Which one is better for you?

By Jasmin Steve On Jun 16, 2021

The 401(k) plan comes in two varieties – the Roth 401(k) and the traditional 401(k). Each offers a different type of tax advantage, and choosing the right plan is one of the biggest questions workers have about their 401(k). It can be a surprisingly complicated choice, but many experts prefer the Roth 401(k) because you’ll never pay taxes again on withdrawals.

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Here are some of the key differences:

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Contributions	Contributions are made with pre-tax income, meaning you won’t be taxed on that income in the current year.	Contributions are made with after-tax income, meaning you won’t receive a tax break in the current tax year.
Retirement withdrawals	Withdrawals at retirement (after age 59 1/2 ) are treated as ordinary income.	Withdrawals at retirement are tax-free.
Employer match	An employer match may be available.	An employer match may be available, and is treated as a contribution to a pre-tax account.
Required minimum distributions	Yes, starting at age 72.	Yes, starting at age 72.
Penalties	Yes, a 10 percent bonus penalty may be levied on early withdrawals.	Yes, a 10 percent bonus penalty may be levied on any earnings taken through early withdrawals.

However, the choice depends a lot on your individual financial situation. Here’s what you need to know about each type and why one might be better for your needs.

Contents

The 401(k) plan

The 401(k) is one of the most popular retirement plans around. About 60 million people have one, and they held a collective $6.7 trillion as of Dec. 31, 2020, according to the Investment Company Institute. Their appeal: A 401(k) plan offers a tax-advantaged way to save for retirement, making it easier for you to roll up some dough for the future.

Regardless of which plan you choose, 401(k) plans have some things in common. Some of the most important features include the following:

Tax breaks for contributing, either now or in the future. Read also : Green's Portfolio – May 2021 – Seeking Alpha.
Tax-advantaged growth on your contributions.
Maximum annual contributions of $19,500 (for 2021), with a $6,500 catch-up contribution for those who are age 50 and older.
Potential for employer matching contributions, with your employer kicking in extra money based on your contributions.
10 percent penalties assessed for early withdrawal, with penalty-free withdrawals beginning at age 59 1/2 .
Plans are subject to required minimum distributions (RMDs), meaning after age 72 you have to take a distribution annually.

Either 401(k) plan helps make investing easy, because they withdraw money from your paycheck every two weeks and then invest that in your selected funds. Many participants like the ease of investing this way and report that they never miss the money.

What is a traditional 401(k)?

A traditional 401(k) is the original version of the plan, and is usually referred to simply as a 401(k). This type of plan allows you to make contributions with pre-tax dollars so that you don’t pay taxes on money you contribute. This may interest you : Tips for teenagers on landing a summer job – The Seattle Times. So your tax break comes today, rather than later.

In this 401(k), you’ll also enjoy deferred taxes on your investment gains. Your money is taxed only when it comes out of the account. That means you can avoid taxes on earnings, such as capital gains and dividends, until you withdraw them from the account at retirement.

What is a Roth 401(k)?

A Roth 401(k) is a relatively new addition, and it allows you a different kind of tax break. With a Roth 401(k) you’ll make contributions with after-tax money, so you won’t enjoy a tax break today. In exchange, any money that you withdraw in retirement will be tax-free.

In a Roth 401(k), you’ll enjoy not only tax-deferred growth of your investment gains but also tax-free withdrawals. The reality is that you won’t pay taxes on any money that comes out of the account at all. The lone caveat: the withdrawals must occur in retirement, meaning mainly that it has to be withdrawn after you turn age 59 1/2 , with a few qualified exceptions such as economic hardship, or for qualified first-time homebuyers.

One other key difference occurs if you’re receiving matching funds for a Roth 401(k), which don’t go into the Roth portion of the account. On the same subject : Suze Orman, Warren Buffett and Other Money Experts Weigh In on How To Best Set Yourself Up for Retirement – GOBankingRates.

“Employer contributions go toward your pre-tax 401(k) funds,” says Rob Greenman, CFP, at Vista Capital in Portland, Oregon. “So by electing an employee Roth contribution, you’re getting a mix of both Roth and pre-tax funds.”

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Roth 401(k) vs. traditional 401(k): Which is better?

The question about which 401(k) plan is better depends so much on your individual situation. A Roth 401(k) works well in many cases, but the traditional 401(k) is really good in others. But not knowing the future means you’ll have to do some guesswork about where your life will lead.

“With perfect information about our career trajectory, future earnings, and future tax rates, we’d simply be able to model whether contributing to our 401(k) on a pre-tax or Roth basis was best,” says Roger Ma, founder and financial planner at lifelaidout in New York. “Unfortunately, we don’t know any of that information.”

However, there are a number of situations where you’re better off picking one or the other based on where you are now and what you might expect in the future. Bankrate’s 401(k) calculator can also help you figure out which plan makes the most financial sense for you.

When the Roth 401(k) is better

Here’s when the Roth is probably a better option:

You’re young and in a low tax bracket

“I recommend making Roth contributions when someone is in a low bracket and expecting to later be in a higher tax bracket,” says Mark Wilson, CFP and founder of MILE Wealth Management in Irvine, California. “If you can pay taxes today at 12 percent to avoid paying taxes in the future at 25 percent, this is a good deal.”

Wilson defines a low bracket as being taxed at the federal level of 12 percent or less. “There are cases where Roths can make sense for folks in higher brackets as long as they are expecting even higher incomes in the future,” says Wilson.

