Roth vs. Traditional 401(k) What’s the Difference?
What’s the difference between a Traditional and a Roth 401(k)?
Let’s start with what’s the same. Both the Traditional and the Roth 401(k) offer special tax advantages that you wouldn’t receive from other taxable investing options. In addition, they’re both funded with contributions directly withdrawn from your paycheck. Finally, they’re both eligible for extra perks like an employer match (aka free money).
Now, here is the key difference: Traditional 401(k) contributions are made with pre-tax dollars while Roth 401(k) contributions are made with after-tax (otherwise known as post-tax) dollars.
How much can I contribute to a Roth or a Traditional 401(k)?
In 2020, you can contribute up to $19,500 to a Roth 401(k), a Traditional 401(k), or a combination of both. For example, you can contribute $10,000 to a Traditional 401(k) and $9,500 to a Roth 401(k). Plus, if you’re 50 or older, you can contribute $6,500 in catch-up contributions for a total 401(k) contribution limit of $26,000.
Can you tell me more about the tax implications of the Traditional 401(k)?
Traditional 401(k) contributions are deducted directly from your paycheck before any taxes are withheld. Here’s an example. Let’s say you earn $40,000 per year but save $3,000 in a Traditional 401(k). Your taxable income is lowered to $37,000 so you would pay less in taxes now.
In addition, the money that you contribute—and any earnings—grow tax deferred until you withdraw it in retirement. At that time, your withdrawals are considered ordinary income and you’ll pay federal and possibly state taxes depending upon where you live. And, if you want to withdraw money before you turn age 59 ½, you’ll also be subject to a 10% penalty unless you qualify for an exception.
What are the tax implications of the Roth 401(k)?
Like a Traditional 401(k), a Roth account is also tax advantaged—but in a different way. Here’s how it works:
If you decide to contribute to a Roth, the money is deducted from your paycheck after taxes have been withheld. So if you earn $40,000 but save $3,000 in a Roth 401(k), you’ll still be paying taxes on all $40,000.
However, the tax benefit comes into play when you withdraw the money. Because you already paid your taxes, you can withdraw contributions—and any earnings—tax-free if you’re age 59 ½ or older and have held your Roth 401(k) account for at least five years.
So in a head-to-head competition of Roth vs. Traditional 401(k) which one would win?
The short answer is that it depends on your unique financial situation and retirement goals. Want a little extra help? Contact us
But really, which type of 401(k) should I choose?
It can be helpful to ask yourself an important question: Do you want to pay your income tax now or later?
If you think your income will increase in the future perhaps because you anticipate getting promoted or earning an advanced degree, then you may fall into a higher tax bracket later. If this is the case, we would recommend making after-tax contributions into a Roth 401(k) account.
However, if you foresee your income decreasing, for example, if you are planning on retiring, taking some time off, or leaving the workforce, then you will likely fall into a lower tax bracket in the future. If this is the case, you may be better suited to make pre-tax contributions into a Traditional 401(k) account.
As a general rule:
- If your current tax bracket is higher than your expected tax bracket in retirement, then consider contributing pre-tax dollars into a Traditional 401(k) account.
- If your current tax bracket is the same or lower than your expected tax bracket in retirement, then consider contributing after-tax dollars into a Roth 401(k) account
What if I’m not sure if my tax rate will be higher or lower in the future?
If you’re on the fence about your tax rate, then it may be prudent to invest in both. By saving for retirement in both a Roth 401(k) and a Traditional 401(k), you’ll know that at least some of your assets will be well-positioned—no matter what the future holds.
What if I want to withdraw my money early—that is, before I turn age 59 ½?
Let’s start with the Roth 401(k). Because you already paid taxes on your contributions, you can generally withdraw that portion of the money tax-free. Click here to read more, or we can also break it down further:
- The portion of the withdrawal that represents your contributions to the account will generally be nontaxable (and not subject to the 10% penalty)
- The portion of the withdrawal that represents earnings will be taxable and potentially subject to the 10% penalty
However, most early withdrawals from a Traditional 401(k) are taxed as ordinary income plus a 10% penalty. There are some exceptions such as permanent disability.
The tax ramifications of retirement accounts can be complicated. As Betterment is not a tax advisor, we encourage you to consult one ahead of making such decisions.
What if I don’t want to withdraw my money for a very long time (if at all)?
When you turn age 70 ½, the IRS usually mandates that you begin withdrawing money from your Traditional 401(k) account. These withdrawals are known as Required Minimum Distributions (RMDs). Even if you roll over your Traditional 401(k) to a pre-tax IRA, the same rules apply.
You also must take RMDs from a Roth 401(k). However, you can roll over your money from a Roth 401(k) to a Roth IRA. If you do, you can avoid the RMD rules, and your account can continue to generate tax-free returns until after you or your spouse dies.
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JST Investment Consulting does not provide tax or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable. The information in these materials may change at any time and without notice.bridgemedia | Buy online Sneaker for Men