How is a traditional 401(k) different from a Roth 401(k)? Most individuals are confused about the two, and that is fair. They sound quite similar and have multiple things in common, but they also have significant differences. Nowadays, Roth alternatives have become available to most people, with three out of four workplaces offering a Roth 401(k) option.
The biggest difference between these two retirement plans is that the Roth investment plan allows the contributors to make their contributions after taxation. This allows them to receive their withdrawals tax-free during retirement. On the other hand, traditional 401(k) plans allow only taxable withdrawals. This means that you can make tax-free contributions before your salary is taxed.
When it comes down to the traditional 401(k) vs. a Roth 401(k), which one should you choose? The concepts below dig deeper into similarities, benefits, and differences between the two retirement account options to help you make your decision.
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The Main Differences Between a Traditional 401(k) & Roth 401(k)
The biggest difference between a traditional 401(k) and a Roth 401(k) is how the cash you contribute is taxed. With a Roth 401(k), you’re contributing to a post-tax retirement savings account. This means that you’re putting money in that’s already been taxed. So, it's one less thing you have to worry about when you retire.
A traditional 401(k) account is a pre-tax account. When you contribute to the account, the money isn’t taxed until you take it out during retirement. While this might sound like a hassle when you’re reaching 60 and forget that they have to tax that cash, it’s actually a great way to lower your taxable revenue each year in order to avoid paying more in taxes right now.
Now, let's look at the differences between the two in terms of their contributions, withdrawals, and access.
Contributions
As mentioned, with a Roth 401(k), you’re contributing with money that has already been taxed. This implies that you’re paying the tax now and will ultimately be going home with less money in your paycheck.
However, when you contribute to a traditional 401(k), your contributions are deducted from your gross income before taxing their salary. Now, what about the contribution limits for a traditional 401(k) vs. a Roth 401(k)? They’re the same. You can contribute a maximum of $19,500 in 2021 to both accounts (if you’re over 50, you can contribute an additional $6,500).
Despite the fact that you have to pay taxes now, a Roth 401(k) is still recommended over a traditional 401(k) for young millennials. Let's find out why.
Withdrawals in Retirement
The major advantage of a Roth 401(k) is that since you’ve already paid taxes on your contributions, withdrawals you make after retirement aren’t taxed. On the contrary, when you pay into a traditional 401(k), you’ll eventually have to pay taxes on that money when you withdraw based on your current tax bracket at the age you retire.
So, assuming you’ve been able to save one million dollars by the time you retire, if you’ve invested in a Roth 401(k) then you’ll be able to receive that full $1 million. However, if you invested in a traditional 401(k) then you’ll have to pay taxes on that. Because most people are in higher tax brackets when they’re reaching 60, we could say that your tax rate is 22%. This means that you’d have to pay $220,000 in taxes on your entire retirement savings.
A retirement nest egg can last longer, obviously, without tax deductions, which makes a Roth 401(k) a great option for younger earners who will be able to contribute to the account now at a lower tax rate.
Access
Individuals using traditional 401(k) can start accessing their money at 59 ½ years of age. Similarly, individuals using Roth 401(k) can start accessing the money at the same age, except they must have held the account for at least five years.
It’s important to note, however, that because your contributions to a Roth 401(k) were made after taxes, you can withdraw your initial contributions at any age without penalty. However, if you withdraw any gains you’ve made before the age of 59 ½, you’ll have to pay a penalty, usually 10%.
Benefits of a Traditional 401(k) Plan
Tax-Free Contributions
If you invest in a 401(k) plan, you are eligible to make pretax contributions towards your investment directly from your paycheck before income taxes are taxed on your salary. This puts your taxable income in a lower tax bracket, meaning you will owe less federal taxes.
Contributions Boosts
Some employers tend to offer contribution matching to their employees that invest in a traditional 401(k) plan. If you’re serious about contributing to your account each year, this can drastically increase your overall account balance over time.
Benefits of a Roth 401(k) Plan
Tax-Free Withdrawals
Taxed contributions towards investment in a Roth plan may be painful, but this guarantees you a more significant cut of your withdrawals in retirement as they will not be taxable.
Emergency Funds
Roth plans allow you to make withdrawals at any age during any time without attracting a penalty or tax. The only time you’ll receive a penalty for withdrawing before the age of 59 ½ is if you’re trying to withdraw gains you’ve made on the account. This is a huge advantage, especially when a need for emergency funds comes up immediately.
While both plans have their advantages and drawbacks, these factors are more felt when you factor in the age of the person contributing to the account. For young contributors, let’s discuss why the Roth plan is likely a better solution.
The Best Option for Young Millennials? A Roth 401(k)
Withdrawals from a Roth 401(k) account are guaranteed at any particular age. However, you have to have had the account for at least five years. This is not the case with a traditional 401(k) account. With those, you can only start making withdrawals at 59 ½ without a penalty.
Because younger millennials are further away from retirement, a Roth 401(k) can make more sense. Generally, there’s a higher likelihood they might need to dip into the cash before they are reaching 60.
Furthermore, younger people contributing to their Roth 401(k) investment plans benefit from paying federal income taxes on that money now. They're still in a lower tax bracket so it makes more sense. When they make a significant portion of their contributions in their 20s and 30s, they can avoid heavy taxes when their income levels rise in the future.
Overall, however, the choice depends on both your current and future goals along with your current financial situation. Want to learn more about investing in retirement accounts? What about investing in the stock market as a way to save for the future?
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