Editor’s Note: this article is a follow up to a previous article listed in the twentythirtyfree.com ‘poor’sonal finance catalogue: (Should You Invest In A 401(k) or IRA (And What Is the Difference Between Them?) is the article leading into this one. The follow-up article in question has been guest-authored by Nate Matherson; a millennial, a lover of personal finance, and the co-creator of a site called lendedu.com.
This article concerns the difference between a Roth 401(k) and a Regular 401(k).
The Roth 401(k) vs. a Regular 401(k).
When you save for retirement, it’s a good idea to do so in an account that provides tax advantages. One of the most popular tax-advantaged retirement accounts is a 401(k). 401(k) accounts are offered by employers (although the self-employed can set up a solo 401(k) too) and there are two different types: Roth 401(k)s and traditional 401(k)s.
While both Roth and traditional 401(k)s provide tax benefits, the tax savings comes at different times – so you need to understand both accounts to know which is right for you.
How Does a Roth vs. Traditional 401(k) Work?
With both a traditional and Roth 401(k), you can sign up with your employer’s plan and have contributions withdrawn directly from your paycheck. You’re allowed to contribute up to annual limits, which are $19,000 in 2019 (or $25,000 if you’re over the age of 50 and eligible to make catch-up contributions of up to $6,000 annually).
This $19,000 or $25,000 limit is an aggregate limit for both Roth and traditional 401(k)s. In other words, you can’t contribute $19,000 to a traditional 401(k) and $19,000 to a Roth 401(k). You have to select one or the other – or could split your contributions and contribute some money to each, up to the maximum combined limit.
When you make these contributions, they come with tax benefits. If you contribute to a traditional 401(k), the tax benefit comes up front when you make the contribution. If you contribute $19,000 in 2019, your taxable income is reduced by $19,000 and you do not pay taxes on the $19,000 you put into your account.
When you contribute to a Roth 401(k), on the other hand, you contribute with after-tax dollars. You do not get a tax benefit in the year you make the contribution. But, you benefit from tax-free growth and are able to withdraw funds from your Roth 401(k) in retirement without paying any income taxes on the money you take out.
Both account types may come with non-tax benefits like the ability to borrow, employer matched funds, and must comply with the Employer Retirement Income Security Act.
Is a Traditional or Roth 401(k) Better?
It’s a tough choice to decide whether to contribute to a traditional or Roth 401(k) as there are benefits to both.
Some people prefer the up-front tax savings a traditional 401(k) provides and, in fact, might not be able to afford to save as much without the immediate tax break. Others would rather defer their tax savings and like the fact they’re effectively able to save more for retirement because their Roth 401(k) balance will be worth more later since they don’t have to worry about taxes being taken out of it.
(Read More: The Three Major Benefits of Adopting an Investing Mindset After You Retire).
Roth 401(k)s can also be rolled into a Roth IRA without incurring taxes. When your money is in a Roth 401(k), you aren’t required to take required minimum distributions after the age of 70 ½. If you’re not sure what RMDs are, you may not know why this matters – but RMDs are required distributions you have to make from a traditional 401(k) after you hit age 70 ½.
The government makes you start taking money out – even if you don’t need it – just so you have to pay taxes on it. This can make your income higher than you’d like it to be as a senior, raising your tax bill and potentially making more of your Social Security benefits subject to taxation.
How to Decide Between a Traditional or Roth 401(k).
When you’re contributing to either a traditional or a Roth 401(k), you’re making a smart financial choice for your future. But, if you’re not sure how to decide between them, some key things to consider include:
1. Whether you could afford to contribute without an up-front tax break: If you can’t afford to put much money away in a 401(k) without getting tax breaks now, you’re likely better off with a traditional 401(k) so you can at least maximize the money you’re saving for the future.
2. Whether you think you’ll pay a higher tax rate now or later: If you suspect you’ll be taxed at a much higher rate as a senior, you’re better off with a Roth 401(k) since you’ll be able to avoid having your future income taxed at this high rate. But, if you think your tax rate will go down once you’ve retired, you’re better off getting the tax break now and paying taxes on less income at your current higher rate.
3. Whether you want to avoid RMDs: If you don’t want to have to take out money on the government’s required schedule, you’re better off with a Roth 401(k) that you can later roll over to a Roth IRA. If you’re torn, you could also opt to simply contribute some of your retirement money to both
accounts so you benefit from tax breaks both now and later.
—
Editor’s Note: Another shout-out of thanks to Nate Matherson of lendedu.com for providing the content for this week’s guest-post.
Let’s crush our dreams together.
SC.
