Tax rates are key to deciding on traditional or Roth 401(k)/403(b) | American Funds

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Tax rates are key to deciding on traditional or Roth 401(k)/403(b)

When choosing between traditional or Roth 401(k)/403(b) contributions, be sure to consider tax rates in your decision.

In general, money that you contribute to a Roth 401(k) or 403(b) account has already been taxed, which allows for tax-free withdrawals.* Traditional 401(k) and 403(b) contributions are made before income taxes have been paid, but withdrawals are taxable. So what’s better — paying taxes now or paying taxes later?

The answer may depend on how your tax rate today compares with your tax rate in retirement.

If your tax rate will be higher in retirement, making Roth contributions now could make sense. Better to pay taxes now rather than later, when rates will be higher. If your tax rate will be lower in retirement, traditional, pretax contributions could be a smart choice. Put off paying taxes now, and pay taxes later when rates will be lower.

Considering a Roth account?

Roth contributions may only make sense if you won’t start taking withdrawals for at least five years, and if you’ll be at least 59-1/2 when you do start. Otherwise, withdrawals may not qualify as tax-free.*

If both these requirements will be met, consider the following questions. If your answer is “yes” to either of them, making Roth contributions could be right for you.

  • Do you expect to be in a higher tax bracket in retirement?

    When estimating your future tax bracket, keep in mind that taxable withdrawals from retirement accounts — especially lump-sum withdrawals — could push you into a higher tax bracket. Qualified withdrawals from Roth accounts are tax-free and won’t increase your taxable income.

  • Do you think that all income tax rates will be higher in the future?

    If tax rates in general are higher when you retire, you may be better off paying taxes now when rates are lower.

Roth and traditional: both good options

Saving for retirement makes sense whether you make Roth or traditional contributions. Both options offer tax benefits. Our traditional vs. Roth analyzer can help you compare the two. You could also consider making both types of contributions.

Check with your employer to see if the Roth option is available in your plan. You should consult a financial professional or tax adviser to find out more.

* Withdrawals from Roth accounts are tax-free if you are at least 59-1/2 years old, or are disabled or have died; also, the Roth account must have been established at least five years before. For nonqualified distributions, earnings are taxable and may be subject to a 10% early withdrawal penalty.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional or downloaded and should be read carefully before investing.

Traditional vs. Roth 401(k)/403(b) analyzer

Use our Roth comparison calculator to see which contribution option might make sense for you.