As you start saving for retirement, the number of account options you encounter seems to multiply. A traditional 401k and a Roth 401k are two options that may have popped up on your radar. You’ve likely heard of a 401k, but what’s the difference between a traditional 401k vs Roth 401k?
I’m glad you asked! The differences are subtle but important to understand as you set up your retirement savings plans. Let’s dive into everything you need to know about these two retirement account options so you can decide which one is better for your situation.
What is the traditional 401k?
A traditional 401k is one retirement account that you’ve likely heard of. In fact, it is one of the most common retirement accounts offered by employers. Many employers even offer a matching contribution program that can supercharge your savings.
As an employee, you’ll have access to different investment choices through your 401k. You will have the ability to contribute to your retirement savings directly from your paycheck before taxes with this account. When you are ready to withdraw money, you will pay taxes on the contributions, matching funds, and earnings at that time.
What is the Roth 401k?
A Roth 401k is very similar to a traditional 401k. It is an employer-sponsored plan that employees can contribute to throughout their careers. The important difference is that you will make contributions to this account with after-tax dollars. When you are ready to withdraw money, you will be able to do so without paying any taxes.
Not every employer offers a Roth 401k as an option to their employees. However, it is not uncommon to have this as an option. Check with your Human Resources department to find out if your employer offers a Roth 401k.
Traditional 401k vs Roth 401k
Before you can decide which option is best for you, it is important to take a look at the fine print. Dive into the details of a traditional 401k vs Roth 401k below:
You are eligible to contribute to either a traditional 401k or a Roth 401k based on what your employer has made available. Unless you plan on starting your own business, you’ll need to work within the options your employer has provided. If you aren’t sure what’s available, then contact your Human Resources department to find out more.
Tax bracket differences
You are eligible to contribute to a Roth 401k or a traditional 401k regardless of your tax bracket. Unlike Roth IRAs which have income limitations, you are able to contribute to a Roth 401k regardless of how much you earn.
The major difference is that your contributions to a Roth 401k are made after you pay your taxes. Contributions to a traditional 401k are made before you pay taxes.
Contribution limit differences
The contribution limits for the Roth 401k and traditional 401k are exactly the same. In 2021, you will be able to contribute up to $19,500 into either a Roth 401k or a traditional 401k.
Additionally, you have the option to make catch-up contributions if you are over the age of 50. You can contribute an additional $6,500 per year if you are qualified to make catch up contributions.
However, you cannot contribute more than this maximum amount to either of these accounts. In most cases, you should choose just one of these accounts to make contributions to. Otherwise, it can get tricky. It is important to note that the IRS changes the contribution limits on a fairly regular basis. Check out what the current rules are on the IRS website.
The differences in a traditional 401k vs Roth 401k in terms of matching contributions are basically nonexistent. Employers are allowed to match your Roth 401k contributions in a similar way to their 401k matches. The amount of the match varies widely based on your employer. Some employers offer a full match. Others offer matching funds to a certain amount. Still, others provide no matching funds.
If your employer offers any matching funds, then make sure to take advantage of that. It is a valuable contribution that you should not overlook. For example, if your employer offers a 100% match then you are essentially earning a 100% return on your contributions. That is an unheard-of return that you should secure if the opportunity presents itself.
For the Roth 401k, the withdrawals are not taxed because you already paid your taxes when you made your contributions. When you withdraw money for a qualified distribution, you will not be required to pay taxes on the contributions or the earnings. You can withdraw the money without any penalties at age 59.5 or if you acquire a disability. The money can also be withdrawn without a penalty by your relatives if you die before spending the money. You should also be aware that the money must be held within your Roth 401k for at least 5 years to withdraw it without a penalty.
For the traditional 401k, all distributions are considered taxable income in retirement. You made contributions with pre-tax dollars, so you’ll need to pay your tax bill when you withdraw the money. Both the contributions and the earnings will be taxed when you withdraw money from this account. You will not be able to withdraw money from your 401k without a penalty unless you are age 59.5, disabled, or incur financial hardship.
Both types of retirement accounts have required distributions. At age 70.5, you will be required to receive distributions from either 401k plan. Although this may seem like a long way off, you should factor this into your retirement plans.
