If you do not understand the difference between traditional and Roth 401k, do not feel bad. Most people have heard of traditional and Roth 401k retirement savings accounts but do not understand their differences.
In general, the differences between these two retirement accounts are tax related. Do you pay tax now or later?
- Contributions to a Roth 401(k) are made after-tax
- Contributions made to a traditional 401(k) are made pre-tax
- The money deposited into Roth 401(k) accounts can be withdrawn tax-free in retirement
- The money deposited into the traditional variety is subject to taxes upon retirement
Let’s take a closer look at the differences between traditional vs. Roth 401k. This will help you determine the best for your unique financial situation.
How the Roth 401(k) is Unique?
Think of the Roth 401(k) as a close relative to the traditional 401(k). The Roth variety applies the tax rules of Roth IRAs to the workplace plan.
Roth 401(k)s take contributions from paychecks after taxes are paid. No tax is paid at the time of withdrawal.
Traditional Vs. Roth 401k: The Similarities
About one-half of employers provide employees with the opportunity to use both a Roth 401(k) and conventional 401(k). There are similarities between Roth 401(k)s and traditional 401(k)s.
The 401(k) maximum contribution applies to both types of accounts. The maximum contribution is $19,500 per year. This does not include matching dollars from the employer.
Employees age 50 and older may contribute an additional $6,500 for a total of $26,000.
Employees may contribute to each of these accounts within the same year. The total contribution to both accounts must be at or below the maximum.
The primary difference between the two types of 401(k)s is when taxes are paid. Let us take a closer look at those differences.
Traditional Vs. Roth 401k: Tax Differences
Contributions made to traditional 401(k)s happen before taxes are paid. This reduces the worker’s adjusted gross income. Income tax is calculated on the lower income.
Roth 401(k) contributions are made after taxes are paid. There is no impact on the worker’s current adjusted gross income. Any employer matching dollars are deposited into the pre-tax account. Taxes are paid at withdrawal.
For traditional 401(k)s withdrawals are taxed like income. Roth 401(k)s qualified distributions are not taxed. However, there are some unique withdrawal rules to note.
With traditional 401(k)s, the withdrawals of employee contributions and earnings are taxed. If the worker withdraws distribution before the age of 59.5, those distributions can be penalized. There are some exceptions detailed by the Internal Revenue Service (IRS).
When it comes to Roth 401(k)s, withdrawals of earnings and contributions before age 59.5 are not taxed if the distribution is qualified. The IRS Roth 401(k) early withdrawal rules are as follows:
- The account must be at least five years old
- The distribution must be the result of the individual’s disability or death on or after age 59.5
Employees with Roth IRAs can withdraw contributions at any point in time.
Traditional vs. Roth 401k: Which Type is Best for You?
You should understand the nuances of traditional 401(k) and a Roth 401(k) before contributions. The deciding factor is when you should pay the tax.
If you would like to pay the taxes today to get them out of the way and free up money down the road, the Roth 401(k) is optimal.
If you believe your tax rate will be higher in retirement, the Roth 401(k) is ideal. Paying the taxes now shields against a possible tax rate increase when your “golden years” arrive.
Paying the tax now may put you in a lower tax bracket in retirement. Furthermore, this approach ensures you can tap into a larger pool of money when you retire.
The bottom line is $200,000 in a Roth 401(k) will prove to be that specific amount. But $200,000 in a traditional 401(k) is actually less than $200,000. Taxes are owed at each distribution.
Remember Roth 401(k) contributions decrease your paycheck by more than contributions made to traditional 401(k)s. Contributions are made after taxes instead of before.
If you think your tax rate will be lower in retirement, the traditional 401(k) is ideal. However, it is difficult to predict future tax rates.
If you are currently in the highest tax bracket, chances are your taxes will be the same or lower. Barring a significant future tax increase.
Traditional vs. Roth 401k: Additional Considerations Beyond Taxes
Though taxes are the primary differences between traditional and Roth 401(k)s, there are other considerations. A tax deduction might seem too good to pass up in the current moment.
