Many employers now offer both a Roth 401(k) and a traditional 401(k). This poses a question: Which one is the best choice for you? Simple question, but the answer is a bit more involved.
While the Roth 401(k) has some awesome benefits (similar to the Roth IRA), the traditional 401(k) may still be the right choice.
In this article, we’ll explain what both types of retirement accounts are and why you might choose one over the other.
How Your Paycheck Is Affected
Similar to a Roth IRA, the Roth 401(k) contributions are after-tax dollars. This means that money coming out of your paycheck and going into a Roth 401(k) is taxed. In contrast, contributions to a traditional 401(k) are not taxed. Your after-tax paycheck will be smaller if you’re contributing to a Roth 401(k) because you’re paying more in taxes.
Any company match that's offered is pre-tax, though. So, you effectively have two accounts within a Roth 401(k). You have the Roth portion, and the pre-tax employer match portion. Both grow together, but if you withdraw or rollover, there are important things to remember.
However, keep reading because distributions during retirement are where you’ll see this tax scenario flip.
Here are some other Roth 401(k) pros and cons to consider.
Distributions During Retirement
If you’ve contributed to a Roth 401(k) and are ready to take out distributions, they’ll come out tax-free. If you contributed $100,000 in after-tax money to your Roth 401(k), the $100,000 plus any gains would become tax-free distributions during retirement.
While contributions into a traditional 401(k) are tax-free, you’ll have to pay taxes on distributions at your income level during retirement.
Understanding what your potential future income level might be would help in deciding which retirement account to choose. If you are mid-career and near the peak of your earnings, a traditional 401(k) can be beneficial since contributions will be tax-free. During retirement, your income tax bracket will be lower. Distributions during retirement will be taxed at this lower level. The overall result is a net saving in taxes.
For those just starting out in their career and on the lower end of their earnings potential, a Roth 401(k) can be advantageous. Yes, you’ll pay taxes on contributions, but at your lower tax rate. Then as your income increases and you near your peak earnings, you can switch over and start contributing to a traditional 401(k).
Also, take into consideration that it’s not only your income level that will change years from now, but possibly tax brackets. We can’t know what might happen with tax brackets or tax percentages. With a Roth 401(k), you don’t have to since distributions aren’t taxed.
Required minimum distributions (RMDs) for both types of accounts occur at age 70 1/2. You can roll your Roth 401(k) funds into a Roth IRA if you want to avoid RMDs. A Roth IRA does not require RMDs.
Both a Roth 401(k) and a traditional 401(k) can take advantage of any company match. For the Roth 401(k), company match distributions are taxed. A company match doesn’t change anything for traditional 401(k) distributions since they are taxed regardless.
Restrictions and Income Contribution Limits
For 2021, 401(k) contribution limits are the same for both types of accounts: $19,500 (or $26,000 if you’re over 50). There are no income restrictions for contributing to a Roth 401(k).
There are some restrictions you’ll want to be aware of. Otherwise, you’ll find yourself paying some hefty penalties. For the Roth 401(k), you’ll need to have held the account for at least five years before taking any distributions. Distributions can start occurring at age 59 1/2, but the five-year restriction still applies. Distributions are also available due to disability or death.
For a traditional 401(k), distributions can occur at 59 1/2 years of age. You'll pay a 10% penalty if you're under 59 1/2 and take distributions.
If you’re considering estate planning, a Roth 401(k) can be beneficial to your heirs. If you’ve met the five-years-held minimum, your heirs won’t have to pay income taxes on any distributions from an inherited Roth.
Making the Right Choice
If you can’t decide between a Roth 401(k) and a traditional 401(k), don’t worry because you don’t have to. You can split the difference and contribute to both account types. This can also be convenient for those who may have fluctuating income through their career.
Contributing to a Roth 401(k) when you’re young isn’t a hard and fast rule. From Charles Schwab’s website, they make a good case for those in their 40s, 50s and 60s saying “even if you end up in a lower income tax bracket when you retire, withdrawals from your traditional retirement accounts could potentially kick you into a higher tax bracket.” They continue, “That could increase your tax bill—including potential taxes on Social Security benefits—and may reduce your disposable income. Higher taxable income could also increase the costs of your Medicare B premiums in retirement. So giving up the tax deduction now may be well worth having tax-free withdrawals later on.”
You can also always discuss your situation with a financial advisor, especially if your finances are complex. An advisor will be able to answer questions and provide explanations on why one scenario may be better than another.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.