With all the rumors circulating recently about potential changes to the tax treatment of 401(k) plans, a quick review of how the broader system currently works may be useful. Indeed, participants in a traditional 401(k) will contribute pre-tax earnings to a retirement plan where the funds will grow on a tax deferred basis.
The account owner can start to receive “qualified distributions” after reaching the age of 59½ when these withdrawals will be taxed as ordinary income. Since workers participating in a traditional 401(k) set aside a portion of their wages before any federal and state income taxes are withheld, the money pulled from their take-home pay and put into the plan basically provides them with more control over their periodic tax withholdings and their end-of-year tax liability (which could bump them down to a lower tax bracket).
That additional flexibility in how and when taxes are paid is one of the key factors behind the growing popularity of a traditional 401(k) arrangement. Further, many Americans will likely have a reduced income once they retire. Since this would put them into a lower tax bracket than when they were fully-employed, the earnings from their tax-deferred 401(k) plan during retirement could wind up being taxed at a much more favorable rate.
However, for savers who anticipate being in a higher tax bracket later in life, a Roth 401(k) is often considered a better option because these plans allow participants to potentially reduce their post-retirement tax liability through paying taxes as they contribute rather than when they start to make withdrawals. Moreover, Roth-style accounts provide a way to lock in current tax rates and hedge against an unexpected tax rate spike, a growing risk as the fiscal strain from Social Security and Medicare increases.
It is also worth remembering that when you withdraw money from a traditional 401(k) plan you are subject to both federal and state income taxes. This means that individuals who spend their working careers in high-income-tax states but then retire in a low- or no-income-tax state may have the ability to reduce or outright avoid any state income tax liabilities.
On the other hand, a Roth 401(k) subjects your retirement dollars to both federal and state income taxes today in return for “tax-free” income during retirement. Since state-level income tax rates can vary significantly, the effect on a person's retirement can be huge. Individuals must therefore consider not just their expected federal tax bracket in old age but also the tax rates in the location they intend to retire.
Sources: U.S. IRS, Fidelity Investments, CNBCPost author: Charles Couch