You have probably come across a Roth 401(k) and may even be considering investing in it. However, you are stuck between the traditional 401(k) and the Roth 401(k). This is the good kind of dilemma to be stuck in as you are looking to invest your money and safeguard it for retirement. In the past, the traditional 401(k) was more preferred by employers and this was demonstrated in how common it was offered in workplaces. However, in the past decade more and more employers are increasingly offering the Roth 401(k), it might be wise to take a step back and consider your options and the potential benefits and drawbacks of each retirement benefit account. While the two account options are intrinsically related, each comes with a set of benefits that may apply to your age bracket and some drawbacks that may apply to your income bracket. With the end goal of making the most returns from your retirement savings, you need to analyze each of these differences and comprehend their implication in your life.
What is a Traditional 401(k)?
A traditional 401(k)is an employer-sponsored plan where employees get access to an extensive range of investment choices for their retirement savings. This account works in a simple format where employees make regular contributions to a retirement savings account set up by the employer. Your contributions and any earnings from this account are often tax-deferred meaning that you will not pay any taxes when making the contributions but you will have to pay tax when you withdraw the savings and returns. The tax rate is usually determined by the current tax and occasionally State rates. In some cases or with certain exceptions you may incur a 10% penalty when you withdraw from your account if you’re under 59½. There are different types of Traditional 401(k) plans with the most lucrative being the employer-matched one where your employer will match all your contributions essentially doubling your savings over a selected period. The income taxes on these matched contributions are also deferred until you withdraw your savings where they are treated as ordinary income.
What is a Roth 401(k)?
Roth 401(k) plans are also employee-sponsored retirement plans that are quite similar to the traditional 401 (k) plans with one exception: all contributions are made after taxes are paid. This savings retirement plan was designed and introduced in 2006 as a combination of the traditional 401(k) and the Roth IRA. Just as the traditional 401 (k), you are allowed to take employer match contributions. This form of retirement savings is often considered more efficient because it is funded with money that is already taxed. As such you are not burdened with any taxes when you withdraw your savings and Returns.
What Are the Similarities Between a Traditional 401(k) and a Roth 401(k)?
There are several similarities between a Traditional 401(k) and a Roth 401(k), and they include:
- Both of these options come with a workplace retirement savings option which comes with the convenience of having your savings deducted directly from your paycheck. This is quite efficient as it will help you conform to the scheduled deduction plan.
- Both the Roth 401 (k) and the Traditional 401(k) allow for your employer to match your contributions. This is very important as it will help you achieve your retirement savings goals faster than anticipated. An employee match contribution means that your employee will contribute the same amount of money you pay to your retirement plans thereby doubling your contribution.
- Both the Roth 401 (k) and the Traditional 401(k) have a comparable contribution limit. This means you can have the same amount on either plan depending on your income tax bracket.
- Both the Roth 401 (k) and the Traditional 401(k) allow for your investments to grow tax free. This means you will only pay income tax when you contribute or withdraw and not the annual capital gains taxes that are required for investment returns.
- Both the Roth 401 (k) and the Traditional 401(k) have limited contribution limits. The 2021 401 (k) contribution and Roth 401 (k) limits allow you to contribute up to $19,500 to your 401(k) a year, or up to $26,000 if you’re 50 or older.
- Both of the savings plans are flexible. This means that you are allowed to switch between your 401(k) Roth and the traditional 401(k).
- On both plans you have Penalty-free withdrawals start at age 59 ½ or with a qualifying event. In this context, qualifying events include disabilities, deaths, or hardships.
What is the difference between the Roth 401k vs traditional 401k?
There are a number of differences between the Roth 401k vs traditional 401k and they stem from the inherent problems that each plan sets out to accomplish. These differences include:
- The main difference between Roth 401k vs traditional 401k is tax contributions. In the Roth 401 (k), you have to pay tax on your contributions before they are remitted to the retirement account. This is often referred to as a post-tax plan. In a traditional 401(k) or a pre-tax savings account, you will pay income tax when you withdraw your savings and returns. This means that your contribution amount goes into the savings account before it is taxed.
- Roth 401 (k) withdrawals are not taxed while traditional 401(k) withdrawals are taxed. Think about it this way, let’s say you are employed with an organization that matches your contributions. You manage to save and earn $1.5 million dollars during your employment period. During your withdrawal, if you saved under the Roth 401 (k) the entire $1.5 million is yours. However, if you saved under the Traditional 401(k), then you will have to pay income tax which may amount to approximately $330,000 if you fall under the 22% tax bracket.
- If you save with a Roth 401 (k) you will only be allowed to withdraw your money after you have held the account for five years or longer. However, if you save with the traditional 401(k) you can start receiving your distributions immediately you attain the retirement age of 59½. This means that if you decide to switch to a Roth 401 (k) in your mid-fifties then you will have to wait until five years have elapsed before you can access the savings even after you have attained the retirement age of 59½.