But envision yourself at the point of retirement. Think about what it would be like for every dollar withdrawn from your 401(k) to be reduced between 25%-35% or more. Your tax bracket ultimately determines the percentage reduction.
Keep in mind, every penny counts at the point of retirement. Social security may not be enough. You can estimate you social security with this calculator. Those in the age range of 40-60 should consider the Roth option.
Withdrawals from a traditional retirement account might elevate you to a higher tax bracket in retirement. The result is a spike in your taxes, leading to elevated Social Security benefit taxes.
It is even possible an elevated taxable income will spike Medicare B premium costs when you retire. In other words, biting the “tax bullet” now might be worth it as withdrawals down the line will be tax-free.
Roth 401(k) required minimum distribution (RMD)
Like traditional 401(k)s but unlike Roth IRAs, there is no need for a minimum distribution at reaching the age of 70.5. This required minimum distribution is referred to as the RMD.
However, if you are still working for the employer, the RMD is necessary at this age. You can eliminate this requirement by rolling over the Roth 401(k) to a Roth IRA.
However, it is important to consider additional factors before making this important decision. Examples of such factors include but are not limited to:
- Distribution Options
- Loan provisions
- Legal Protection
- Investment choices
Estate planning is important. Roth 401(k)s are favorable as the money in this account is not subjected to income taxes to heirs.
Heir taxation only applies if the Roth 401(k) was established less than five years before the account holder’s death.
Traditional vs. Roth 401k: Does It Make Sense to use Both?
Some retirement planning experts insist it is best to invest in each of these two unique accounts. You may always change your contributions as your tax and income situation changes.
Some employer plans even permit splitting contributions between these two unique accounts.
What About Income and Contribution Limits?
This is a frequent question. Thankfully, there are no income limits for Roth 401(k)s and traditional 401(k)s. You can contribute to either 401(k) regardless of how much money you make.
However, there is an exception. If your employer classifies you as a “highly compensated employee”, your contributions may be limited. This limit is the result of the IRS non-discrimination requirements.
Those classified as highly compensated employees fit one or all of the following criteria:
- Earn $125,000 or more per year
- Are in the top 20% of earners at their business
- Own greater than 5% of the business
Consult with your employer’s human resources department to determine if the classification applies to you.
In terms of contribution limits, the yearly 401(k) contribution limit is $19,500 for the year 2020.
However, this limit escalates to $26,000 for those older than 50 years of age. The decision to distribute these contributions to each type of 401(k) account is completely up to you.
Traditional vs. Roth 401k: Penalty Fees and Taxation as the Money Grows
If you withdraw the money you have added to either type of 401(k) before the age of 59.5, you must pay the taxes as well as a 10% penalty fee.
However, there are exceptions. There are hardship exceptions detailed by the IRS. For these unique situations, you may be able to take the money out of your 401(k) without taxation/penalty.
On the bright side, you won’t pay taxes on interest, dividends, or capital gains stemming from your contributions. Taxes are never paid as the money is growing. It is paid either before contribution or at withdrawal.
Be sure to consult with a tax advisor before making any type of withdrawal from your retirement account.
The Moral of the Story
It is in your interest to diversify your retirement savings. Do not dump all retirement savings into a single account, stock, or mutual fund. As is often said, variety is the spice of life. This saying certainly proves true in the context of retirement investing. Learn how to start investing now.
Perform an exhaustive review of your unique financial situation. Determine which approach to retirement saving/investing is optimal for your unique situation.
No investment can consistently outperform a tax-protected retirement account. The tax savings give these accounts a significant advantage for wealth creation.
For most retirement savers a blend of the following is optimal:
- Traditional vs. Roth 401k
- Mutual funds
- Real estate
It must be noted there is a chance federal tax rates will increase in the future. This is especially worrisome given increasing federal debt in response to COVID-19 and the economic bailout.
If federal taxation rates spike in the years and decades to come, traditional 401k(s) will provide less of a payout than anticipated. However, if federal tax rates decrease, a reliance on a Roth 401(k) might backfire.
Think long and hard about all the factors detailed above. Consider your unique financial goals before determining investment in a traditional vs. Roth 401k, or both.
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