Let’s walk through an example.
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How will life be different if you contribute to a designated Roth account instead of a traditional 401k or 403b account? The easiest way to see is to walk through an example. Let’s say you’re in the following situation:
- You earn wages of $60,000.
- You’re in the 24% tax bracket.
- You plan to contribute $6,000 ($500 per month).
- Your company matches your first $4,000 of contributions at 50 cents on the dollar.
First we’ll see what happens if the money goes into a traditional account, and then we’ll see what changes if you choose a Roth account instead.
Traditional account
If your contributions go to a traditional account, you still pay Social Security tax on the full $60,000 of earnings, but you pay income tax on only $54,000. In the 24% tax bracket the $6,000 reduction in your taxable income saves you $1,440.
That $1,440 in tax savings isn’t likely to come to you in the form of a big refund. It normally shows up mainly as a reduction in the amount of income tax withholding taken from your paycheck, although the change in withholding isn’t necessarily precisely the same as the actual tax savings. You may not even notice that you’re receiving a tax benefit because it has little effect on the amount of tax you owe at the end of the year (or the size of your refund), but it’s there in the form of a net paycheck that’s about $120 per month bigger than it would be without the tax savings.
Meanwhile, you end up adding $8,000 to your traditional 401k account: $6,000 from your contributions and $2,000 from the company’s matching contribution. Eventually you’ll have to pay tax on your distributions from that account, including all the earnings that build up over the years.
Roth account
If your contributions go to a Roth account, you pay Social Security tax and income tax on the full amount. Again you should understand that the tax difference doesn’t usually show up in a lump at the end of the year. The difference normally shows up in the amount of withholding from your paycheck. The difference is that your net pay didn’t get the $120 per month boost you would have received from contributing to a traditional account.
You end up adding $6,000 to your Roth account and $2,000 to your traditional account. (The rules say the matching contribution has to go to a traditional account, not a Roth account.) The total amount added to your retirement savings is the same, but $6,000 is in an account where all your withdrawals, including any earnings that build up in that account over the years, will be tax free if you follow the rules.
Contributions to a Roth account squeeze your budget somewhat more than if you put the same amount in a traditional account. The payoff comes from having a lot more wealth in retirement because distributions from this account will be tax-free.