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Youth is also a big advantage, allowing money to grow tax-free even longer.

“The younger a person is, the more advantage a Roth can have for them, because they have a longer time for the money to grow,” says Edward J. Snyder, CFP and founder of Oaktree Financial Advisors in Carmel, Indiana. “The younger person is also more likely to be in a lower tax bracket than someone who is mid- to late-career.”

You expect tax rates to rise

Even if you don’t expect to earn more, you might expect tax rates across the country to increase, and such a rise could make the Roth 401(k) more attractive today.

“We are experiencing, as a country, some of the lowest tax rates in our history,” says Alexander Koury, CFP, of Hosler Wealth Management in Phoenix. “Considering the massive debt we already have, plus the trillions of dollars the government is spending to help its citizens through the COVID-19 crisis, it is likely in the future tax rates will be higher.”

Of course, there’s always uncertainty in any projections, especially predicting the political winds.

“The risk is that you may not know your income in the future and you may not know what tax rates will be in the future,” says Marguerita Cheng, CFP and CEO at Blue Ocean Global Wealth in the Washington, D.C. area.

You already have a traditional 401(k)

If you’ve already funded a traditional 401(k), it can make sense to add a Roth plan to the mix. It can actually be valuable to not have all your eggs in one retirement basket, even if it does make the most financial sense today. That’s because having both plans will offer you flexibility later.

“Having money spread out in both pre-tax and Roth accounts gives ‘future you’ more flexibility to better control your tax bracket in retirement,” says Ma.

“They will be able to choose to take withdrawals from sources that are pre-tax, like a traditional 401(k), or after-tax like a Roth 401(k),” says Snyder. “This can help them get more income out of investments and not go into a higher tax bracket.”

“If you only have money in a traditional 401(k), you’ll have less flexibility, as withdrawals will be taxed at your marginal tax rate, and you’ll be subject to required minimum distributions,” says Ma.

“RMDs can have an impact on the taxation of Social Security benefits and Medicare surcharges,” says Greenman.

Exceed certain income thresholds and more of your Social Security check becomes taxable. A mix of accounts can help you avoid this scenario.

You want to avoid RMDs

Both the traditional 401(k) and the Roth 401(k) have required minimum distributions, but the Roth allows you to escape them without a tax penalty.

“While both Roth and traditional 401(k) participants will face RMDs, if they roll funds over to Roth IRA and IRA accounts, the Roth IRA funds have no associated RMDs,” says Greenman.

Inside a Roth IRA, you won’t have to take a distribution ever, and there are other key differences between a Roth 401(k) and Roth IRA.

Meanwhile, converting a traditional 401(k) to a traditional IRA doesn’t help you avoid RMDs, and you can’t convert that account to a Roth IRA without incurring hefty taxes.

When the traditional 401(k) is better

Here’s when the traditional 401(k) plan is probably the better option:

You’re in a high tax bracket and save money

Because the traditional 401(k) gives you a tax break on contributions today, it can make sense to use that break today when your tax costs are high.

“If someone is in the highest tax bracket (37 percent), and they think they will be earning less as they approach retirement, then it may make sense to contribute on a pre-tax basis,” says Ma.

That’s the course of action recommended by Marianela Collado, CFP, at Tobias Financial Advisors in Fort Lauderdale, Florida, but she adds an important stipulation.

“Having said that, even this only makes sense if you are disciplined enough to take the savings associated with making that traditional 401(k) contribution and you save that, too,” says Collado.

Collado says that if you’re not disciplined enough to invest that tax savings from the traditional 401(k), “then the tax-free growth [in a Roth] will far outweigh what you could’ve accumulated in a traditional plan on an after-tax basis.”

You can’t get matching contributions on a Roth 401(k)

Some employers don’t offer matching contributions for 401(k) plans at all. However, some subset of employers provide this perk for traditional 401(k) plans only – but not Roth 401(k) plans, because of how tax laws benefit these traditional plans.

“Some employers do not match on Roth 401(k) contributions, because they are unable to get the tax benefit,” says Marc Schindler, owner of Pivot Point Advisors in the Houston area. “If this is the case, the worker can utilize the regular 401(k) to capture the match and then switch to the Roth later in the year.”

Using Schindler’s strategy you can still capture the full employer matching – which advisers universally agree is the thing you must do – with early-year contributions to a traditional plan.

Can I contribute to both a 401(k) and a Roth 401(k)?

If you want to take advantage of the benefits of a traditional 401(k) and a Roth 401(k), you can do so. For example, you could make contributions for the first half of the year into the Roth version to take advantage of its tax-free withdrawals in retirement and use the second half of the year to get benefits from the traditional 401(k) plan’s tax breaks on contributions. Or you could alternate years, using the Roth plan one year and the traditional plan the next. Either way, your plan’s administrator will track and categorize your contributions appropriately for tax purposes.

Regardless of which 401(k) plan you choose – or if you choose both – your total contributions in any single year are limited to the annual maximum. That maximum does not include any employer match on your contributions, however. So the match counts as a bonus above and beyond your own personal contributions.

Bottom line

The choice between a traditional 401(k) and a Roth 401(k) can depend on a lot of factors that are specific to your individual financial situation. While the experts love the Roth 401(k) for its many tax benefits, you’ll have to decide whether that makes sense for your needs and future.