Previously, I talked about the various types of investment options that are available to save for retirement. Two of the most popular and well-known options are the traditional 401K and the Roth 401K. Since these are the two most popular options, I think it is important to dive deeper into them. I want to talk about the differences between these two retirement plans and their advantages and disadvantages. Let’s dive in.
What is a Traditional 401K?
Recall, a traditional 401K is a retirement savings plan that is offered by an employer. It is a tax-advantaged way for employees (a.k.a. yourself) to save and invest a percentage of their (your) salary for retirement. The amount that an employee can contribute is determined by the plan and the employee’s salary. These contributions are made pre-tax, which means that they are not subject to income tax when they are contributed. They are, however, subject to income tax when you withdraw the money when you retire.
What is a Roth 401K?
A Roth 401K is a type of 401K retirement savings plan that allows an employee to contribute post-tax dollars. This means that the money contributed to the Roth 401K has already been taxed and will not be taxed when the money is withdrawn in retirement.
Similarities between a Traditional and Roth 401K
The money invested in a 401K is typically invested in a variety of different funds, such as stocks, bonds, and mutual funds. Both plans have contribution limits that are set by the IRS. Since these limits can change year to year, it is important to check in with the IRS website or your employer’s retirement site to see the most up to date contribution limits. Employers might offer matching contributions to employees that contribute to either plan. Both plans have early withdrawal penalties. If an employee withdraws money from their traditional 401K or Roth 401K before they turn 59.5 years old, they might be subject to a 10% early withdrawal penalty. There are some exceptions to this rule, such as using the money to purchase a home for a first-time home buyer or if an individual becomes disabled or if an individual wants to use the funds to pay for qualified medical expenses. It would be very important to check with a tax and financial professional before making any withdrawals before the age of 59.6 years old.
Differences between a Traditional and Roth 401K
The biggest difference between the two plans is how the contributions and withdrawals are taxed. IN a traditional 401K, contributions are made on a pre-tax basis, which means that they are deducted from taxable income. However, withdrawals in retirement are taxed as ordinary income. In a Roth 401K, contributions are made on a post-tax basis, which means that they are not deducted from taxable income. However, withdrawals in retirement are tax-free.
Another difference between the two types of 401Ks is that there are no income limits for contributions to a traditional 401K, whereas there are income limits for contributions to a Roth 401K. Additionally, traditional 401Ks have required mandatory minimum distributions (RMDs) starting at age 72, while Roth 401Ks do not have RMDs. Employer matching contributions can be made to both types of 401Ks, and the contribution limits for both are the same. It’s also possible to have both a traditional 401K and a Roth 401K if the combined contributions do not exceed the annual contribution limit.
Advantages
Traditional 401K
One of the biggest advantages of a traditional 401K comes from the fact that contributions are made on a pre-tax basis, which can help reduce an individual’s taxable income. Many employers offer matching contributions to traditional 401Ks, which can only help increase the amount of money saved. Finally, the money invested in a traditional 401K grows tax-deferred, which means that it is not subject to taxes until it is withdrawn in retirement.
Roth 401K
The withdrawals in retirement are tax free. Contributions are made with post-tax dollars and the money grows tax-free and is not taxed when it is withdrawn in retirement. There are no required minimum distributions (RMDs). There are no income limits that restrict eligibility for a Roth 401K, which is unlike the Roth IRA [more to come on the Roth IRA].
Disadvantages
Traditional 401K
Just as tax-deferral is an advantage, it is also a disadvantage because the money is taxed in retirement, which can reduce an individual’s retirement income. Additionally, traditional 401Ks require people to start taking minimum distributions when they reach age 72. These are known as required minimum distributions (RMDs).
Roth 401K
There is no upfront tax break because the contributions are made with post tax dollars. Therefore, contributions do not reduce an individual’s taxable income. Some employers might not offer matching contributions to Roth 401Ks, which can limit the amount of money that is being saved for retirement.
How to Decide Which Plan is Best?
Deciding between a traditional 401K and a Roth 401K can be a difficult choice, as both plans have their own unique advantages and disadvantages. The best option for anyone will depend on that individual’s personal financial situation and their retirement goals.
If someone expects to be in a higher tax bracket in retirement than they are currently in, a Roth 401K may be the better option. This is because the money invested in a Roth 401K grows tax-free and is not subject to taxes when it is withdrawn in retirement. Additionally, if an individual expects to be subject to required minimum distributions (RMDs) in retirement, a Roth 401K may be a better option, as RMDs are not required for Roth 401Ks. However, if an individual expects to be in a lower tax bracket in retirement than they are currently in, a traditional 401K may be a better option, as the money invested in a traditional 401K is taxed when it is withdrawn in retirement at a potentially lower tax rate. Ultimately, the decision between a traditional 401K and a Roth 401K will depend on a person’s personal financial situation and their retirement goals. It may be helpful to speak with a financial advisor to determine which option is best for them.
If you have any doubts at all or need additional information, use the resources available to you from your employer. Each employer should have a benefits site with this information available and even potentially a financial advisor that can be dedicated to helping you out. If all else fails, find a financial planner near you and ask that person for help. Explain your situation to them and use their expertise to determine the best plan for you.
Disclaimer: I am not a financial advisor. The content on knowxchange.com or “this site” are for educational purposes only and merely cite my own personal opinions and experiences. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know and understand that all investments involve some form of risk. There is no guarantee that you will be successful in making, saving, or investing money. Additionally, there is no guarantee that you won’t experience any loss when investing. Please seek the advice of a financial professional and do your own research.