Both traditional 401(k)s and Roth 401(k)s are tax-advantaged retirement plans that allow individuals to boost their retirement savings. But while traditional accounts are funded with pre-tax money, Roth accounts are funded with after-tax money.
In deciding which type of account is right for them, an investor might start by thinking about when they want to receive tax benefits—now, or in retirement? Asking that question can lead to more considerations, including what their predicted tax bracket will be when they retire. These factors and more can help an investor decide where to put their money for retirement.
Roth 401(k) vs Traditional 401(k)
Employers may offer tax-advantaged accounts like traditional and Roth 401(k)s to their employees to encourage retirement savings. Before deciding on a Roth or traditional 401(k), it’s important to understand the differences between each account and the situations where they are most useful.
What Is a Traditional 401(k)?
A traditional 401(k) is an employer-sponsored retirement savings account that allows individuals to make pre-tax contributions. These contributions are typically made through elective salary deferrals that come directly out of an employee’s paycheck and are excluded from their taxable income. Employers may also choose to make contributions.
When an employee retires, distributions from the account, including all contributions and earnings, are taxable as income. Employees can start taking distributions penalty-free at age 59 1/2. If you choose to take out distributions earlier, you will have to pay a 10% penalty fee.
Here is an example of how a traditional 401(k) works:
Emily’s employer offers traditional 401(k)s. Emily makes $50,000 annually and contributes 5% of her paycheck to her 401(k). By the end of the year, she has contributed $2,500 (untaxed) to her 401(k).
Let’s say Emily has saved $250,000 by the time she’s 59 1/2. She wants to start withdrawing from her 401(k). Whatever she withdraws will now be taxed according to her current tax bracket.
If she withdraws $10,000 and she’s in a tax bracket with 10% income tax, she will owe $1,000 on the $10,000 she withdrew.
Pros of a Traditional 401(k)
There are a number of advantages of a traditional 401(k) plan, including:
Immediate tax benefits. As of 2020, employees can contribute up to $19,500 per year, and employees over the age of 50 can typically make additional annual catch-up contributions of $6,500 to help them boost their savings as they near retirement.
Because employee contributions are usually taken directly out of an employee’s paycheck, pre-tax, it lowers the employee’s taxable income in the year they make the contribution, and they’ll likely pay less income tax that year than if they had not contributed.
Employer contributions. Employers may offer to match employee contributions up to a certain amount. Some employees choose to save at least the “matched” amount in their 401(k)s to take advantage of what is essentially free money. There are caps to these contributions as well: In 2020, total plan contributions (from both employee and employer) cannot exceed 100% of the employee’s compensation or $57,000 ($63,500, including catch-up contributions), whichever is less.
Tax-deferred growth and compound interest. Within a 401(k) account, employee contributions can typically be invested in one of a handful of investment options offered by the plan, such as mutual funds and target-date funds. Any earnings on these investments can grow tax-deferred, meaning they’re not subject to tax inside the account. The account also accrues compound interest, the returns investments earn on their returns.
Cons of a Traditional 401(k)
There are some 401(k)s limitations that are important to be aware of.
• Early withdrawal penalties. When an individual invests their money in a 401(k), they’re essentially tying up those funds until age 59 1/2. Taking distributions before then can subject a person to both income tax and a 10% early withdrawal penalty.
While it is possible to access the funds in your 401(k) through a 401(k) loan or a hardship distribution, executing these options means following strict rules and can potentially hurt one’s ability to save for retirement.
• Limited investment options. Typically, employers may only offer one or two funds to choose from. Individuals looking for a wider variety of investment possibilities inside a retirement account may want to consider the merits of an IRA versus a 401(k).
• Required minimum distributions. Individuals can’t keep money in a 401(k) forever. At age 72, they typically must start taking required minimum distributions (RMDs). The IRS provides worksheets that can help calculate the minimum amount an individual must withdraw from their account each year.
What Is a Roth 401(k)?
A designated Roth 401(k) is technically a separate account that exists inside a 401(k) and allows for designated Roth contributions. If this feature is available through an employer’s 401(k) plan, employees can designate some or all of their elective deferrals as Roth contributions.
A Roth 401(k) functions in many ways like a traditional 401(k) with one main difference: Contributions are made with after-tax funds. As with traditional 401(k) accounts, contributions are usually made with elective deferrals from an employee’s paycheck, yet contributions are included in the employee’s gross income.
Roth 401(k)s have the same contribution limits as their traditional counterparts. Employees can contribute up to $19,500 in 2020, and those over the age of 50 can contribute an extra $6,500 to boost their savings as they near retirement.
Withdrawals made from the account at retirement are not subject to income tax after age 59 1/2.
Here’s an example of how a Roth 401(k) works:
Let’s say you earn $3,000 per month and have set aside 6% as a Roth 401(k) contribution. Then $180 is deducted from your salary each month after tax withholdings. This is as opposed to a 401(k) contribution, which is deducted from pretax dollars.
Pros of a Roth 401(k)
There are a number of benefits to a Roth 401(k):
• Employer contributions. When an individual makes a Roth contribution, their employer may also make a matching contribution—though the match must be placed in a traditional account. Total employer and employee contributions across both accounts are limited to the lesser of 100% of an employee’s compensation or $57,000; or $63,500 for employees making catch-up contributions.
• Tax-free growth. Invested contributions grow inside the account tax-free, a subtle but important difference from traditional 401(k)s, which offer tax-deferred growth. Withdrawals made from the account after certain requirements are met are not subject to income tax.
