When planning for retirement, you may be wondering which retirement vehicle is best for you and your financial situation: a traditional 401(k) or a Roth 401(k)?
A 401(k) is a retirement plan offered by an employer where qualified employees make recurring contributions from their pre-tax income. If you want to know more about 401(k)s, check out: Here are 3 Important Things to Know About Your 401(k).
Meanwhile, Roth 401(k)s are similar to regular 401(k)s except that you make after-tax contributions to a Roth account and are allowed tax-free withdrawals at the time of retirement.
Roth 401(k)s are becoming increasingly popular thanks to easier access. People keen on saving are taking full advantage of this. Per a Transamerica Annual Retirement Survey 2016 report, when given an option, six in 10 workers chose to contribute to Roth 401(k)s.
Let’s take a quick look at what differentiates traditional 401(k)s from Roth 401(k)s.
Contributions
The most striking difference between a traditional 401(k) and a Roth 401(k) is how the money you contribute is taxed. A traditional 401(k) is a pretax savings account where contributions are made before they’re taxed. Thus, it reduces your current adjusted gross income.
Meanwhile, a Roth 401(k) is a post-tax retirement savings account where contributions are made after taxes. Thus, it has no impact on current adjusted gross income. Moreover, employer matching dollars go into a pre-tax account and are taxed at the time of distribution.
Withdrawals
In traditional 401(k)s, withdrawals are taxed as ordinary income based on your current tax rate at retirement.
With Roth 401(k)s, you don’t need to pay taxes on qualified distributions in retirement. However, only employer matches to your Roth 401(k), if any, will still be taxable at the time of retirement.
Let’s take a look at the following table to understand the withdrawal system better:
Access & Early Withdrawal Penalties
A traditional 401(k) allows you to have penalty-free access to your money when you reach 59 ½ years of age.
However, you need to maintain a Roth 401(k) account for at least five years before you withdraw money. So, if you are 57 years old and are planning to start a Roth 401(k), you need to keep in mind that you will not be able to access it for a locking period of five years.
Also, if one chooses to withdraw funds from a traditional 401(k) account prior to turning 59 ½, they face a 10% penalty on whatever distribution they take. Meanwhile, for Roth 401(k) accounts, the early withdrawal penalty of 10% is on investment earnings only. [Quick tip: One may save themselves from paying penalties by instead opting for a loan from his Roth 401(k) and repaying it on time.]
Required Minimum Distributions
One must begin taking required minimum distributions, or RMDs, after turning 70½ from traditional and Roth 401(k)s. However, you may roll your Roth 401(k) funds into a Roth IRA to avoid RMDs. This is particularly helpful when you are planning tax-free distributions for your heirs.
Traditional or Roth 401(k): Which Should You Choose?
Deciding between these two retirement accounts really depends on your age. Let’s consider a scenario where you are young and ambitious and feel that you will retire in a higher tax bracket. In such a situation, think about maxing out your Roth 401(k) contributions. Thus, if your tax rate rises, your savings will be worth more at the time of retirement.
However, if you see yourself in a lower tax bracket at retirement, you should consider contributing to a traditional 401(k).
Because it is hard to predict tax rates, hedging yourself against changing tax rates by parking money in both traditional and Roth 401(k) accounts is something to consider.
It’s also advisable to invest tax savings from each year’s contribution if you are opting for a traditional 401(k). This will help you to match a Roth 401(k) and after-tax value of a traditional 401(k).
But if it’s not possible to invest tax savings, a Roth 401(k) is a wise choice, especially for individuals who make maximum contributions and fall in a high tax bracket.
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401(k) vs. Roth 401(k): What You Need to Know
When planning for retirement, you may be wondering which retirement vehicle is best for you and your financial situation: a traditional 401(k) or a Roth 401(k)?
A 401(k) is a retirement plan offered by an employer where qualified employees make recurring contributions from their pre-tax income. If you want to know more about 401(k)s, check out: Here are 3 Important Things to Know About Your 401(k).
Meanwhile, Roth 401(k)s are similar to regular 401(k)s except that you make after-tax contributions to a Roth account and are allowed tax-free withdrawals at the time of retirement.
Roth 401(k)s are becoming increasingly popular thanks to easier access. People keen on saving are taking full advantage of this. Per a Transamerica Annual Retirement Survey 2016 report, when given an option, six in 10 workers chose to contribute to Roth 401(k)s.
Let’s take a quick look at what differentiates traditional 401(k)s from Roth 401(k)s.
Contributions
The most striking difference between a traditional 401(k) and a Roth 401(k) is how the money you contribute is taxed. A traditional 401(k) is a pretax savings account where contributions are made before they’re taxed. Thus, it reduces your current adjusted gross income.
Meanwhile, a Roth 401(k) is a post-tax retirement savings account where contributions are made after taxes. Thus, it has no impact on current adjusted gross income. Moreover, employer matching dollars go into a pre-tax account and are taxed at the time of distribution.
Withdrawals
In traditional 401(k)s, withdrawals are taxed as ordinary income based on your current tax rate at retirement.
With Roth 401(k)s, you don’t need to pay taxes on qualified distributions in retirement. However, only employer matches to your Roth 401(k), if any, will still be taxable at the time of retirement.
Let’s take a look at the following table to understand the withdrawal system better:
Access & Early Withdrawal Penalties
A traditional 401(k) allows you to have penalty-free access to your money when you reach 59 ½ years of age.
However, you need to maintain a Roth 401(k) account for at least five years before you withdraw money. So, if you are 57 years old and are planning to start a Roth 401(k), you need to keep in mind that you will not be able to access it for a locking period of five years.
Also, if one chooses to withdraw funds from a traditional 401(k) account prior to turning 59 ½, they face a 10% penalty on whatever distribution they take. Meanwhile, for Roth 401(k) accounts, the early withdrawal penalty of 10% is on investment earnings only. [Quick tip: One may save themselves from paying penalties by instead opting for a loan from his Roth 401(k) and repaying it on time.]
Required Minimum Distributions
One must begin taking required minimum distributions, or RMDs, after turning 70½ from traditional and Roth 401(k)s. However, you may roll your Roth 401(k) funds into a Roth IRA to avoid RMDs. This is particularly helpful when you are planning tax-free distributions for your heirs.
Traditional or Roth 401(k): Which Should You Choose?
Deciding between these two retirement accounts really depends on your age. Let’s consider a scenario where you are young and ambitious and feel that you will retire in a higher tax bracket. In such a situation, think about maxing out your Roth 401(k) contributions. Thus, if your tax rate rises, your savings will be worth more at the time of retirement.
However, if you see yourself in a lower tax bracket at retirement, you should consider contributing to a traditional 401(k).
Because it is hard to predict tax rates, hedging yourself against changing tax rates by parking money in both traditional and Roth 401(k) accounts is something to consider.
It’s also advisable to invest tax savings from each year’s contribution if you are opting for a traditional 401(k). This will help you to match a Roth 401(k) and after-tax value of a traditional 401(k).
But if it’s not possible to invest tax savings, a Roth 401(k) is a wise choice, especially for individuals who make maximum contributions and fall in a high tax bracket.
A Simple Way to Build Wealth
No matter what your financial goals are, investing in quality stocks is an option worth considering. Stocks have produced better returns than other kinds of investments over the years and generated significant wealth for shareholders. If you're interested in stocks but you're nervous about picking the right ones, Zacks can help. Our research team makes it simple to find long-term buys with long-term wealth-building potential. Starting today, you can see our private selection of stocks priced under $10, Warren Buffett-style value picks, dividend stocks and more. Click here for your sneak peak >>