Do you have a 401(k) with both a Roth and traditional option? Do you ever wonder which you should choose and why? Or even if you’re allowed to choose both? In this blog, we are going to cover Roth 401(k) vs traditional 401(k). We will cover both the similarities and differences between Roth and traditional 401(k) and explain 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 vs Traditional 401(k)
Now that you have the 401(k) basics down, let’s get into Roth vs traditional 401(k). Your employer may offer both options for you, and you can decide how to save your money. A Roth account grows tax-free. By choosing Roth, you are choosing to pay income tax on the 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.
A traditional 401(k) 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. 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 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.
The contribution limit for these two accounts is the same. You can defer $19,500 out of your paycheck into a traditional 401(k) if you are under age 50, and $26,000 per year if you are 50 or older. Alternatively, you can contribute $19,500 to your Roth 401(k) if you are under 50, and $26,000 if you are 50 or older.
Remember though, you can’t max out both. The combined contribution limit for both accounts is $19,500. As long as the total amount of contributions between these two types of accounts does not exceed $19,500 (or $26,000), you are able to have both types. For example, if you are under 50 and you contribute $15,000 into your Roth 401(k), this leaves $4,500 that you can contribute to your traditional 401(k).
Note: Employer matching or flat contributions do not count against these limits. The limits above are for employee contributions only.
Make sure you don’t make these 401(k) mistakes!
The IRS allows favorable tax treatment in retirement accounts to incentivize people to save for retirement. The IRS also imposes rules on when you can access this money without penalty to dissuade people from using their retirement savings before retirement. The age the IRS allows withdrawals from most retirement accounts is 59.5. Prior to that, without specific circumstances, the IRS imposes certain penalties and taxes on early withdrawals.
Early withdrawal rules of traditional 401(k)s differ slightly from early withdrawals of Roth 401(k)s. None of the money in a traditional account has ever been taxed, so when it comes out, regular income taxes must be paid. In addition to the regular income taxes, an early withdrawal penalty generally applies, this penalty is 10% of the unqualified withdrawal. That’s a large chunk to hand over to the IRS before even seeing your money!
With a Roth 401(k), the money you have put in has already been taxed, so that amount won’t be taxed again. Early withdrawals from a Roth 401(k) are pro-rated though. A portion of your early withdrawal will be a tax-free return of contributions, and the other portion will be an early withdrawal of the growth, which will incur regular income tax with an unqualified withdrawal. Early withdrawals from a Roth 401(k) may also be subject to the 10% tax penalty unless there are specified circumstances.
Click here to see the IRS penalty exceptions.
Should you choose a Roth 401(k) or a traditional 401(k)?
This answer depends on multiple factors. The general rule of thumb is if you think you will be in a higher tax bracket in retirement than you are today, choose Roth. By choosing Roth, you are paying taxes at your current tax rate, and avoiding them at your higher retirement tax rate.
If you think you are currently in a higher tax bracket than you will be in retirement, traditional may be the way to go. This way, you get a tax deduction now while you are in a high bracket, and pay taxes later while in a lower one.
It’s not always easy to figure out which tax bracket you’ll be in once you retire. For one thing, tax rates can change in the future and we have no way of knowing how they will change. For another, we can’t exactly see into the future to know exactly what your retirement income needs will be, we can only estimate based on information we have today.
For this reason, it may be a good idea to have both Roth and traditional money in your retirement portfolio. This will allow you to strategically withdraw traditional money in retirement to allow you to pay taxes in the lower brackets and then supplement your income with the tax-free Roth money. If your employer matches your contributions, you already have traditional retirement money in your account. You may want to consider adding at least some Roth funds so you have options in retirement.
Roth vs Traditional 401k(k)
There are many decisions to be made when it comes to retirement saving and planning. How you invest your money, choosing Roth or traditional, and how much to save are the most important decisions to be made to have a successful retirement. Having a fee-only financial planner who can assist you in making these decisions can help you rest assured knowing you’re on the right track.
If you are interested in the comparison between Roth 401(k) and Roth IRA, then you can read this blog to find out more.
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 middle-class professionals 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.