The past few years have brought about trends of early retirement, the rise of gig-work, and the Great Resignation. It may be safe to say that more people are making major changes to their lives than ever. Even if you aren’t making major changes to your life, it is important to regularly review the contributions you are making to your Traditional 401k vs. Roth 401k.
Your personal situation will determine whether the Roth 401k or Traditional 401k is a better retirement vehicle. Because your life is subject to change, your retirement strategy, too, should be subject to change. At Dechtman Wealth Management, we want to help you determine if a Roth 401(k) or Traditional 401K is best for you in your current season of life.
Both vehicles have pros and cons, and much of the discussion will come down to tax implications and strategy. So, let’s dive in on the Roth 401k vs. Traditional 401k and what life circumstances and stages might make one a better choice over the other.
What Is a Traditional 401K?
The employer-sponsored 401k has long been the go-to retirement savings vehicle for millions of Americans. It was created to help employees save for retirement, offering a tax break on their contributions along the way.
Here’s how it works: You, the employee, choose to have a certain percentage of your paycheck deposited into your 401k account each pay period. This is a pretax contribution- it happens before you see your paycheck and before income taxes are paid. The money you contribute is set aside in your 401k account, where you make your investment allocations, meaning you select the stocks, funds, or other assets you want to invest in.
From this point, your investments grow tax-deferred until you’re ready to start making withdrawals in retirement. When you begin taking money out (most likely after age 59 1/2), those withdrawals are taxed as regular income at your marginal tax rate at the time of the withdrawal. If you choose to take a withdrawal prior to 59 ½, you will be taxed and hit with a 10% penalty on the amount withdrawn.
A Brief History of the Traditional 401k
The Traditional 401k came about in 1978 as a spin-off of a similar financial product, the Cash or Deferred Arrangement, or CODA. The goal of the companies who had been using CODAs was to defer compensation, but getting buy-in from the IRS on the idea took time, as these things do. In January of 1980, Internal Revenue Code Section 401k became law, offering a tax-deferred, employer-sponsored program for employees to save for retirement. Before that, most people relied on pensions (which were much more common at the time) or Social Security. The 401k allowed employees to take control of their retirement planning and put away money each month, with the added benefits of employer contributions and deferring taxes.
What Is a Roth 401K?
The Roth 401k is another employer-sponsored retirement vehicle, but this variation allows employees to make contributions with after-tax dollars. In other words, you don’t get an up-front tax break on your contributions, but the trade-off is that you won’t have to pay taxes on qualified withdrawals down the road, either.
Here’s how it works: Similar to the Traditional 401k, you, the employee, choose to have a certain percentage of your paycheck deposited into your Roth 401k account each pay period. The difference is that you’re now making after-tax contributions with your funds now going to your 401k after income taxes are paid. From within your 401k, you’ll select the stocks, mutual funds, or other assets you want to invest in within the account.
From there, your money will grow tax-free until you’re ready to start making withdrawals in retirement. The money will come out tax free if you’ve the account for over 5 years and are over the age of 59 ½. The biggest benefit is that you’ve already paid your taxes, so your contributions and gains are yours to keep- tax-free when you make qualified withdrawals in retirement.
A Brief History of the Roth 401k
The Roth 401k was introduced as an investment option at the beginning of 2006. The concept was to create another retirement savings option for employees, specifically one that would be funded with after-tax dollars. The thinking was that some employees would prefer to pay taxes upfront on their contributions to have tax-free income in retirement.
Key Differences and Similarities
Now that we’ve covered the basics of both 401k types let’s take a closer look at some key differences and similarities.
Access to Funds
One of the key differences between a Roth 401k and a Traditional 401k is when you have access to the funds in your account.
Accessing funds in a Traditional 401k before retirement is difficult and expensive. If you withdraw funds prior to age 59 ½ you’ll face taxes and a 10% penalty. There are a handful of exceptions for things such as death, disability, medical expenses, child or spousal support, and military duty, among others. However, the intent is very clearly to discourage early withdrawals—plan for any funds put into your Traditional 401k to stay put until retirement. Some 401(k) plans allow for participants to take out a loan. Before taking a loan it is important to understand the costs and implications. If you might need access to your money before retirement, a traditional 401k may not be the best option.
While the Roth 401k is also intended to be a long-term retirement savings vehicle, it does offer more liquidity than the Traditional 401k. Because you’ve already paid taxes on the contributions made to your Roth 401k, you can withdraw your contributions at any time without penalty. This can be helpful if you face an unexpected financial emergency and need access to cash. However, it’s important to note that while you can withdraw your contributions without penalty, you will face taxes and a 10% penalty on any earnings withdrawn before age 59 1/2 unless a qualifying exception applies.
