401(k) vs. Roth 401(k): Which One Is Better?
- March 30, 2022
- by Angela
In this article, I will talk about two retirement plans - 401(k) and 401(k) Rorth. At first glance they seem to be the same because they have 401(k) in their name, but in fact, there are big differences between them. To know what the differences are between them and which is better for your situation read on…
What is a Roth 401(k)?
The Roth 401(k) pension savings plan was designed in 2006 and consists of a combination of the characteristics of two savings pension plans - the traditional 401(k) and the Roth IRA.
A Roth 401(k) retirement savings allows you to make contributions after taxes are taken out, and when you retire you withdraw money without paying any taxes on the initial balance and any growth.
What Are the Similarities Between a Traditional 401(k) and a Roth 401(k)?
There are four similarities between these two retirement savings plans:
- Both retirement savings plans are offered through your employer. You elect to contribute a portion of your wages each pay period and the employer transfers it to your account.
- Both can have an employer match or company gifting. What does this mean? With the employer match, your employer will match a part of your contribution up to a certain percentage of your wages. If your employer offers you this plan, be sure to accept it, it is like getting a raise for free.
- Both 401(k) accounts (Roth and Traditional) have the same contribution limit, which is shared. In 2022, the contribution limit is $20,500 per year, and if you are over 50, then the contribution limit is $27,000 per year. You can contribute to either type of account in the same year, but the total contributions in that year cannot exceed these amounts.
- The selection of investments is generally the same between the two plans and the money may even be pooled together in the same account. The plan administrator will track which money is pre-tax (Traditional) and which money is post-tax (Roth) and your statement will show the breakdown.
401(k) vs. Roth 401(k): How Are They Different?
The biggest difference between these two retirement plans is in the way they are taxed.
Roth 401(k) is a savings account after tax. This means that your contributions will be taxed before you contribute.
Unlike the Roth 401(k) the traditional 401(k) is a pre-tax savings account. This means that your taxes will be reduced when the contribution is made.
Roth 401(k) vs 401(k)
Made after-tax, which means you paying taxes on that money (it counts as income)
Contributions are paid before taxes (reduces your taxable income), but you pay taxes when you retire.
No taxes on withdrawals of the initial balance or any growth
All withdrawals will be taxed at the usual rate of income tax (counts as income in the year you take it out).
After 5 years, you may withdraw the contributions. At 59 ½ full access.
Penalty-free withdrawals at 59 1/2 years, no matter how long you have 401(k).
Contributions to a Roth 401(k) count as taxable income. That means your salary is reduced by the contribution, plus the taxes. For example, let’s say you earn $100,000 per year and are in the 30% overall tax bracket. If you contribute $10,000 to your Roth 401(k), you would need to earn $14,286 to cover both the taxes and the contribution.
Contributions to a Traditional 401(k) are a tax deductible, so if you contribute $10,000 you only need to earn $10,000. At that point, your taxes are reduced by $3,000 since your taxable income is reduced to $90,000. In essence, the government has allowed you to avoid paying taxes on the $10,000 as an incentive to save.
The Traditional 401(k) is a much better option than the Roth 401(k) if your tax rate will be lower during retirement. However, the Roth 401(k) is better if you think your tax rate will increase during retirement. Having a bit of both can provide flexibility in terms of how much taxable income you will have in retirement.
In 2022, the contribution limit is $20,500 per year, and if you are over 50, then the contribution limit is $27,000 per year.
Withdrawals in Retirement
There are big differences in withdrawals between these two types of retirement accounts.
When you retire, and you take money out of your Roth 401(k) you pay zero taxes. That is because you already paid taxes on the contributions, and any growth in the account is also tax free. That is a really nice feeling.
On the other hand, if you have a 401(k) you will have to pay tax on the amount you withdraw based on your retirement tax rate. That can hurt, but if your tax rate while you were earning was 30%, and your tax rate in retirement is 10% that is a nice win. With a Traditional 401(k) you are getting a subsidy from the government in the form of a tax break, and then letting that tax break “ride” until retirement.
Some advocate for Roth since the taxes are “done”. Others advocate for Traditional since you can make bigger contributions due to the subsidy effect. It is up to you how you want to approach it. With the Traditional 401(k) you maximize net worth and minimize taxes in the short term which is good, especially if your luck taxes a turn for the worse. Having a little or both types of accounts also doesn’t hurt and can offer some extra flexibility later on.
Access and Doubling as an Emergency Fund
Another difference between Roth 401(k) and 401(k) depends on your age, and if you already have an emergency fund.
If you are getting close to retirement, the 401(k) might be better because you can access it at 59 1/2 years old no matter how long you have had the account.
On the other hand, with a Roth you have to wait 5 years to access the money without penalty no matter your age.
Once a Roth account has been open for 5 years, it can double as an emergency fund since the contributions are available to you without penalty. That is a rather advanced approach to your emergency fund and isn’t right for everybody. The goal is to keep your retirement contributions in the retirement account until retirement and not pull them out early…
Who Is Eligible for a Roth 401(k)?
If your employer offers you this option, then you are set. Not all employer sponsored retirement plans offer this option. However it is becoming more popular all the time.
If your employer does not offer a Roth option you can check into using an Individual Roth account to make this type of contribution.
How Much Should I Invest in a Roth 401(k)?
How much to save is totally up to you. Some advocate for maxing out your retirement contributions if you are able.
Others say to save at least 15% of your salary. This means that if you have $75,000 in annual earnings you would set aside $11,250 or $937.5 per month.
What Kinds of Funds Should I Choose for My Roth 401(k)?
There will likely be many choices, life path funds, stock funds, bond funds, international funds, stable value funds, etc… For more on these, see our post on asset allocation - what you can bet on. Aside from what to invest in, a major concert is investment fees, so review not only the fund options but also their expense ratios when it comes to making a decision. The lower the fees the higher the compound rate you will enjoy on your investments.
If you have no idea what any of these mean, make sure to talk to a financial advisor. They will give you the best advice and will help you sleep well at night knowing you made an informed choice.
Should I Roll Over My Traditional 401(k) to a Roth 401(k)?
Rolling from a Traditional to a Roth incurs a tax hit on the balance. You should only do this if you fully understand the consequences of recharacterizing the money.
For example, if you want to transfer $100,000 and your tax rate is 25%, you would owe $25,000 in taxes on the transfer. You would also be showing $100,000 in income for that year. That can complicate other tax benefits that are dependent on income, such as the all important ACA subsidies. Recharacterizing only makes sense if you have a detailed plan and you are sure the reduction in your nest egg is worth it.
Talk With an Investment Pro About Your 401(k)
It is best to consult a financial expert (typically available for free through your employer’s retirement plan) to get concrete advice on the fund options and the best place to invest your money given your age, family, desired asset allocation, and overall financial situation.
If you want to get rid of paying taxes when you retire, the better option is Roth 401(k), because you will pay taxes only while you are employed. When you retire, you will have money at your disposal without having to pay taxes. However, if you want to minimize taxes now and maximize how much you can put away, the Traditional 401(k) is a better option. Having a blend of both isn’t a bad idea either.