Should You Invest in a Traditional or Roth 401(k)?
If you’ve just landed a new job and have access to a workplace retirement plan like a traditional 401(k) or a Roth 401(k), congratulations: You’re one of the lucky few. Nearly half of Americans don’t have access to retirement plans at work.
But choosing between a traditional 401(k) and a Roth 401(k) isn’t always easy. Depending on your situation, one might shine while the other falls short.
What’s the difference between a traditional 401(k) and Roth 401(k)?
The main difference between a traditional 401(k) and Roth 401(k) is their tax treatment. The money you contribute to a traditional 401(k) lowers your taxable income for the year, and thereby your tax bill. However, your qualified withdrawals will be considered part of your ordinary income for the year and taxed at your current tax rate. Think of it as taking a tax break now as opposed to later.
With a Roth 401(k), your contributions have no effect on your taxable income for the year. But qualified withdrawals are tax-free. So you’d be sacrificing taking a tax break now in exchange for tax-free withdrawals down the road.
If you expect to retire in a higher income tax bracket, a Roth 401(k) could work for you because your withdrawals will be tax-free. But if you think you’ll retire in a lower tax bracket, you might want to lower your taxes during your working years and pay taxes later at a smaller rate through a traditional 401(k).
But there’s more to it than that. Here are some other important points to consider.
|Traditional 401(k)||Roth 401(k)|
|Contributions||Made with pre-tax dollars, meaning contributions are made before taxes are withheld from your paycheck for federal income tax purposes.||Made with after-tax dollars, meaning taxes have already been withheld for income tax purposes.|
|Maximum contributions||In 2022, you can contribute up to $20,500 to a traditional 401(k) or $27,000 if you’re at least 50.||In 2022, you can contribute up to $20,500 to a Roth 401(k) or $27,000 if you’re at least 50.|
|Qualified withdrawals||You can make penalty-free withdrawals at age 59 1/2.||Penalty-free withdrawals are allowed at age 59 1/2 if you’ve been contributing to your account for at least five years.|
|Penalties||Non-qualified withdrawals are taxed at your current income tax rate and may be subject to a 10% penalty.||Ordinary income taxes apply to the non-contribution portion of your withdrawal. A 10% penalty also may apply.|
|Required minimum distributions (RMDs)||You must begin taking RMDs at 72.||RMDs are also required upon turning 72.|
|Employer match||Your company may match your contributions to an extent.||Employer matching contributions are possible, but these must go into a pre-tax account similar to a traditional 401(k)|
Should I invest in a traditional 401(k)?
Most financial experts say you should consider a traditional 401(k) if you expect to retire in a lower income tax bracket. That way, you get immediate tax breaks during your higher-earning years. Even though you’ll owe taxes on your withdrawals, it will theoretically be a smaller hit.
Here’s an example: Say you’re currently in the 35% tax bracket. Contributions of $10,000 for the year in a traditional 401(k) save you $3,500 in income taxes. If you withdraw $10,000 when you retire into the 12% bracket, you would owe just $1,200 in taxes.
But remember: Qualified withdrawals you make in retirement will be added to your earned income. So these can push you into a higher tax bracket even if you retire into a lower one. Not only would that mean a bigger tax bill, but also higher taxes on your Social Security benefits.
Should I invest in a Roth 401(k)?
If you expect to retire in a higher income tax bracket, a Roth 401(k) may be a better bet. As long as you’re at least 59 1/2 and you’ve been contributing to your Roth 401(k) for at least five years, your withdrawals are tax-free.
And since you’ve already paid taxes on your contributions, your Roth withdraws won’t be considered part of your ordinary income. But the main downside to a Roth 401(k) is your contributions don’t lower your taxable income throughout your working years.
What are my other options?
You may find that your 401(k) options come with high fees or no employer matching contributions. Don’t fret. You can always open an individual retirement account (IRA) or Roth IRA.
A traditional IRA functions similarly to a traditional 401(k). Contributions to a traditional IRA lower your taxable income. On the other hand, Roth IRAs don’t lower your taxable income, but allow for tax-free qualified withdrawals.
But unlike Roth 401(k)s, Roth IRAs have some unique advantages. You can withdraw contributions from Roth IRAs tax-free and penalty-free at any time. Roth IRAs also have no required minimum distributions, so your money can keep growing your whole life.
The bottom line
The decision whether to open a traditional 401(k) or Roth 401(k) may come down to timing. If you want immediate tax breaks, a traditional 401(k) could be better. But if you can sacrifice that now in exchange for tax-free withdrawals later, a Roth 401(k) may be right for you.
It’s important to carefully examine each. And if neither suits you, remember you have other options.
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