When planning for retirement, one of the most important decisions you’ll make is how to save and invest your money. Two popular options are the Traditional 401(k) and the Roth 401(k). Both are employer-sponsored retirement plans, but they differ in several key ways, including how and when you’re taxed. Understanding these differences can help you choose the right plan for your financial situation and retirement goals.
Before we delve into the specifics of each plan, it’s important to understand what a 401(k) is. Named after a section of the Internal Revenue Code, a 401(k) is a type of retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. The money you put into a 401(k) grows tax-free until you start making withdrawals in retirement.
Overview of Traditional 401(k)
The Traditional 401(k) is a pre-tax retirement savings plan. This means that contributions are made with pre-tax dollars, reducing your taxable income for the year. The money grows tax-deferred, meaning you won’t pay taxes on it until you withdraw it in retirement. This can be a significant advantage if you expect to be in a lower tax bracket in retirement than you are now.
However, when you start making withdrawals in retirement, those distributions are taxed as ordinary income. This includes both your original contributions and any investment earnings. In addition, if you withdraw money before age 59 ½, you may be subject to a 10% early withdrawal penalty in addition to income taxes, unless certain exceptions apply.
Contribution Limits
For 2021, the maximum amount you can contribute to a Traditional 401(k) is $19,500 if you’re under age 50. If you’re age 50 or older, you can make an additional “catch-up” contribution of $6,500, for a total of $26,000. These limits are set by the IRS and can change from year to year.
It’s also worth noting that these are just the limits for employee contributions. Employers can also contribute to your 401(k), and their contributions don’t count toward these limits. The total combined contribution limit for employee and employer contributions is $58,000 for 2021, or $64,500 if you’re age 50 or older.
Withdrawal Rules
With a Traditional 401(k), you can start making penalty-free withdrawals at age 59 ½. However, you must start taking required minimum distributions (RMDs) by April 1 of the year after you turn 72. If you don’t take these RMDs, you could be subject to a hefty penalty.
The amount of your RMDs is determined by the IRS and is based on your life expectancy and the balance of your 401(k). If you don’t need the money for living expenses, these mandatory withdrawals could potentially push you into a higher tax bracket.
Overview of Roth 401(k)
The Roth 401(k) is a post-tax retirement savings plan. This means that contributions are made with after-tax dollars. Unlike a Traditional 401(k), you won’t get a tax break on your contributions in the year you make them. However, the money grows tax-free, and qualified distributions in retirement are also tax-free.
This can be a significant advantage if you expect to be in a higher tax bracket in retirement than you are now. It can also be beneficial if you expect tax rates to be higher in the future. With a Roth 401(k), you pay taxes now at your current rate, and then never have to worry about taxes again, as long as you meet the requirements for a qualified distribution.
Contribution Limits
The contribution limits for a Roth 401(k) are the same as for a Traditional 401(k). For 2021, you can contribute up to $19,500 if you’re under age 50, or up to $26,000 if you’re age 50 or older. These limits include both your contributions and any employer matching contributions.
However, it’s important to note that because Roth 401(k) contributions are made with after-tax dollars, effectively you can save more in a Roth 401(k) than in a Traditional 401(k). That’s because the same dollar amount in a Roth 401(k) is worth more than in a Traditional 401(k), since the Roth 401(k) balance won’t be reduced by taxes upon withdrawal.
Withdrawal Rules
Like a Traditional 401(k), you can start making penalty-free withdrawals from a Roth 401(k) at age 59 ½. However, to qualify for tax-free withdrawals, you must also have held the account for at least five years. This is known as the “5-year rule.”
Unlike a Traditional 401(k), a Roth 401(k) does require RMDs during the account owner’s lifetime. However, if you roll over your Roth 401(k) to a Roth IRA, you can avoid RMDs. This can be a significant advantage if you don’t need the money for living expenses and want to leave it to grow tax-free for as long as possible.
Choosing Between a Traditional 401(k) and a Roth 401(k)
Choosing between a Traditional 401(k) and a Roth 401(k) largely comes down to your current tax rate versus your expected tax rate in retirement. If you expect to be in a lower tax bracket in retirement, a Traditional 401(k) may be the better choice. If you expect to be in a higher tax bracket, a Roth 401(k) may be more beneficial.
However, there are other factors to consider as well. For example, if you want to minimize RMDs, a Roth 401(k) may be the better choice. If you want to maximize employer matching contributions, a Traditional 401(k) may be more beneficial. Ultimately, the best choice depends on your individual circumstances and retirement goals.
Considerations for High Earners
If you’re a high earner, you may be better off with a Traditional 401(k). That’s because your contributions will reduce your taxable income now, when you’re in a high tax bracket. Then, when you start making withdrawals in retirement, you’ll likely be in a lower tax bracket.
However, if you expect your income to remain high in retirement, or if you expect tax rates to increase in the future, a Roth 401(k) may be more beneficial. Even though you won’t get a tax break on your contributions now, your withdrawals in retirement will be tax-free.
Considerations for Young Savers
If you’re young and just starting out in your career, you may be better off with a Roth 401(k). That’s because you’re likely in a lower tax bracket now than you will be in the future. By paying taxes now, you can avoid paying them later when your tax rate may be higher.
Plus, because you have a long time until retirement, the tax-free growth offered by a Roth 401(k) can be a significant advantage. Over several decades, the compound growth of your investments can result in a substantial balance that can be withdrawn tax-free in retirement.
Conclusion
Both the Traditional 401(k) and the Roth 401(k) offer valuable opportunities for saving for retirement. Each has its own advantages and disadvantages, and the best choice depends on your individual circumstances and retirement goals. By understanding the differences between these two types of 401(k)s, you can make an informed decision that will help you achieve your retirement savings goals.
Remember, it’s always a good idea to consult with a financial advisor or tax professional before making major decisions about your retirement savings. They can help you understand the implications of each option and guide you in making the best choice for your situation.