Do you have a 401(k) with both a Roth and traditional option? Do you ever wonder which you should choose to contribute to and why? How do you even know if you’re allowed to choose both? In this blog, we are going to cover Roth 401(k) vs traditional 401(k). We will explain both the similarities and differences between Roth and traditional 401(k) and when you might want to choose each option.
What is a 401(k)?
A 401(k) is a type of retirement plan that is offered through an employer. It allows for employee deferrals, meaning money comes out of the employee paycheck and goes straight into the 401(k) account. Many 401(k)s also offer matching contributions in which an employer matches, up to a certain limit, the amount of money the employee puts in. This match is often in the form of a percentage of salary.
For example, if your employer offers a 401(k) with a 100% match up to 3% of salary, this means if you put 3% of your salary into your 401(k), your employer will add that same amount out of their pocket into your 401(k). If your employer offers a 50% match up to 7%, this means you need to put in a full 7% of your salary to receive the full match of 3.5% from the employer (50% of 7).
Some employers do flat contributions, in which they add a set amount to the account and the employee doesn’t need to add money to receive it. However your employer does their contributions, it is important to ensure you are getting the maximum amount of “free” money offered to you by contributing at least the amount needed to receive the match.
Roth 401(k) vs Traditional 401(k)
Now that you have the 401(k) basics down, let’s get into Roth 401(k) vs traditional 401(k). Your employer may offer both options for you, and you can decide how to save your money. The biggest difference between a traditional 401(k) and a Roth 401(k) is how the money that you contribute is taxed. Let’s go through a couple of examples.
What is a traditional 401(k)?
A traditional 401(k) is a retirement account that grows tax-deferred. This means the money is taken from your paycheck before income taxes are withheld, so when it is added to the account, no taxes have been paid on it yet. The money will grow in that account tax-deferred, and you will pay taxes on both the growth and contributions at the time of withdrawal. This lowers your taxable income currently but creates taxable money in retirement.
For example, If your salary is $100,000 and you contribute 10% of your salary to a traditional 401(k), then you get a $10,000 tax deduction. So in your W-2, instead of your total wages appearing as $100,000, they will appear as $90,000 since you contributed $10,000 to your traditional 401(k). This means that your taxable income will be lower and your taxes will be lower. However, when you retire and withdraw that money, every dollar that you withdraw from that traditional 401(k), you have to pay federal taxes (and maybe state taxes).
What is a Roth 401(k)?
A Roth 401(k) is a retirement account that grows tax-free. By choosing Roth, you are choosing to pay income tax on the Roth 401(k) contributions now. Your money then grows in that account until retirement, and the growth comes out completely tax-free when you make qualified withdrawals. This keeps your tax bill today the same but lowers your tax bill in retirement.
With the Roth 401(k), you don’t get any tax deductions upfront. However, when you retire and withdraw all of that money that you’ve accumulated, you pay $0 in taxes. Let me illustrate to you the potential power of a Roth 401(k). Let’s say you contribute $10,000 each year to a Roth 401(k) for a total of 30 years and you made an average of 7% return per year. At the end of 30 years, you’ve accumulated close to $1,000,000 and all of that is tax-free.
One thing to keep in mind is that regardless of which type of contribution you decide to make, employer contributions to your retirement account will always be traditional. This is because no taxes have been paid on that money when it gets added.
Who is eligible for a Roth 401(k)?
This is where Roth 401(k)s can be a great tool to have in your financial toolbox. Anyone can contribute to a Roth 401(k), regardless of income, if the employer offers Roth as an option. There are no income restrictions to be eligible to contribute to a Roth 401(k).
Can you do both a Roth 401(k) and a Traditional 401(k)?
You can contribute to both a Roth 401(k) and a traditional 401(k) at the same time. There are limits to these accounts though, and those limits are aggregate. You can’t max out both a Roth 401(k) and a traditional 401(k). The yearly maximum limit is combined between both accounts.
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Roth 401(k) and Traditional 401(k) Contribution Limits 2023
The contribution limit for Roth 401(k) and traditional 401(k) for 2023 is the same. You can defer $22,500 out of your paycheck into a traditional 401(k) if you are under age 50, and $30,000 per year if you are 50 or older. Alternatively, you can contribute $22,500 to your Roth account if you are under 50, and $30,000 if you are 50 or older.
Remember though, you can’t max out both. The combined contribution limit for both accounts for 2023 is $22,500. As long as the total amount of contributions between these two types of accounts does not exceed $22,500 (or $30,000), you are able to have both types. For example, if you are under 50 and you contribute $15,000 into your Roth account, this leaves $7,500 that you can contribute to your traditional 401(k).
401(k) vs Roth 401(k): Required Minimum Distributions (RMDs)
At the moment, Roth 401(k)s and traditional 401(k) are subject to the required minimum distribution (RMD). Therefore, the account owner must start taking RMDs from her Roth 401(k) for the year in which she reaches age 70½ and continue for every year thereafter.
However, starting in 2024, RMDs will no longer be required for Roth 401(k) accounts. This change is part of the SECURE 2.0 Act of 2022. No RMDs for Roth 401(k)s means that you can leave the money in the account and let it grow tax-free.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.