401k vs. Roth 401k: Which is Better?

When it comes to saving for retirement, there are many options. Two of the most popular are the 401k and the Roth 401k. This guide will compare and contrast these two options and help you decide which is correct. Remember that everyone’s situation is different, so you should speak with a financial advisor for specific advice about what would be best for your needs.

The difference between a Roth 401(k) and a traditional 401(k)

A Roth 401(k) and a traditional 401(k) are two retirement savings plans offered by some employers. The main difference between the two is how contributions and withdrawals are taxed.

In a traditional 401(k), contributions are made with pre-tax dollars, meaning that the money is taken out of your paycheck before taxes are deducted. This reduces your taxable income in the year you make the contribution, and you don’t pay taxes on the money until you withdraw it in retirement. At that time, the money you withdraw is subject to federal income taxes.

In contrast, with a Roth 401(k), contributions are made with after-tax money, so you don’t get a tax break in the year you contribute. However, the money grows tax-free, and when you withdraw it in retirement, you don’t have to pay income tax on it, including any investment gains.

What Are the Similarities Between a Roth 401(k) and a Traditional 401(k)?

A Roth 401(k) and a traditional 401(k) are both retirement savings plans offered by some employers, and they share some similarities. Here are a few:

• Contribution Limits: Both types of 401(k) plans have the same contribution limits set by the IRS. In 2023, the contribution limit is $22,500 for those under 50 years old, and an additional catch-up contribution of $7,500 is allowed for those 50 or older.
• Employer Matching Contributions: Employers may offer matching contributions to both types of plans, which can help increase your savings. The amount and terms of matching contributions will vary by employer.
• Early Withdrawal Penalties: Both plans have penalties for early withdrawals made before age 59 ½. In most cases, you’ll owe a 10% penalty in addition to income taxes on the amount withdrawn.
• Rollover Options: If you leave your job or retire, you may be able to roll over your 401(k) balance into another qualified retirement plan, such as an IRA or another employer’s plan. This option is available for traditional and Roth 401(k) plans.

Key Takeaway

• The difference between a traditional and a Roth 401(k) is when you pay the taxes, now or in the future. 
• A Roth 401(k) benefit provides tax-free income during retirement. 
• If your employer offers a traditional 401(k) and Roth 401(k), consider splitting contributions between the two.
• A Roth IRA annuity’s benefit is tax-free income during retirement for the rest of your life.

Paying The Taxes: Today or Tomorrow?

The difference between a traditional 401(k) and a Roth 401(k) is when you pay the taxes.

Traditional 401(k)

• If you save for retirement with a 401(k) plan, you will contribute money before the money is taxed. This means you get a tax break when you put your income in.
• Your money will grow without paying taxes (tax-deferred) until you withdraw your income.
• If you withdraw money from your account, it is considered ordinary income. You must pay taxes on this money at your current tax rate. Use one of our 401(k) calculators to see.

Roth 401(k)

• With a Roth 401(k), you make your contributions with after-tax dollars without a tax deduction.
• Withdrawals of contributions and earnings are tax-free at 59½, and you’ve held the Roth 401(k) account for five years.

Should I Take The Tax Deduction?

A tax deduction now can seem like a pretty good deal, but you have to think ahead. You may have less money when you retire because of the ever-increasing tax rates. That means that you will need to save more money for your retirement.

If you end up in a lower income tax bracket when you retire, money taken out of your retirement account could make you go into a higher tax bracket. This means more taxes and less money to live off.

When you retire, your Medicare B premiums could be higher. This is because they are based on your taxable income. However, if you give up the deduction now by choosing a Roth 401(k), then when you retire, the withdrawals will be tax-free.

When can I take withdrawals from a 401k and a Roth 401k?

You can generally begin withdrawing from a 401(k) or a Roth 401(k) without penalty at age 59 1/2. However, it would be best to start taking distributions, also known as Required Minimum Distributions (RMDs), from a traditional 401(k) at age 73. If you fail to take the RMD, you may be subject to a 50% penalty on the amount that should have been withdrawn.

For a Roth 401(k), there are no RMD requirements, so you can keep the funds in the account for as long as you like. This can be advantageous if you want to continue growing your retirement savings tax-free for as long as possible.

What Are 401(k) and Roth 401(k) Contribution Limits?

The contribution limits for a 401(k) plan and a Roth 401(k) plan are the same. In 2023, the maximum amount you can contribute to either plan is $22,500 if you are under 50. If you are 50 or older, you can contribute an additional $7,500 in catch-up contributions, bringing the total contribution limit to $30,000.

