If you’ve just landed a new job and have access to a workplace retirement plan like a traditional 401 (k) or Roth 401 (k), congratulations – you’re one of the lucky few. Nearly half of Americans do not have access to occupational retirement plans.
But choosing between a traditional 401 (k) and a Roth 401 (k) isn’t always easy. Depending on your situation, one might shine while the other isn’t up to par.
What’s the difference between a traditional 401 (k) and a Roth 401 (k)?
The main difference between a traditional 401 (k) and a Roth 401 (k) is their tax treatment. The money you contribute to a traditional 401 (k) reduces your taxable income for the year and therefore your tax account. However, your qualified withdrawals will be considered part of your ordinary income for the year and taxed at the current tax rate. Think of it as taking a tax break now instead of later.
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With a Roth 401 (k), your contributions have no effect on the year’s taxable income. But qualified withdrawals are tax free. So you would sacrifice a tax break now in exchange for tax-free withdrawals down the road.
If you plan to retire on a higher income tax bracket, a Roth 401 (k) might work for you because your withdrawals will be tax free. But if you plan to retire with a lower tax bracket, you may want to lower your taxes during your working years and pay your taxes later at a lower rate through a traditional 401 (k).
But there is more. Here are some other important points to consider.
|Traditional 401 (k)||Roth 401 (k)|
|Contributions||Made with pre-tax dollars, which means contributions are paid before taxes are withheld from your paycheck for federal income tax purposes.||Made with after-tax dollars, which means that taxes have already been withheld for income tax purposes.|
|Maximum contributions||In 2022, you can contribute up to $ 20,500 to a traditional 401 (k) or $ 27,000 if you’re 50 or older.||In 2022, you can contribute up to $ 20,500 to a Roth 401 (k) or $ 27,000 if you’re at least 50.|
|Qualified withdrawals||You can make withdrawals without penalty at the age of 59 1/2.||Penalty-free withdrawals are allowed at the age of 59 1/2 if you’ve contributed to your account for at least five years.|
|Sanctions||Unqualified withdrawals are taxed at the current income tax rate and may be subject to a 10% penalty.||Ordinary income taxes apply to the non-contributory part of the withdrawal. A 10% penalty may also be applied.|
|Minimum Deployments Required (RMD)||You need to start taking RMD at 72.||RMDs are also required at the age of 72.|
|Correspondence from the employer||Your company may match your contributions to some extent.||Matching employer contributions are possible, but these must be paid into a pre-tax account similar to a traditional 401 (k)|
Should I invest in a traditional 401 (k)?
Most financial experts say you should consider a traditional 401 (k) if you plan to retire in a lower income tax bracket. This way you will get immediate tax breaks during your years with higher earnings. Even if you will have to pay taxes on your withdrawals, it will theoretically be less of a hit.
Here’s an example: Let’s say you’re currently in the 35% tax bracket. Contributions of $ 10,000 for the year on a traditional 401 (k) save you $ 3,500 in income taxes. If you withdraw $ 10,000 when you withdraw into the 12% bracket, you should only have $ 1,200 in tax.
But remember: the qualified withdrawals you make in retirement will be added to your earned income. So these can push you into a higher tax bracket even if you retire in a lower one. Not only would this mean a higher tax burden, but also higher taxes on social security benefits.
Should I Invest in a Roth 401 (k)?
If you plan to retire on a higher income tax bracket, a Roth 401 (k) might be a better bet. As long as you are at least 59 1/2 and have contributed to your Roth 401 (k) for at least five years, your withdrawals are tax free.
And since you’ve already paid taxes on your contributions, your Roth withdrawals won’t be considered part of your ordinary income. But the main downside to a Roth 401 (k) is that your contributions don’t reduce your taxable income during your working years.
What are my other options?
You may find that your 401 (k) options have high commissions or no matching employer contributions. Don’t worry. You can always open an Individual Retirement Account (IRA) or Roth IRA.
A traditional IRA works in a similar way to a traditional 401 (k). Contributions to a traditional IRA reduce taxable income. On the other hand, Roth IRAs do not reduce taxable income, but allow qualified tax-free withdrawals.
But unlike the Roth 401 (k) s, the Roth IRAs have some unique advantages. You can withdraw contributions from Roth IRAs tax-free and penalty-free at any time. Additionally, Roth IRAs have no required minimum distributions, so your money can continue to grow throughout your life.
The bottom line
The decision on whether to open a traditional 401 (k) or a Roth 401 (k) can depend on timing. If you want immediate tax breaks, a traditional 401 (k) might be better. But if you can sacrifice it now in exchange for tax-free withdrawals later, a Roth 401 (k) might be for you.
It is important to examine them carefully. And if neither of you suits you, remember that you have other options.
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