Are you trying to decide between contributing to a Roth 401(k) or a traditional 401(k)? You’re not alone! Retirement planning can be confusing, and when it comes down to choosing the right investment account, many of us are left feeling uncertain about which option is best for our financial situation. But fear not.

We’ll break down the difference between a Roth vs. a Traditional 401(K) and highlight some key pros and cons of each type of plan that will make it easier for you to decide which one could provide you with greater future wealth accumulation capabilities. So buckle up and deeply dive into these popular retirement accounts.

Roth vs. Traditional 401(k)s

At their core, Roth and traditional 401(k)s are similar in many ways. Both accounts let you set aside pre-tax income for retirement savings and provide tax benefits. For instance, with both types of accounts, contributions made are excluded from your taxable income, potentially reducing the amount of taxes you pay annually.

The biggest difference between a Roth 401(k) and a traditional 401(k) is when the money gets taxed – now or later on. With a traditional 401(k), you get an up-front tax break because contributions are taken out of your paycheck before taxes have been calculated; but then, when it comes time to withdraw that money in retirement, it’ll be taxed as regular income.

Considerations to Take into Account when Choosing a Retirement Plan

When deciding between a Roth or traditional 401(k), one of the biggest considerations is your current income level; if you’re in a lower tax bracket now, you may benefit more from the up-front tax break offered by a traditional 401(k). However, if you anticipate being in a higher tax bracket when it comes time to withdraw that money for retirement, contributing to a Roth 401(k) could be the better option since withdrawals are tax-free.

Another factor to consider is whether or not your employer matches contributions. Many employers will match employee contributions up to certain limits; however, with Roth accounts, those matches would be made after taxes have been calculated, which could reduce the amount of money you receive.

Advantages and Disadvantages of Roth 401(k) Plans

Advantages

• Tax-Free Withdrawals: Roth 401(k) contributions are made after taxes have been calculated, so all withdrawals taken in retirement will be tax-free (assuming you meet the 5-year holding period).
• No Required Minimum Distributions: Unlike traditional 401(k) accounts, Roth 401(k)s do not require you to start taking distributions at age 70 ½. This means you can leave the money invested and continue compounding your gains for longer periods.
• Penalty-Free Access to Funds: If you need access to funds before retirement (for instance, if you’re changing jobs or experiencing financial hardship), you can take a penalty-free withdrawal from your Roth 401(k).
• Contribute After-Tax Money: Unlike traditional 401(k)s, Roth 401(k)s allow you to contribute after-tax money, which can be beneficial if you have already maxed out your pre-tax contribution limits.
• Access to Funds During Retirement: With a Roth 401(k), you can access funds during retirement without worrying about taxes or penalties – as long as it meets certain criteria.

Disadvantages

• Contributions are Made After Tax: You don’t get the immediate tax break from pre-tax contributions since contributions are made after taxes have been calculated.
• Employer Matching Contributions are Taxed as Regular Income: Many employers match employee contributions up to certain limits; however, with Roth accounts, those matches would be made after taxes have been calculated, which could potentially reduce the amount of money you receive in comparison to a traditional account.
• Limited Access to Funds Before Retirement: Unlike traditional 401(k)s, Roth 401(k)s generally do not allow for early withdrawal without penalty before age 59 ½. If you need access to funds before retirement, you’ll be subject to a 10% penalty and taxes on any distribution before meeting certain criteria.
• Contribution Limits are Lower: In 2020, the overall contribution limit for 401(k)s is $19,500; however, Roth 401(k)s have a much lower limit of $6,000 (which includes employer contributions). This means that traditional accounts may be a better option if you’re looking to maximize your retirement savings potential in a single year.

Advantages and Disadvantages of Traditional 401(k) Plans

Advantages

• Upfront Tax Benefits: Since contributions are taken out of your paycheck before taxes have been calculated, you receive an immediate tax break with traditional 401(k)s.
• Employer Matching Contributions: Many employers match employee contributions up to certain limits; however, with Roth accounts, those matches would be made after taxes have been calculated, which could reduce the amount of money you receive in comparison to a traditional account.
• Tax-Deferred Growth Potential: Traditional 401(k)s allow for compound growth and appreciation within the account that is not taxed until you withdraw the funds during retirement.
• Access to Funds Before Retirement: Traditional 401(k)s generally allow for early withdrawal without penalty before age 59 ½, so if you need access to funds before retirement, a traditional 401(k) may be the better option.
• No Restrictions on Contribution Limits: Traditional 401(k)s do not have any restrictions regarding contribution limits, so you can maximize your contributions and take advantage of all available tax benefits.

Disadvantages

• Taxable Withdrawals in Retirement: Since contributions are taken out of your paycheck before taxes have been calculated, withdrawals made during retirement will be taxed as regular income.
• Age Restrictions on Access to Funds: For a withdrawal from a traditional 401(k) account to be penalty-free, it must occur after age 59 ½ (or without meeting certain criteria).
• Potentially Lower Investment Returns: Since traditional 401(k)s are subject to taxation, any money withdrawn before retirement is subject to taxes and potential penalties, which can reduce the amount of return an investor receives.
• Investment Options May be Limited: Traditional 401(k) plans typically have limited investment options available, so investors may not be able to diversify their portfolios as much as they would like.

FAQS

Is it better to do a Roth or traditional 401k?

The decision between Roth or traditional 401(k)s ultimately comes down to your needs and financial goals. If you’re looking for an immediate tax break, a traditional 401(k) may be the better option; however, if you think your tax rate will be higher in retirement than it is now, then a Roth 401(k) may be the better choice.

Can I withdraw from Roth 401k?

Yes, you can withdraw from a Roth 401(k) only if the withdrawal meets certain criteria. If withdrawals are made before age 59 ½ (or without specific qualifying conditions), then they are subject to an additional 10% penalty in addition to taxes; however, withdrawals from Roth accounts can be taken out tax and penalty-free as long as the owner meets the 5-year holding period.

What is the maximum Roth 401k contribution?

The maximum contribution amount for a Roth 401(k) in 2020 is $6,000 (which includes employer contributions). This limit is lower than the overall contribution limit for traditional 401(k)s which is $19,500.

Conclusion

The right choice for you depends on your financial situation. Analyzing your income, taxes, and future career trajectory can help determine whether a Roth or traditional 401(k) is best for you. Make sure that whichever option fits well into current and long-term financial goals. This decision is personal, so it’s important to talk to an experienced professional, like a certified financial planner, who can guide you about which works best for achieving your retirement dreams.