Retirement takes money, and it’s never too early to begin planning. The 401(k) plan is one of the most popular ways to save for retirement. 67% of private industry workers have access to 401(k) plans. If your employer offers several types of plans, you may have to make a decision: Roth 401(k) vs traditional 401(k).
If you’re facing this decision, here’s what you need to know.
What Is a 401(k) and How Does It Work?
A 401(k) is a tax-advantaged retirement account that is designed to help Americans save for retirement. They’re offered as an employee benefit by employers, so you need to work for an employer that offers the plan to start using one.
In general, you can deposit up to $20,500 per year to your 401(k). You make contributions through deductions from your paycheck. Your employer can also make contributions on your behalf, often as matching funds based on how much you personally contribute.
When you put money into a 401(k), you restrict your access to it until you reach retirement age. That usually means age 59 ½, though you can access it earlier in some circumstances. Withdrawing money outside of these special circumstances means paying a penalty.
In exchange for these restrictions, the government offers tax benefits to savers. That’s where the difference between a Roth 401(k) vs. a traditional 401(k) comes into play.
Roth 401(k) vs. Traditional 401(k)
Roth 401(k)s and Traditional 401(k)s have one very important difference: the tax incentives they provide.
With traditional 401(k)s, the more common of the two, you can deduct the money you contribute to the account from your income when you file your tax return at the end of the year. That means that contributing money reduces your current tax bill.
In exchange, when you withdraw money from a traditional 401(k) in retirement, those withdrawals are treated and taxed as regular income.
Imagine you have a taxable income of $50,000.
You decide to contribute $5,000 to your traditional 401(k). You get to report a taxable income of just $45,000 when you file your tax return, which ultimately lowers your tax bill by $1,100.
In effect, it cost you $3,900 to save $5,000 for retirement. At higher incomes, the savings are even greater due to higher tax rates.
Ultimately, traditional 401(k)s defer your taxes to retirement. Because many people have less income in retirement and are in a lower tax bracket, this is a good deal.
With a Roth 401(k), you do not get to deduct contributions from your income. You pay taxes on them as usual.
In exchange, you do not pay any taxes on the money you withdraw in retirement whether you withdraw principal or earnings from the account. That means that you pay taxes upfront to avoid taxes in the future. That can be a big advantage if you wind up in a higher tax bracket in retirement.
Early Withdrawal Penalties
One other important difference between traditional and Roth 401(k)s is the early withdrawal penalty.
With a traditional 401(k), you can’t withdraw any funds from the account, except under select circumstances, without triggering penalties.
Outside of those select circumstances, Roth 401(k)s allow you to withdraw contributions, but not earnings without penalty. However, you don’t get to choose whether you’re withdrawing contributions or earnings.
Your withdrawal is prorated between the two based on your account balance and withdrawal amount so you’ll likely pay some penalties and taxes, just not to the same extent as you would with a traditional 401(k).
If you contributed $8,000 to a Roth 401(k) and that money has earned $2,000, leaving your balance at $10,000, any early withdrawals you make will be treated as 80% contributions and 20% earnings.
You’ll pay tax and a 10% penalty on 20% of the money you withdraw.
This makes Roth 401(k)s slightly more flexible than traditional 401(k)s, but you still want to avoid making early withdrawals whenever possible.
Roth 401(k) vs. Traditional 401(k): Which Is Better for You?
Choosing whether to use a traditional or Roth 401(k) requires good prediction skills, both when it comes to your personal situation and the US Tax Code.
A traditional 401(k) defers taxes. If you have a high tax rate now and will be in a lower tax bracket during retirement, you’ll pay less tax overall. Most people assume this will be the case for them because retirees tend to have lower incomes than working people and current tax brackets cause rates to increase with income.
Roth 401(k)s involve paying taxes now to avoid them later. If you’re in a low tax bracket now and expect to be in a higher one in retirement, paying taxes now will save you money in the long run.
Put simply, traditional 401(k)s are good for high earners while Roth 401(k)s are good for lower-income people.
However, changes to tax rates and brackets also play a role. If the government decides to raise everyone’s taxes, regardless of income, a Roth 401(k) becomes a better deal for everyone. If taxes get reduced, a traditional 401(k) would have been the better choice.
Barring unexpected and significant changes to how the United States taxes its citizens, most people will likely be better off with a traditional 401(k). The exceptions are people who are low-income and in the low income and in the 10% or possible 12% tax bracket or taking advantage of the Savers’ Credit.
You may also consider using both types of accounts, contributing to a Roth 401(k) when you’re young and your income is relatively low and moving to a traditional account later in your career when your income is higher.
