We all know how important it is to invest in a retirement savings account with tax advantages. But all the nitty-gritty involved in building your retirement nest egg can make your head spin.
So, if you’ve been struggling to figure out whether a traditional 401(k) is better for you or a Roth 401(k), you’ve come to the right place!
Here’s a concise and clear guide on 401(k), traditional 401(k) and Roth 401(k), and the best option for you between the two.
What Is a 401(k)?
A 401(k) is a tax-advantaged retirement savings plan offered by employers all across America.
When you sign up for a 401(k), you agree to put away a percentage of your paycheck into an investment account. The employer may also agree to match up with this percentage in part or full.
Today, employees have access to two 401(k) plans: traditional and Roth 401(k). The traditional 401(k) was introduced in 1978, whereas the Roth 401(k) was introduced in 2006.
Let’s take a look at the similarities and differences between the two 401(k) investment plans and how they can impact your savings.
Traditional VS Roth 401(k): Similarities
- Both are retirement savings options.
- Both have the same contribution limit.
- Both provide tax-advantaged growth on investment.
- Both have a maximum annual contribution limit.
- Contributions to both plans are matched by the employer.
- Both 401(k) plans have required minimum distributions (RMDs) starting at 72.
- Both plans offer tax breaks (in the present or future).
- Both attract early-withdrawal penalties of 10%.
- Both provide distributions to you and your beneficiaries due to disability or death.
Traditional VS Roth 401(k): Differences
- Contributions are made from pre-tax income.
- You get tax breaks in the present.
- It reduces your taxable income/current adjusted gross income.
- Deferred taxes on investment gains.
- All withdrawals are taxed at the income tax rate in the future.
- All the money is only taxed when it comes out of your account.
- State income taxes may be applied.
- You can start receiving distributions at age 59 ½ regardless of when you started.
- Contributions are made from after-tax income.
- No tax breaks in the present.
- Withdrawals aren’t taxed.
- Contributions aren’t taxed.
- Paycheck goes down with consecutive contributions.
- Growth on contributions is tax-free.
- You can start receiving distributions at age 59 ½ only if you have held the account for at least 5 years.
- Employer-matched contributions go into a pre-tax account and are taxed during distribution.
Traditional VS Roth 401(k): Which Is Better?
Select Traditional 401(k) If…
- You need a little extra cash in the present.
- You want to save money.
- You’re in a higher tax bracket at present.
- You are expecting to earn less in the future.
- If your employer is matching your traditional 401(k) contributions only.
- If you plan to move to a state that doesn’t collect income tax in your retirement.
- If you started after the age of 54 ½ and need to access money at the age of 59 ½.
Bottom Line: If you’re starting to invest in a 401k quite late, then the traditional 401(k) would be the better option for you.
Select the Roth 401(k) If…
- You are young.
- You want tax-free growth on investment.
- You want tax-free withdrawals during your retirement.
- You are fine with a little less in your paycheck today.
- You have already signed up for a traditional 401(k).
- If you are in a lower tax bracket at present and expect to be in a higher tax bracket later on.
- If you are expecting higher tax rates in the future.
Bottom Line: If watching a chunk of your retirement savings getting taxed is a heavy blow to your heart, then choose the Roth 401(k).
Can You Opt For Both Traditional and Roth 401(k)?
You can choose to make contributions to both traditional and Roth 401(k) accounts on a year-by-year basis. This means you can decide how you want to split your contribution in either of the 401(k)s for that year.
Here’s an example:
For the year 2021, your 401(k) contribution is $19,500. Then you can choose to split it into equal halves and contribute $9,750 to both traditional and Roth 401(k) accounts. This limit only applies to the employee’s contribution to the account. Employer contributions aren’t included in the limit.
For those of age 50 or older, there’s the option of making a catch-up contribution to the 401(k) of $6,500.
The 401(k) contribution limit for 2021 is $19,500 and the same for 2022 is $20,500.
When determining the best retirement savings plan, there will always be some assumptions and predictions involved. There are factors outside of your control that may affect your income, tax brackets, and tax percentages in the future.
If you need a professional opinion, you could always ask a financial or investment expert for advice.
The best option is to carefully assess your current options and go with either of the plans. You’ll end up saving something for your retirement anyway.