The key distinction between a Traditional 401k vs Roth 401k is when your employer-sponsored retirement plan is taxed. You contribute after-tax money to a Roth 401(k), and you can withdraw it tax-free once you reach retirement age. Traditional 401(k)s allow you to make pre-tax contributions, but you’ll have to pay income tax on the payouts you receive when you retire.
The number of programs that provide a Roth 401(k) has increased dramatically in the previous five years. A Roth option is now available in about three out of four company retirement plans, which is fantastic news for you!
Younger savers are beginning to take advantage of this new option and the tax benefits that come with it (no surprises here). In fact, Gen Z is now the most likely generation to contribute to a Roth 401(k) at work (14%).
What are your thoughts? Which should you choose if you have a choice between a traditional 401k vs Roth 401k at work? Let’s look at the distinctions between these solutions so you can make the best decision possible.
What is a Roth 401k?
The Roth 401(k), like the standard 401(k), is a form of retirement savings plan that firms offer to their employees. Contributions to a Roth 401(k) are made after taxes have been deducted from your paycheck. As a result, the money you put into your Roth 401(k) grows tax-free, and you’ll be able to take tax-free distributions when you retire. It’s a reason to rejoice whenever the words “tax” and “free” appear in the same phrase!
In 2006, the Roth 401(k) was introduced, combining the greatest aspects of both the standard 401(k) and the Roth IRA. Just like a typical 401(k), you can take advantage of a company match on your contributions if your employer offers one (k). Furthermore, the Roth component of a Roth 401(k) allows you to make tax-free withdrawals.
Traditional 401k VS Roth 401k: Similarities
Let’s start with the similarities between a standard 401(k) and a Roth 401(k).
First and foremost, as previously said, these are both workplace retirement savings choices. Contributions to either sort of 401(k) are deducted automatically from your paycheck. Who said retirement planning was difficult?
Second, both plans often involve a matching contribution from the firm. Approximately 86 percent of firms with a 401(k) match employee contributions. If your workplace offers a match, take advantage of it. Your boss is providing you with free money!
Third, the contribution maximum is the same for both types of 401(k)s. You can save up to $20,500 per year in your account in 2022 (or $27,000 if you’re over 50). When compared to the Roth IRA’s contribution maximum of $6,000 per year, the ability to invest that much every year is a big benefit of either type of 401(k).
The Roth 401(k) shares many of the same benefits as a traditional 401(k), but that’s where the similarities end. Let’s take a look at some of the significant distinctions between these two retirement savings strategies.
Traditional 401k VS Roth 401k: Major Differences
|Traditional 401k||Roth 401k|
|Tax treatment of contributions||Contributions are made before taxes, so your current adjusted gross income is reduced.||Contributions are made after taxes, so they have no impact on your current adjusted gross income. Employer matching funds must be deposited into a pre-tax account and dispersed before being taxed.|
|Tax treatment of withdrawals||Retirement distributions are taxed as ordinary income.||In retirement, there are no taxes on qualifying distributions.|
|Withdrawal rules||Contribution and earned withdrawals are taxed. If you accept distributions before the age of 59.5, you may be punished unless you meet one of the IRS exceptions.||Withdrawals of contributions and earnings are tax-free as long as the IRS considers the payout qualified: The account has been open for at least five years, and the distribution is as follows:|
Which is Best for You? Traditional 401k VS Roth 401k
This decision is based on how you wish to deposit and withdraw funds from your account. Let’s start with putting money in today.
Choose a Roth 401(k) if you’d rather pay taxes now and be done with them, or if you believe your tax rate will be greater in retirement than it is now. By paying taxes on that money now, you’re protecting yourself from a possible increase in tax rates after you retire, even if your taxable income drops, potentially putting you in a lower tax bracket.
You’ll also have access to a larger pool of money in retirement: $100,000 in a Roth 401(k) is $100,000, but $100,000 in a standard 401(k) is $100,000 less the taxes you’ll have to pay on each distribution.
In exchange, because Roth 401(k) contributions are made after taxes rather than before, they will cut your paycheck more than standard 401(k) contributions. If you want to lower your taxable income now or defer taxes until retirement because you think your tax rate will go down, a regular 401(k) is the way to go.
However, keep in mind that:
- You’re deferring those taxes until a period when your income and tax rates are both unknown, and your income and tax rates may be higher if you improve in your job and earn more.
- You must invest the tax savings from each year’s traditional 401(k) contribution if you want the after-tax value of your traditional 401(k) to equal that of a Roth 401(k). See our study on the Roth IRA benefit, which also applies here, for more information.
- If you can’t or won’t invest your tax savings, which could be significant, the Roth 401(k) is a suitable option for people in high tax brackets making maximum contributions.
Finally, remember that you can divide the difference and contribute to both accounts. You can also transfer between them at any time during your career or the year if your plan permits it. Using two accounts in retirement can help to diversify your tax status, which is always a good thing.