Retirement funds should be set aside for retirement. If you need funds prior to 59 ½, monies in your bank account or non-retirement investment account would be the best place to pull from first. However, if you suspect you may need access to your 401k funds before retirement, a Roth 401k offers more liquidity and fewer penalties.
Regarding how much you can contribute to your 401k, the IRS imposes contribution limits each year based on inflation and other economic factors. Let’s explore the contribution limits for a traditional 401k vs. a Roth 401k.
For 2022, the contribution limit is $20,500 for employees under the age of 50. If you’re 50 or older, you can make an additional $6,500 in catch-up contributions, totaling $27,000 for the year.
The IRS imposes the same contribution limits on the Roth 401k as the Traditional 401k. For 2022, the contribution limit is $20,500 for employees under the age of 50. In addition, if you’re 50 or older, you can make an additional $6,500 in catch-up contributions, totaling $27,000 for the year.
Total Annual Contribution Limit
Remember that the contribution limit for both a Traditional 401k and Roth 401k is an annual limit, not per account. This is important because you may ultimately choose to have both types of 401ks. Or you may have multiple 401ks through multiple current or previous employers. In either case, the $20,500/$27,000 contribution limit applies to the total amount you contribute to all of your 401ks in a year, not per account.
There’s no difference in the amount you can contribute to a Traditional 401k or Roth 401k. The IRS imposes the same contribution limits on each type of account, so we have to call this one a wash!
One of the benefits of 401k plans is that many employers will offer to match a portion of employee contributions, making 401ks an especially attractive retirement savings option. When it comes to employer contributions and employer matches, there are important differences between Traditional and Roth 401ks to be aware of.
Before we dive in, though, one thing to note is that if your employer offers a 401k match and you have the option of a Roth 401k, you can elect to contribute to one or both. If you elect to contribute to both, employer contributions are generally allocated to the traditional 401k portion.
All contributions into a Traditional 401k are made with pretax dollars – both those you make and those made by your employer. Therefore, both the employee and employer contributions and the earnings on those contributions will be subject to taxes when withdrawn in retirement.
Roth 401ks tout the benefit of tax-free growth and withdrawals, but a portion of the contributions into the Roth 401k account will need to be taxed at withdrawal, and those are the contributions your employer makes. So the Roth election will lower your tax obligation in your retirement years, but it won’t eliminate it entirely.
Employer matches are a valuable part of your compensation package. Even with a Roth 401k, the employer contributions will likely go to a Traditional 401(k), which means the monies will be subject to taxes at withdrawal. If your employer allows their match to go into a Roth 401(k), that is likely going to be the best option for you.
401k accounts are designed for long-term retirement savings, and as such, there are penalties for early withdrawals. With that said, life happens, and sometimes you may need access to your 401k funds before you turn 59 1/2. Let’s explore the withdrawal rules and penalties for Traditional and Roth 401ks.
With a traditional 401k, you’ll pay taxes on your contributions and earnings at withdrawal. In addition, if you withdraw funds before you reach age 59 1/2, you’ll also be subject to a 10% early withdrawal penalty. There are some exceptions to the 10% penalty, though, including withdrawals made for certain qualified medical expenses, disability, or to prevent eviction or foreclosure on your home.
With a Roth 401k, you’ve already paid taxes on your contributions, so no taxes are due at withdrawal. Additionally, you can withdraw your principal contributions without penalty if the account has been established for at least five years. However, if you withdraw earnings from your Roth 401k before you reach age 59 1/2, you’ll owe taxes and a 10% early withdrawal penalty on those earnings unless you qualify for an exception.
The ability to access your principal contributions without penalty makes the Roth 401k a better choice if you think there’s a possibility you may need to withdraw funds early. However, you do still have a five-year timeframe before being able to access contributions without penalty. The more lenient withdrawal rules for a Roth 401k may make it a powerful tool to begin building generational wealth by helping your children save for retirement. That versatility gives the Roth 401k the win in this category.
There comes a time when the IRS says the free ride is over, and they require that you begin taking distributions from your tax-deferred retirement accounts. Let’s explore Required Minimum Distributions (RMDs) for both 401k types.
RMDs for Traditional 401ks begin at age 72. Before that, you’re not required to take distributions, but you may begin taking distributions at 59 1/2 without penalty. The amount of the RMD is based on life expectancy tables and the account balance at the end of the prior year. Additional guidance is made available by the IRS or your tax or financial advisor.
