If you have to choose between a traditional or Roth deferral, you will have to decide whether it’s better to get a tax break now or in retirement. A traditional deferral lowers your taxable income today, while a Roth deferral offers tax-free withdrawals later. A financial advisor can work with you to determine which is a better fit for your current tax bracket, future income and retirement plans.
What Is an Employee Deferral?
When you make a contribution to a retirement plan, like a 401(k), with pre-tax dollars that’s called an employee deferral. Because these contributions are pre-tax, they reduce your taxable income for the year, which may lower your tax bill. The account invests these funds and they grow tax-deferred until you begin withdrawing them in retirement.
The IRS taxes withdrawals from an employee deferral account as ordinary income. If you take distributions before age 59.5, you may also face a 10% early withdrawal penalty unless an exception applies.
For example, suppose you earn $80,000 per year and contribute $10,000 to a traditional 401(k) through employee deferrals. For tax purposes, it would reduce your taxable income to $70,000. This could place you in a lower tax bracket and provide significant short-term tax savings.
When comparing an employee deferral with a Roth deferral, this traditional approach is often preferred by individuals who expect to be in a lower tax bracket in retirement than they are today.
A Roth deferral allows you to contribute to your retirement plan using after-tax dollars. That means you won’t get a tax break on the contributions today, but your money can grow tax-free. Qualified withdrawals in retirement are also tax-free. Like employee deferrals, Roth contributions are typically made through payroll deductions into your 401(k) or similar retirement plan. The key difference lies in the timing of when you pay taxes. Using the same amount from the employee deferral example, if you earn $80,000 and contribute $10,000 to a Roth 401(k), your taxable income would remain $80,000 for the year. But when you retire and begin taking withdrawals, that $10,000 (plus any earnings) could be withdrawn tax-free, provided that you meet the age and holding requirements. Keeping this in mind, Roth deferrals can be especially advantageous for younger earners, those who expect to be in a higher tax bracket later in life, or anyone looking to minimize their tax liability in retirement.
The main difference between an employee deferral and a Roth deferral lies in the tax treatment of contributions and withdrawals. Here’s a table comparing key features: If you have to choose between a traditional employee deferral and a Roth deferral, think about your current tax rate and what it could be in retirement. A Roth deferral may be better if your income is lower now and likely to rise. A traditional deferral, on the other hand, might be better if you’re earning more now and expect a lower income later. Choosing between an employee deferral and a Roth deferral means thinking about your current finances, future plans, and when you expect to retire. Here are a few questions to help you decide: Some financial professionals suggest splitting your contributions between traditional and Roth deferrals. This can give you tax flexibility and help manage future tax changes. Reviewing your plan each year can also help keep it in line with your long-term goals. Each option has unique advantages depending on your income level, tax outlook and future financial needs. Traditional employee deferrals offer immediate tax savings, while Roth deferrals provide tax-free income in retirement. Ultimately, the best choice depends on your personal financial situation and retirement goals. Photo credit: ©iStock.com/Prostock-Studio, ©iStock.com/Pekic, ©iStock.com/coffeekai Read the full article hereWhat Is a Roth Deferral?
Employee Deferral vs. Roth Deferral
Feature
Employee Deferral (Traditional)
Roth Deferral
Contribution Type
Pre-tax
After-tax
Tax Deduction
Yes, lowers current taxable income
No, taxed in the year earned
Growth
Tax-deferred
Tax-free
Withdrawals in Retirement
Taxable
Tax-free (qualified distributions)
Ideal For
Higher earners now, lower in retirement
Younger or growing earners
How to Choose the Right Option for You
Bottom Line
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