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If you haven’t heard, there is more than one type of 401(k). You’ll want to know the differences between a traditional and Roth 401(k).
Learning more about the differences will help you make the most out of your retirement savings.
Both account types offer similar benefits and are a great way to prepare for retirement.
The key difference between the two is when you pay taxes.
More and more employers are offering a Roth 401(k) alongside the traditional 401(k).
A little over half of the employers that provide a retirement savings plan include a Roth 401(k).
You may be asking yourself which one is better or how to choose? The answer mostly depends on your personal financial goals.
You’ll mainly want to ask yourself if you’d rather pay taxes now or when you retire.
This article will go over the differences and benefits of both accounts.
Similarities of a Traditional and Roth 401(K)
A traditional and Roth 401(k) are workplace retirement savings plans. They both offer the ease of having contributions automatically withdrawn from your paycheck.
Each one is capable of receiving a company contribution match. If your employer offers a match, you should definitely take advantage of it.
Each 401(k) type will have the same contribution limit.
As of 2020, the limit is $19,500 a year, and anyone age 50 and up is eligible for an additional $6,500 catch-up contribution.
Summary of the similarities
- Both are workplace retirements savings plans
- They both can receive a company match
- They have the same contribution limits
Differences Between a Traditional and Roth 401(K)
As stated at the beginning of the article, the key difference between the two is when you pay taxes.
Taxes can cause quite a bit of confusion and are never fun to deal with.
Here is a simple explanation of how these account types are taxed:
- A Roth 401(k) has its contributions taxed before they enter your 401(k) account.
- A traditional 401(k) does not tax your contributions until after you withdraw them.
Choosing a Roth 401(k) means you will pay the taxes now instead of when you retire.
When choosing a traditional 401(K), you will pay taxes when you retire. The contributions made in a traditional 401(k) will lower your current taxable income.
A total yearly income of $50,000 and a contribution of $19,000 in a traditional 401(k) the taxable income will be $31,000.
If you have $1 million saved in your Traditional 401(k), you will have to pay a large chunk of taxes once you retire. (Around $220,000 if you are in the 22% tax bracket.)
Whatever amount saved in your Roth 401(k) is yours, and you don’t have to worry about paying taxes when you retire.
Another difference is how you can access the money. Both allow you to start receiving distributions at age 59 1/2 or older.
In addition to the age requirement, you cannot withdraw from a Roth 401(k) unless you have held the account for five years.
This isn’t a big issue if you are a long way from retirement.
However, if you are close to the age of 59 ½ you’ll want to consider how this will affect your retirement plans.
Traditional 401(k) pros
- Contributions will lower your taxable income
- Because your contributions are pre-tax, you will get bigger paychecks
- Five years held rule does not apply
- Better if you have a lower tax bracket during retirement
Traditional 401(k) cons
- Withdrawals may push you into a higher tax bracket
- The earnings/growth made is taxed when you retire
- Your tax bracket may be higher during retirement
Roth 401(k) pros
- Account growth/earnings are not taxed when you retire
- Withdrawals won’t push you into a higher tax bracket
- Usually recommended for young people
- Better if you believe your tax bracket will be higher during retirement
- Heirs will not have to pay income taxes if the account is at least five years old
Roth 401(k) cons
- Paying taxes now means smaller paychecks
- Your tax bracket may be lower during retirement
- Account must be held for at least five years
Which One Is Better?
You don’t have to only have one or the other. You could contribute half to each account type.
This will allow you to take advantage of the benefits that each one offers.
If you had to choose between them, you might want to pick the Roth 401(k).
You won’t have to worry about a withdrawal kicking you into a higher tax bracket, and your account growth isn’t taxed.
With a traditional 401(K), the earnings/growth is taxed at retirement. Many argue that outweighs any of the tax benefits you receive when making contributions.
No one knows what the future holds, it’s up to you to decide which account type will suit you best.
If your finances are complicated, you may want to speak with a financial advisor to help make the best decision.
Keep in mind tax laws and retirement rules are subject to change.
What matters most is that you start saving and planning for retirement as soon as possible.