Roth 401k vs 401k: Which One Should You Choose?

roth-401k-vs-401k-fi

Everyone knows about the 401k plan, but did you know that it comes in two varieties? The 401(k)’s cousin, known as Roth 401(k), is becoming more and more prominent in recent years.

Each of these options offers various advantages, presenting workers with a real dilemma about which option to choose. While making the decision can be surprisingly complicated, both options can present a way to pave your future. 

In this blog post, we discuss Roth 401(k) vs 401(k) to provide you with an idea of which plan will work best for you.

 

What Is a Traditional 401(k)?

Usually referred to as simply 401(k), the traditional 401(k) is the first version of this plan. It allows you to make contributions using pre-tax dollars, so you don’t have to pay taxes for the money you’ve contributed. 

In this way, your tax break can come sooner instead of later. The traditional 401(k) allows you to enjoy deferred taxes made from your investment gains. 

This means that your money is only taxed once it comes out of your account. Using this option lets you avoid taxes from your earnings, such as capital dividends and gains, until retirement, when you decide to withdraw them from the account. 

 

What is a Roth 401(k)?

This is a relatively new plan, allowing workers to follow a different type of tax break. Through this plan, you can make your contributions with money after-tax, which means you won’t be enjoying a tax break soon. 

Rather, you can look forward to the tax-free money that you withdraw for retirement. Apart from tax-free growth on your investment gains, other perks with a Roth 401(k) include tax-free withdrawals. 

Moreover, you won’t need to pay taxes on money that comes out of your account; the only downside to this plan is that withdrawals can only be done during retirement.

This means that you can only make withdrawals after the age of 59 ½, where the only exceptions are qualified first-time homebuyers or economic hardship.

 

How the Traditional 401(k) and Roth 401(k) are Similar 

Here are just a few similarities that the traditional 401(k) and a Roth 401(k) share. 

  • Both serve workers as retirement savings options. Both kinds of 401(k) plans can help you enjoy the convenience of getting the contribution taken out of your paycheck. 
  • Both types may include a company match. Around 86% of companies offering a 401(k) or something similar can provide employee contributions with a match. If you work in a company that can offer a match, be sure to take it — this means your employer is giving free money. 
  • The next thing they have in common is that they share the same contribution limit. Starting in 2022, the contribution limit will be set at $20,500 per year, which increases to $27,000 for those over the age of 50. Such opportunities are a great perk to both types of 401(k), allowing you to invest a relatively large sum of money. This is especially true when compared to the contribution limit of $6,000 per year with Roth IRA. 

 

How the Traditional 401(k) and Roth 401(k) are Different 

As already discussed, these two kinds of 401(k)s may have similarities, but they also have key differences.

Each offers a different type of tax advantage, which makes it much harder for workers to choose the right plan. 

Below is a breakdown of these differences.

 

Traditional 401(k)

Roth 401(k)

Contributions 

Under a traditional 401(k), contributions are made through pre-tax income. This means that you won’t be taxed for your income in the current year.

With the Roth 401(k), contributions are made through after-tax income. So you won’t be able to get a tax break for the current tax year. 

Retirement Withdrawals 

After the age of 59 ½, withdrawals as a retiree are treated as regular income.

Withdrawals during retirement are tax-free. 

Employer Match

Under the traditional 401(k), employer matches may be available. 

Under the Roth 401(k), employer matches may also be available. However, it is treated as a contribution to a pre-tax account. 

Required Minimum Distributions 

Yes, starting at age 72.

Yes, starting at age 72. However, money can be rolled into a Roth IRA. 

This will allow you to avoid distributions and pass the money onto your heirs. 

Penalties 

A 10% bonus penalty from the full withdrawal amount can be levied as a result of early withdrawal. 

A 10% bonus penalty from any earnings may be levied as a result of early withdrawal. 

Tax Treatment of Contributions

A traditional 401(k) reduces your current adjusted gross income since contributions are made before tax. 

Contributions are made after taxes, so there’s no effect on the current adjusted gross income. 

Withdrawal Rules 

Both earnings and withdrawals of contributions are taxed. Distributions may also be penalized if withdrawn before the age of 59 ½ unless an exception by the IRS is met. 

Earnings and contributions aren’t taxed, provided that the distribution is qualified by the IRS. One such qualification is that the account has been held for over five years with the distribution: 

  • Made on or after age 59 ½ 
  • Due to death or disability 

Furthermore, contributions can’t be withdrawn at any time. 

 

While these are some of the most obvious differences, the choice between these two options will ultimately come down to your individual financial situation.

Here are a few more tips on which type is best for you and your needs.

 

Which is Better for You: Traditional 401(k) or Roth 401(k)?

This question can only be answered after reflecting on your individual situation. In a lot of cases, the Roth 401(k) can work well, but the traditional 401(k) is just as good for others. 

