What’s your plan?
Some employers offer both traditional 401(k) and Roth 401(k) options. For 2019, the maximum that an individual can contribute is $19,000 for those under 50, and $25,000 for those over 50.
There are income restrictions regarding the amount that you can contribute. In 2019, if your income exceeds $280,000, there will be limits regarding the monthly contributions.
With a traditional 401(k), contributions are with pretax income. Any interest, dividends and capital gains are tax deferred. However, when you initiate withdrawals, all of withdrawals will be subject to ordinary income tax liability.
With a Roth 401(k), contributions are made with after-tax income. All interest, dividends and capital gains are tax free. When you make withdrawals from your Roth account, which you can do without restriction after age 59 your withdrawals are tax free if your contributions were in the account for at least five years.
For both types of accounts, there can be income tax penalties if you make withdrawals prior to 59 unless other exceptions apply. Before you make any withdrawals prior to 59 familiarize yourself with the exceptions so that you can avoid income-tax penalties.
Many employees do not know what proportion of their contribution should be placed in a traditional 401(k) or a Roth 401(k). You have the option to split your eligible contribution any way you choose. There are several factors to take into consideration.
Some employers provide a match for contributions to traditional 401(k) accounts. Regulations do not allow employers to match contributions to Roth 401(k) accounts. Accordingly, even if you do wish to make some contributions to a Roth account, you must take into consideration the match. Try to make sufficient contributions to your traditional 401(k) to maximize the match.
For example, assume you can afford to make a $10,000 total contribution. If the employer is willing to match up to $3,000 of your contribution to a traditional 401(k) account, you should make at least a $3,000 contribution. You can then decide how to apportion the remaining $7,000 part of your contribution.
If you are just starting to work, and/or are in a low tax bracket (for example, your marginal tax bracket is 15%), it makes sense to maximize the use of the Roth account. The prevailing advice is that a Roth account has definite advantages if you anticipate that you will be in a higher tax bracket when you retire.
For most employees, there is uncertainty as to what their tax bracket will be when they retire. Not only is it difficult to predict what their retirement income will be, but it is also impossible to know how future legislation will impact future tax rates. Because of this uncertainty, it makes sense to split your contributions into both traditional and Roth accounts.
Another factor is unexpected expenses. No one can predict situations that require unplanned withdrawals. Withdrawals for higher education or a first-time home purchase are not allowable exceptions to avoid tax penalties. If you do not have an emergency fund for unexpected one-time expenses, it would be advantageous to have access to funds without penalty.
You can make withdrawals of principal from your Roth account at any time without penalty. It makes more sense to make a withdrawal of principal only from a Roth account as opposed to making a withdrawal from a traditional 401(k) prior to 59
and face a 10% tax penalty in addition to the ordinary income tax due.
The bottom line: the lower your tax bracket is, the larger the contributions to your Roth. Splitting your contributions will provide you some flexibility. It is important for you to understand the exceptions of your plan to avoid paying a penalty for early withdrawal.