Can I have both types of 401ks?
The contribution limitations are the same for both a Roth 401k and a traditional 401k. You cannot contribute more than $19,500, plus catch-up contributions, to a combination of these accounts in the same year. Generally, it is best to stick to one of these options. You’ll need to decide on one option and move forward with it.
Can I roll a traditional 401k into a Roth 401k?
It is possible to roll your traditional 401k into a Roth 401k. However, you should be prepared to deal with the tax consequences. Unfortunately, this can be a major hurdle depending on the size of your traditional 401k.
Remember, the money in your traditional 401k has not been taxed because you’ve been able to make contributions with pre-tax dollars. Contributions made to a Roth 401k must be made with after-tax dollars. When you make the switch, you’ll be required to pay taxes on the amount of money you are rolling over.
Before you dismiss the tax consequences as not a big deal, consider this example. Let’s say you have a traditional 401k with an account balance of $100,000. That’s a sizable amount of retirement savings! When you make the switch, you’ll need to pay taxes based on the tax bracket you fall into that year. Let’s say you are in the 24% tax bracket, you could be stuck with a $24,000 tax bill to roll over your account. That can be enough to wipe out anyone’s emergency fund!
Although it is possible to roll over your traditional 401k into a Roth 401k, it might not be your best financial move. If you can’t afford to pay the taxes on the rollover, then you may need to just stick to your traditional 401k.
Take a closer look at your current financial situation before deciding to rollover your funds.
Is the Roth 401k better?
Both the traditional 401k and Roth 401k have pros and cons. Although one is not the clear winner for every scenario, the Roth 401k has more advantages for anyone in the early stages of their career.
If you anticipate that your income will grow over time, then a Roth 401k offers more benefits. You can choose to pay taxes on your contributions now while you are in a lower tax bracket. When it is time to pull money out of your retirement accounts, then you will not have to worry about the tax burden of a potentially higher tax bracket.
If you feel that your income is at its peak, then you might prefer the traditional 401k. The account will allow you to contribute pre-tax dollars now and pay taxes upon withdrawal. You can take advantage of a potentially lower tax bracket in the future with this strategy.
Most of us plan for our incomes to rise throughout our careers. Whether you are building your side hustle into a thriving business or working your way up the ladder with successful salary negotiations, most of us have room for our income to grow. With that, the Roth 401k is typically the best option for most young professionals.
Pay taxes today or pay taxes in the future?
The choice between a traditional 401k vs Roth 401k boils down to your preference to pay taxes now or in the future.
The Roth 401k gives you more control over your tax liabilities in the future because you are paying your tax bill upfront. When you hit retirement, you won’t have as big of a tax bill. That can be a big plus for anyone on a fixed income. The fewer expenses you carry into your retirement the better. You don’t want to be worried about making ends meet after you’ve left the workforce for good.
A traditional 401k allows you to defer a part of your tax bill until later in life. Although this might give a bit more breathing room in your budget now, it might make things tighter in retirement.
The strategy you choose will be based on personal preference and what your employer offers. If you are only able to contribute to a traditional 401k, then your choice is simple. Making the effort to save for retirement early can only be rewarded. The option of a Roth 401k may bring even more financial stability in retirement. But funding either account is infinitely better than not saving for retirement at all.
Of course, these strategies are dependent on the tax code. It is completely possible that a changing tax code will affect either of these strategies in a negative way. But you can only work with the information you have available to you now. You can decide to tweak your strategy in the future as necessary.
The bottom line
A Roth 401k can be a useful savings vehicle for your retirement plan. If you have the opportunity to contribute to a Roth 401k, then take advantage of it!
Whatever you do, make sure to start saving for retirement as soon as possible. Even if times are tight, make it a priority in your budget to take care of your future self. If necessary, you might need to increase your income to fund your retirement savings. Luckily, there are many flexible side hustle options that can allow you to pad your retirement savings over time.
The key is to make a financial plan for your retirement and stick to it. That should include investing in a variety of vehicles, such as a Roth 401k, along the way. If you aren’t sure where to get started, then consider taking our course on investing for retirement to get started.