You probably might have heard of a Roth 401(k) and traditional 401(k), and be wondering how different they are from each other. However, these two are confusing but they also have some similarities with some pretty huge differences.
401(k)s and Roth IRAs are popular tax-advantaged retirement savings accounts that differ in tax treatment, investment options, and employer contributions. In a perfect scenario you’d have both in which to put aside funds for retirement.
The Roth 401(k) is a type of retirement savings plan that allows you to make contributions after taxes have been taken out. Then, you receive tax-free withdrawals when you retire.
The Roth 401(k) was introduced in 2006 and was designed to combine features from the traditional 401(k) and the Roth IRA.
With a Roth 401(k) you can take advantage of the company match on your contributions, if your employer offers one, just like a traditional 401(k). And the Roth component of a Roth 401(k) gives you the benefit of tax-free withdrawals.
What Is a 401(k) Plan?
A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code.
Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions.
The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can be tax-free.
401(k) vs. Roth 401(k): How They’re the Same
Nada. You can contribute to a traditional or Roth 401(k) no matter how much you make. There’s one exception: If you’re considered a “highly compensated employee” your contributions may be capped because of the IRS’s non-discrimination requirements.
Check with your HR team or 401(k) plan administrator if you think that might apply to you.
The annual 401(k) contribution limit in 2020 is $19,500 (or $26,000 if you’re over 50). How (and whether) you split that between a traditional and Roth account is up to you.
Age requirement for withdrawals
You can’t take your money out of a 401(k) until you’re 59½ (unless you’re going through a hardship or meet one of the IRS’s other exceptions). Otherwise, you’ll have to pay all the taxes you owe plus a 10% penalty fee. Ouch.
Required minimum distributions (RMDs)
You have to start withdrawing your money in the year you turn 72 (unless you’re still working for that employer). If you don’t there are — you guessed it —more hefty fees.
Taxes while your money’s growing
Good news: You won’t pay taxes on any capital gains, dividends, or interest that your contributions earn. (Nice.)
401(k) vs. Roth 401(k): How They’re Different
The biggest difference between a traditional 401(k) and a Roth 401(k) is how the money you contribute is taxed. I know taxes can be confusing (not to mention a pain to pay!), so let’s start with a simple definition and then we’ll dive into the details.
A Roth 401(k) is a post-tax retirement savings account. That means your contributions have already been taxed before they enter your Roth 401(k) account.
On the other hand, a traditional 401(k) is a pre-tax savings account. When you invest in a traditional 401(k), your contributions go in before they’re taxed, which makes your taxable income lower.
How do those definitions play out when it comes to your retirement savings? Let’s start with your contributions.
With a Roth 401(k), your money goes in after-tax. That means you’re paying taxes now and taking home a little less in your paycheck.
When you contribute to a traditional 401(k), your contributions are pretax. They’re taken off the top of your gross earnings before your paycheck is taxed.
You may be wondering why anyone would contribute to a Roth 401(k) if it means paying taxes now. If you only look at the contributions, that’s a fair question. But hang with me. The huge benefit of a Roth 401(k) is what happens when you start withdrawing money in retirement.
Withdrawals in Retirement
The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free.
Any employer match in your Roth 401(k) will still be taxable in retirement, but the money you put in—and its growth!—is all yours. No taxes will be taken out when you use that money in retirement.
By contrast, if you have a traditional 401(k), you’ll have to pay taxes on the amount you withdraw based on your current tax rate at retirement.
Here’s what that means: Let’s say you have $1 million in your nest egg when you retire. That’s a pretty nice stash! If you’ve got it in invested in a R401(k), that $1 million is yours.
However, if $1 million is in a traditional 401(k), you’ll pay taxes on your withdrawals in retirement. If you’re in the 22% tax bracket, that would mean $220,000 of that $1 million is going to taxes. That’s a hard pill to swallow, especially after you’ve worked so hard to build your nest egg!
It goes without saying that your nest egg will last longer if you’re not paying taxes on your withdrawals. That’s a great feature of the Roth 401(k)—and a Roth IRA too for that matter.
Another slight difference between a Roth 401(k) and a traditional 401(k) is your access to the money. In a traditional 401(k), you can start receiving distributions at age 59 1/2.
With a R401(k), you can start withdrawing money without penalty at the same age, but you also must have held the account for five years.
If you’re still decades away from retirement, you don’t have anything to worry about! But if you’re approaching the 59 1/2 year mark and thinking about starting a Roth 401(k), it’s important to be aware that you won’t have access to the money for five years.
Which Is The Best for You?
The whole traditional-vs-Roth 401(k) question has a lot to do with taxes, and everyone’s tax situation is different. Ellevest isn’t a tax pro, so we can’t tell you exactly what’s right for you.
Here’s what we can tell you: If you think your tax rates are going to go up in retirement, consider the Roth. If you think your tax rates are going to go down in retirement, or you need to reduce your taxable income today, then consider the traditional.
Something else to think about: If federal tax rates go up in the future, then the decision to use a traditional will have less of a payoff. If federal tax rates go down, the decision to use a Roth could come back to bite you.
There’s no way of knowing that, so one way to hedge your bets is to use both a traditional and a Roth 401(k). You can divide your contributions between the two any way you want — you just can’t do more than $19,500 ($26,000 if you’re over 50) in total.
If your main account is a Roth and your employer gives you a match, as mentioned above, this strategy might come built-in. Either way, it’s a good idea to talk to a tax pro to really understand what’s right for you.
The whole “which type of 401(k)” question isn’t half as important as just getting started. Putting money toward your future regularly and often is step one in going after the retirement you deserve.
1. Who is eligible for the Roth 401(k)?
As soon as you join the Plan, you can start making after-tax Roth contributions.
2. Is the Roth 401(k) a separate plan from our 401(k) plan?
No. The Roth 401(k) is a type of contribution being offered within the Plan.
3. Whatare the differences between the pre-tax 401(k) contribution and the Roth 401(k) contribution?
The key difference between a Roth contribution and a pre-tax contribution is WHEN you pay taxes: now or later; and WHAT you pay taxes on: contributions and earnings or just your contributions.
I would like to say that it’s not whether you should take a Roth over a traditional 401(k), but what is the right mix of savings to achieve your life and retirement goals.
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