If your employer offers a 401K plan, you may have the option between a Roth and a traditional 401K. Both plans help you save for retirement but have different tax outcomes. Understanding the difference (and consequences) can help you choose the right plan.
What is a 401K?
A 401K is a tax-advantaged account to help employees save for retirement. In most companies, it replaced the traditional company-supplied pension, allowing employees to have more say in how much they invest and where.
401K plans are sponsored by employers and employees can only invest in the options the sponsor provides, but there are many tax advantages for contributing to a 401K. Depending on the type of account you choose, you may earn the tax advantages when you contribute or when you withdraw the funds.
What is a Traditional 401K?
A traditional 401K is the account most people think of when they think of retirement accounts. You contribute funds before taxes and your money grows tax-deferred until you withdraw it in retirement.
You get the tax break now, when you contribute, but will pay taxes when you retire and withdraw the funds.
How Does the Traditional 401K Work?
With a traditional 401K, the contributions you make are before taxes, so they lower your tax liability today. In retirement, you’ll pay the taxes on any withdrawals at whatever tax rate you fall under. Since your money grows tax-deferred, there are minimum distribution requirements once you hit age 72. This means you’ll be required to take a minimum distribution based on your balance so you pay the taxes owed on the funds.
Your employer can also choose to match your contributions. For example, your employer may match 100% of your contributions on up to 3% of your salary. If you make $100,000 that means they’d contribute up to $3,000 to match your contributions.
Who Should Choose the Traditional 401K?
The traditional 401K is often the default for most employees, but it doesn’t have to be. In some cases, it makes more sense than a Roth 401K, but not always.
For example, if you’re young and in a low tax bracket right now, paying the taxes now makes more sense than when you’re older, so a traditional 401K wouldn’t make much sense. But, if you’re older and just starting your retirement account, a traditional 401K may make more sense, especially if you think you’ll be in a lower tax bracket when you retire than you’re in now.
Another consideration is where you live. If you live in a state that collects state income tax now but you plan to move to a state that doesn’t collect it during retirement, choose the traditional 401K and pay fewer taxes.
What is a Roth 401K?
A Roth 401K works a little differently than a traditional 401K. Rather than getting the tax benefits today, you contribute funds after taxes. Your contributions and earnings grow tax-free.
Your Roth 401K balance grows tax-free and your withdrawals are tax-free too. If you wait until retirement (after age 59 ½) to withdraw funds, you’ll pay no taxes on any of the money. The only exceptions to the rule are if you apply for a hardship withdrawal or you qualify as a first-time homebuyer.
How Does the Roth 401K Work?
Contrary to the Traditional 401K, your contributions are post-tax, which allows your contributions and earnings to grow tax-free since you already paid your tax liability. Your employer can also match your contributions if they offer a match. However, your employer contributions aren’t part of the Roth 401K. They’ll be treated as a traditional 401K, which means you’ll pay taxes on the employer contributions when you withdraw the funds.
The good news is that most people are in a lower tax bracket during retirement, so you’ll pay fewer taxes than you would if you withdrew them before retirement.
Who Should Choose the Roth 401K?
It’s a tough decision to choose between the traditional and Roth 401K, but if you look at it from a tax standpoint it’s a lot easier.
If you’re in a lower tax bracket now than you think you’ll be in retirement, pay your tax liability now, before your contributions. Let your money grow tax-free and enjoy the tax-free withdrawals during retirement.
If you think your situation is the other way around, then a traditional 401K makes more sense.
What’s Better – Roth or Traditional 401K?
Both the Roth and traditional 401K have many advantages. You can’t go wrong with either one because in both cases, you’re saving for retirement, which is key. The younger you start your account, the better off you’ll be and in that case, a Roth 401K makes more sense.
But if you started late or you’re in a high tax bracket for another reason, a traditional 401K may save you more money and allow your retirement funds to go further.
Weighing your options and/or opening both a traditional 401K and Roth IRA or vice versa can help too. When you diversify your risk and your tax liabilities, you come out ahead of the game.
No matter your age or how much you do or don’t have saved yet, it’s important to start a 401K for retirement if your employer offers it. If for no other reason, you should take the employer contributions, which means you must contribute the max amount they will match.
An employer contribution is like getting free money for retirement. Even if you have to pay taxes on the funds when you withdraw, it will help supplement your retirement income and allow you to enjoy your golden years.
Talk to your tax advisor about the Roth or traditional 401K to see which one is right for you and if your employer doesn’t offer one, look at your IRA options to get your retirement plan started.