Because the future is so uncertain, it means that you will need to do a lot of research regarding trends to figure out where you will be better off.

 

According to experts, if we had the right details to go on with regards to our future earnings, career trajectory, and future tax rates, one can simply contribute to a 401(k). 

 

Unfortunately, we can’t really find out such pieces of information for sure, which is why there are various plans available to us.

Luckily, there are a few situations that can help us determine whether or not you’re better off picking one over the other based on your current standings and where you expect to be in the future.

 

When the Roth 401(k) Might Work for You

Here are just a few instances where the Roth 401(k) could be a better option:

  1. You Already Have a Traditional 401(k) - If you’re currently funding a traditional 401(k), it only makes sense to add a Roth plan as well. Doing so will help you to safeguard your investments by not having everything in just one basket, even if it makes sense right now. This is a great idea, since having both 401(k) plans can offer you flexibility once you retire. Having the option to withdraw between a source that’s both pre-tax and after-tax will surely work to your advantage. Taking this step will allow you to get more out of your investments while avoiding getting into a higher tax bracket. By only putting money in a traditional 401(k), you won’t have as much flexibility, and you’ll need to provide the required minimum distributions
  2. If You Want to Eliminate RMDs - While both a traditional 401(k) and a Roth 401(k) have a required minimum distribution, the Roth will let you skip the RMD without having to pay extra taxes. With a Roth IRA, you won’t ever have to take a distribution and there are also other key areas of differences between a Roth IRA and a Roth 401(k). Moreover, converting your traditional 401(k) to a traditional IRA won’t provide the same results. You won’t be able to avoid RMDs in this way and you won’t be able to convert that account into a Roth IRA without having to pay huge taxes. 
  3. You’re in a Low Tax Bracket - Experts recommend for people in a low tax bracket who are expecting to reach a higher tax bracket later to get a Roth 401(k). A low bracket is classified as being taxed at a federal level of 12% or lower. If you’re able to pay your taxes at 12% today in order to avoid paying taxes at 25% in the future, a Roth 401(k) is a great deal. There are even cases where this option can make sense for people in higher brackets if they’re expecting an even bigger income in the next few years. 
  1. You’re Expecting Tax Rates to Rise - If you’re not expecting to earn more, you might be expecting tax to increase throughout the country, which can make the Roth 401(k) a better choice. Throughout the pandemic, the country has experienced some of the lowest tax rates in history. With the huge debt the country has already amassed, along with the money the government has been providing during the COVID-19 crisis, tax rates will likely be higher. However, there is still uncertainty in such predictions, especially due to political conflicts. 

 

When the Traditional 401(k) Might Work for You

Below are a few situations when a traditional 401(k) could be better for you:

  1. You’re in a High Tax Bracket - A traditional 401(k) will give you a tax break on contributions you make today, so it only makes sense to use those breaks, especially if your tax costs are high. If you happen to be in the highest tax bracket at 37%, and you feel that you’ll be earning less as you get closer to retirement, then the best option is to contribute on a pre-tax basis. However, this will only make sense if you have enough discipline to take the savings you’ve made from your traditional 401(k) distributions and put it into savings too. If you aren’t disciplined enough to invest the tax savings from your traditional 401(k), then it’s best to put your investments in a tax-free Roth plan since this will save you more money in the long run.
  2. A Roth 401(k) Can’t Give You Matching Contributions - Some employers don’t offer matching contributions for 401(k) plans at all. Fortunately, other employers offer such perks for traditional 401(k) plans due to the benefits that tax laws get from the traditional plans. They’re unable to receive a tax benefit, so some employers don’t provide a match on Roth 401(k) contributions, according to experts. In this case, you can make use of the traditional 401(k) to get a match, where you can switch to the Roth 401(k) at a later time. Using this strategy will allow you to get the benefits of employer matching — something that advisers universally agree is the best thing you can do for yourself. At the same time, you can also place early-year contributions to your traditional plan.

 

Grow and Invest With Us 

If you’re still undecided for the victor in the fight between Roth 401(k) vs 401(k), then consult our team at 121 Financial Credit Union. Serving members all over Jacksonville, FL, and the surrounding areas, we offer financial services such as investments, loans, and more. 

As leaders in the industry, we’re the financial advisor that everyone trusts, where 121 FCU is your one-stop-shop for everything

Back to Blog

Related Articles

Saving for Retirement: Preparing in your 20's, 30's, and 40's

For some, saving for retirement can be an intimidating subject. Then, add in talk of investing, and...

How to Save for Retirement without a 401k: 5 Alternative Ways

Our work’s value is seen in the lives we lead and the ability to secure our future and that of our...

Ronald McDonald House 4th Annual Deck the Doors presented by 121FCU

121 Financial Credit Union is joining the community in making the holidays extra special for...