The reason for RMDs is to ensure that a taxpayer does eventually pay the deferred income tax. With a Roth 401k, you’ve already gotten your tax obligation out of the way, so there is never an RMD from a Roth 401k.
This is another area where the Roth 401k has an apparent advantage over the Traditional 401k. If you have a Roth 401k, you are not required to take distributions at any age because you’ve already paid taxes on the contributions.
As we’ve seen, there are some penalties associated with early withdrawals from a 401k account. Let’s investigate the potential penalties associated with both account types.
As we discussed earlier, if you withdraw funds from your Traditional 401k before age 59 1/2, you’ll be subject to a 10% early withdrawal penalty. In addition, if you don’t begin taking RMDs by age 72, you’ll be subject to a 50% excise tax on the amount of the RMD.
If you withdraw funds from your Roth 401k before age 59 1/2, you’ll be subject to a 10% early withdrawal penalty on any earnings that you withdraw unless you qualify for an exception. The keyword here, earnings, is crucial. With a Roth 401k, you are always free to withdraw your principal contributions without penalty. Without qualifying for an exception, if you withdraw more than the principal amount you’ve contributed before age 59 1/2, you will incur a 10% penalty.
If you’re confident you’ll be leaving your retirement funds alone until retirement, there shouldn’t be any major difference in penalties between the two types of 401ks. If you think there’s a possibility you’ll need to access your funds early, the Roth 401k offers the ability to do so without penalty, provided you only withdraw your principal contributions.
How to Determine Which 401K Is Best for You
Which 401k is best for you depends on several factors. Specifically, your age, tax bracket, where you live, and the amount you can afford to save for retirement will all influence which 401k type is best for you.
Your age will be an important factor when deciding between a Roth 401k or a Traditional 401k. The earlier you begin saving for retirement, the more time your money has to grow. If you’re in your 20s or 30s, a Roth 401k may be the better choice, as the money you contribute will have more time to grow tax-free, and you’re likely in a lower tax bracket than you will be later in your career. If you’re closer to retirement, a Traditional 401k may be the better choice as your money will have less time to grow, and you’re likely in a higher tax bracket than you were earlier in your career.
This one gets tricky as you don’t just want to consider your current tax bracket, but what tax bracket you expect to be in in the future, too. If you expect to be in a higher tax bracket later, a Roth 401k may be the most financial sense. The money you contribute to a Roth 401k will be taxed at your current lower rate, and then when you retire and begin taking distributions, you’ll be in a higher tax bracket and will pay less in taxes overall. On the flip side, if you expect you’ll be earning less in retirement than you do now, it may make more sense to go with a Traditional 401k.
Where You Live
This one is a bit less direct, but it’s wise to consider nonetheless. If you live in a state with high taxes, it may be advantageous to go the Traditional 401k route. Contributing to a Traditional 401k will lower your taxable income for the year, lowering your state tax burden. On the other hand, if you have a Roth 401k, your contributions are made with after-tax dollars, so there is no immediate state tax benefit.
The Amount You Can Afford to Save
It’s not always easy to know how much you can afford to save for retirement now, let alone how much you’ll be able to save in the future. But, if you can project your current and future finances with confidence, it can be helpful in deciding which 401k is best for you. If you work in a role that is on a clear career path with raises and promotions at predictable intervals, you may be able to more accurately predict how much you’ll be able to contribute to your 401k in the future.
The Benefits of Investing in Both 401K Types
Throughout the article, we’ve commented that one 401k may be better than the other in certain situations. We’ve also hinted at another idea, too: You don’t have to limit yourself to one or the other.
Assuming both options are available, nothing is preventing you from contributing to both a Roth 401k and a Traditional 401k. We believe this may be the best strategy for many people.
When you have both options and can consider the entirety of your financial situation, everything we’ve shared above, you can make an informed decision that is best for you and update it as your life circumstances dictate. Most 401k administrators allow participants to select a dollar amount to contribute to either 401k account or a percentage of their income.
The Bottom Line
Both Roth 401ks and Traditional 401ks have their own set of pros and cons. Which one is better for you depends on your specific financial situation. If you’re trying to decide between the two, consider your age, tax bracket, where you live, and how much you can afford to save. You may also find that the best strategy is to contribute to both types of 401ks. Explore your options and learn more about which 401k is best for you. Speak with a financial advisor at Dechtman Wealth Management today.
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