Should I Roll Over My Traditional 401(k) to a Roth 401(k)?

Some factors to consider when deciding whether to roll over to a Roth 401(k) include the following:

• Current and future tax rates: If you expect your tax rate to be higher in retirement than now, it may make sense to pay the taxes now and convert to a Roth 401(k). On the other hand, if you expect your tax rate to be lower in retirement, it may be better to keep your traditional 401(k) and avoid paying taxes now.
• Investment returns: The longer you have until retirement, the more time your investments have to grow tax-free in a Roth 401(k). If you have several years or decades until retirement, the potential tax-free growth of a Roth 401(k) may be a compelling reason to make the conversion.
• Estate planning: If you leave your retirement assets to heirs, a Roth 401(k) can be more tax-efficient than a traditional 401(k) since your heirs won’t have to pay income taxes on the withdrawals.

Utilizing Both 401(k) and Roth 401(k) Plans At The Same Time

You may be able to have both a traditional 401(k) and a Roth 401(k) and split contributions between the two retirement accounts.

• In 2023, you can contribute up to $22,500 to a 401(k).
• If your employer offers both traditional and Roth, you can split the $22,500 contribution between the two.

What Kinds of Mutual Funds Should I Choose for My 401(k) and Roth 401(k)?

Choosing mutual funds for your 401(k) and Roth 401(k) depends on your financial goals and risk tolerance. However, here are some general guidelines to consider:

• Diversification: It’s essential to choose a mix of mutual funds to diversify across different asset classes, such as stocks, bonds, and real estate investment trusts (REITs). This can help reduce your overall investment risk.
• Expense ratio: Mutual funds charge fees for managing the fund, known as expense ratios. Look for mutual funds with lower expense ratios, as these fees can eat into your returns over time.
• Performance: Look at the historical performance of the mutual fund over several years to determine its track record. Remember that past performance does not guarantee future results, so it’s important to consider other factors when choosing mutual funds.
• Risk level: Consider your risk tolerance when choosing mutual funds. Generally, stocks are riskier than bonds, but they also offer the potential for higher returns over the long term. If you have a long time horizon until retirement, you may be able to take on more risk in your investments.
• Target date funds: Many 401(k) plans offer target date funds, which are mutual funds that automatically adjust their asset allocation as you approach retirement. These can be a good option for those who want a hands-off approach to investing.

What is the difference between a Qualified Distribution from a traditional 401(k) versus a Roth 401(k)?

A Qualified Distribution from a traditional 401(k) and a Roth 401(k) differ in tax treatment.

In a traditional 401(k), contributions are made with pre-tax income, meaning you don’t pay taxes on the money you contribute to the plan. However, when you withdraw in retirement, the money is taxed as income at your current tax rate.

A Qualified Distribution from a traditional 401(k) occurs after age 59 1/2, and you won’t be subject to the early withdrawal penalty of 10%. Additionally, you can withdraw the money without paying taxes if it is used for certain qualified expenses, such as medical or higher education.

On the other hand, in a Roth 401(k), contributions are made with after-tax dollars, meaning you pay taxes on the money you contribute upfront. However, when you withdraw in retirement, the money is tax-free if you meet specific requirements. A Qualified Distribution from a Roth 401(k) occurs after age 59 1/2, and the account has been open for at least five years.

Required Minimum Distributions

It would be best to take a required minimum distribution (RMD) from a Roth 401(k) unless you still work for that employer. After that, you must take RMDs from a traditional 401(k) plan.

SECURE Act 2.0 made a change to the distribution rules. In 2023, individuals not already 72 can take their first RMD at 73. This is different from before when the age was 72.

Tax-Free Retirement Income For The Rest Of Your Life

If your employer does not offer a Roth 401(k), an individual can open a Roth IRA annuity with similar benefits instead. Once the Roth IRA requirements are met, the annuity will distribute a tax-free income for the rest of the retiree’s or married retirees’ lifetimes, even after the Roth IRA annuity has run out of money.

Next Steps

To summarize, regarding retirement savings, both the 401k and the Roth 401k have benefits and drawbacks. It’s important to remember that no one plan is suitable for everyone, so consider your individual needs when deciding what option is best for you. All this being said, getting straightforward advice from a professional can help you determine which type of retirement account would benefit your particular circumstances. If you want tailored financial advice based on your personal retirement goals and risk tolerance, request a free quote from a knowledgeable financial advisor today. With proper planning, you can develop a savings strategy that will enable you to retire comfortably and secure your future.

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