• Potential tax savings. While there is no way to predict the future, it’s possible that paying taxes now helps individuals avoid the chance of paying higher taxes in the event of future tax hikes.
Cons of a Roth 401(k)
As with traditional 401(k)s, there are a few limitations of a Roth 401(k) investors may want to know about:
• Withdrawal limits. Withdrawals of contributions and earnings are not taxed as long as the account has been open for five years and the employee is age 59 ½ or older. Penalty-free withdrawals can also be taken if the employee becomes disabled, or they die and their beneficiary makes withdrawals.
• RMDs. Roth 401(k)s are also subject to required minimum distributions. Employees typically must start making withdrawals no later than age 72.
• Budget impact. Individuals do not get the immediate tax benefits of making a traditional contribution, so Roth contributions can hit people’s wallets a little bit harder in the short-term than a traditional 401(k) might.
Which to Choose: Roth vs a Traditional 401(k)
Traditional 401(k)s offer tax-deferred growth that is taxed at an individual’s income tax rate when withdrawn, usually after retirement. As a result these plans can be most tax efficient for those who will have a lower marginal rate after they retire than they did while they were working.
On the other hand, an investor might look into the Roth 401(k) option if they feel that they pay less in taxes now than they will in retirement. For example, an individual who is relatively young and still climbing the corporate ladder may not have reached their peak earning years yet. They may draw more income later in life and when they retire. By paying taxes now while in a lower tax bracket, the individual might be able to avoid paying higher taxes later.
The Benefits of Investing in Both a Roth 401(k) and Traditional 401(k)
Some employees might have the option to switch back and forth between making traditional and Roth 401(k) contributions, thus taking advantage of the pros of each type of account.
Divvying up contributions between both types of accounts allows for greater flexibility in tax planning down the road. Upon retirement, an individual can choose whether to withdraw money from their tax-free 401(k) account or the taxable account traditional 401(k) account each year, to help manage their taxable income.
It is important to note that the $19,500 contribution limit is a total limit on both accounts. So, for instance, an employee might choose to save $12,000 in their traditional 401(k) and $7,500 in their Roth 401(k) for the year. They are not permitted to save $19,500 in each.
How Traditional and Roth IRAs Can Help Plan for Retirement
Traditional and Roth IRAs can also play an important role in retirement planning. Not all employers offer 401(k)s, and those who do generally only offer them to full-time workers. Part-timers, freelancers, and others may be left without a 401(k) option.
IRAs can be a way for individuals to reap some of the same benefits that 401(k)s offer. While 401(k)s are qualified employer-sponsored plans, anyone can open an IRA through a bank or brokerage firm as long as they have earned income.
Additionally, IRAs have the potential to give individuals more freedom to choose specific investments. While employer-sponsored 401(k)s may offer a handful of investments, IRAs can be made up of a wide variety of stocks, bonds, mutual funds, ETFs, index, and even real estate.
What is a Traditional IRA?
Traditional IRAs function much like a traditional 401(k). Contributions are made with pre-tax money, are allowed to grow tax-deferred, and are subject to income tax when they are withdrawn. Withdrawals made before age 59 1/2 are subject to income tax and an additional 10% early withdrawal penalty. For 2020, individuals can contribute up to $6,000 a year, or $7,000 if they’re over age 50. Traditional IRA accounts are subject to RMDs.
The tax deduction for traditional IRAs begins to phase out when you make a certain amount of money. The more money a person makes, the less they are able to deduct. And if an individual makes too much, they won’t be able to deduct anything.
What is a Roth IRA?
There are some key differences between Roth IRAs and Roth 401(k)s. With both, contributions are made with after-tax money, are allowed to grow tax-free, and are not subject to tax when they’re withdrawn.
Yet with a Roth IRA, individuals can withdraw their contributions at any time. Withdrawals of earnings are potentially subject to tax and a 10% early withdrawal penalty if made before age 59 1/2. As with a traditional IRA, the Roth IRA contribution limit is also $6,000 a year, with an extra $1,000 available for catch-up contributions at age 50. Roth IRAs are not subject to RMDs.
Not everyone qualifies to contribute to a Roth IRA. Eligibility is based on how much an individual makes. As of 2020, taxpayers who file singly must have a modified adjusted gross income (MAGI) of under $139,000 to contribute to a Roth. Those married filing jointly must have a MAGI less than $206,000.
Investing in Both Traditional and Roth IRAs
Individuals can have both a traditional and Roth IRA, though as with traditional and Roth 401(k) plans, the contribution limits are cumulative across all accounts. For example, an individual could make a $3,000 contribution to their Roth and another $3,000 contribution to their traditional IRA before they hit the contribution limit.
When it comes to retirement plans, investors don’t necessarily have to decide on a Roth or traditional 401(k)—or even a 401(k) or an IRA. Some individuals might choose one of these investment accounts, while others might find a combination of plans suits their goals.
Employer-sponsored Roth and traditional 401(k) plans offer options when it comes to contributing pre- or after-tax dollars. In companies where employers match a certain percentage of employee contributions, that “free money” can help add to the account balance.
Individuals contributing to either kind of 401(k) can invest more money each year by adding IRA accounts to their portfolio. Doing so may be particularly helpful to people who are already maxing out their 401(k)s. If an individual’s employer offers a 401(k)without a Roth option, adding a Roth IRA can help diversify tax benefits and provide flexibility in tax planning down the road.
For people who don’t have access to an employer-sponsored retirement account, IRAs offer the chance to reap the same tax-advantaged benefits that go along with having a 401(k)s. Traditional IRAs lower taxable income in the short term, and Roth IRAs provide tax-free withdrawals in retirement.
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