Wealth Management. He can be reached at ekauders@oldpointwealth.com or at
757-728-1893.