Paying Taxes now Versus Later
The most important and fundamental difference between the Roth 401 (k) and the Traditional 401(k) is the tax contributions. Most people often choose the traditional 401 (k) because of the freedom from paying tax. Think of it like postponing your IRS issues until you reach retirement age. However, this is not often a good choice because every dollar that you will withdraw from your traditional 401 (k) will be reduced by at least 20 to 30 percent depending on your tax bracket. This means that you have to work 20 or 3o times harder to save up for the impending taxes depending on how you want to spend your retirement savings. Additionally withdrawals from your traditional 401 (k) may increase your income tax bracket thereby subjecting you to more debts and lower disposable income.
This doesn’t necessarily mean that the Roth 401 (k) is better. However, you need to have a complete overview of how your decision will impact your future income tax bracket and savings.
Here’s when it may make sense to use a Roth 401(k):
- When you are in a lower marginal income tax bracket for instance if you are between 10% and 12% in the federal tax bracket.
- If you expect to have multiple taxable retirement incomes like social security and annuities.
- If the contributions do not affect how much you take home. Roth 401 (k) contributions come with a tax burden that will reduce how much you are able to take home. If you cannot maintain the same dollar-for-dollar retirement savings then this plan is not for you.
- If your current financial situation, i.e. your income and assets are more suited for tax-deferred assets.
- If you are able to max out your tax-advantaged contributions and still retain surplus income for retirement in a fully-taxed account.
- If you have the expectation that you may need some of your retirement savings before you reach 65 years old.
- If you qualify for tax deductions/credits that you will not be able to qualify for in retirement.
- If you work in a state with low income rates but expect to retire in a state with higher income rates.
- If addition of your Roth contributions to your taxable income do not come with significant implications such as pushing you into a higher marginal tax bracket
Here’s when it may make sense to use a traditional 401(k)
- If you are in one of the highest marginal tax brackets
- If your contributions won’t make any meaningful difference in your tax bracket plan particularly if you plan on making significant changes like applying for a new job.
- If you do not have or expect multiple retirement incomes apart from qualified distributions from retirement accounts.
- If your current income excludes you from tax breaks like child tax credits.
- If you work in a state with high income tax rates and expect to retire in a state with lower income tax rates.
- If you expect periods where you will have little disposable income such as when you are sending your child to university or paying for a new investment.
- If you do not expect to withdraw from your retirement savings before you attain the retirement age.
Can I contribute to a Roth 401k and a Traditional 401k?
A more flexible option is the combined contribution to both the Roth 401k vs traditional 401k. To be able to make a contribution to both of these plans, you have to enquire on whether your employer offers the combined option. If your employer plan allows it, then you are in a much better financial position to contribute to both particularly if your employer also matches your contributions. If you decide on contributing to both, the annual contribution limit is $19,500 in 2020 and 2021, if you’re under age 50. $26,000 if you’re age 50+.
Which is a better option Roth or Traditional 401k?
Regardless of the option you choose, if you have a consistent plan for your monthly investment then you are on the right track. However, when choosing between the Roth 401k vs traditional 401k in the current economic situation then the Roth 401k is the better option. The significant reasons that position the Roth 401k over the traditional 401k include:
- Tax benefit: while it may be tempting to delay your tax payments, you still have to pay them. Additionally, the current economic situation that has been worsened by the pandemic is a sign that income tax and other related taxes may be affected in the future. It is better to take care of your tax payments instead of deferring them and having to contend with these bills when you retire, pay them when making your contributions and forget about them.
- Better Retirement Flexibility: you may reach retirement and decide on running a home-based business or operating a BnB on the coast. However, this can be hindered when using traditional 401 (k) because of the tax payments that will put considerable strain on your finances. You will be in a much better position of opening and running your business successfully or spending on your retirement plans under Roth than the traditional one.
If you have decided on contributing to a Roth 401 (k) then there are a few factors that you need to consider including
- Eligibility: You become eligible for the 401 (k) Roth if it is offered by your employer regardless of your income tax bracket.
- Contribution Limits: According to the IRS (2020), “Aggregate* employee elective contributions are limited to $19,500 in 2021 and in 2020 and $19,000 in 2019 (plus an additional $6,500 in 2021 and in 2020 and $6,000 in 2019 for employees age 50 or over).”
- Monthly Contribution Plan: Everyone has different savings and retirement goals. However, Chris Hogan at Dave Ramsey recommends saving at least 15% of your income.
- Mutual funds that you should choose: all investments come with risks and the key to maintaining healthy risk levels is diversifying your portfolio. It is commonly argued and believed that higher risks come with higher returns and lower risks come with lower returns. However, this is not applicable for all investment opportunities. It is recommended that you balance your retirement fund across four main mutual funds that include growth and income, growth, aggressive growth, and international funds. You can also consult an investment expert on the best mutual funds to invest in.
Investing in either a Roth or Traditional 401 (k) is a great start towards saving for your retirement. However, it is more important to make an informed decision on which option best suits your needs and financial status. These saving plans come with a flexible option of rolling over. If you decide that the Roth is better than the traditional 401 (k) or vice versa you can easily switch between the two. Always remember that your retirement savings plan is safeguarding you during your old age. As such, do not tap into this fund unless you have a medical emergency or can no longer make ends meet.
Disclaimer: The opinions expressed in the Savvy Worker Blog are intended for general informational purposes only and are not to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.