When planning for the future and building a nest egg for retirement, it’s important to know the difference between 401k and Roth 401k. While you won’t be limited to these choices, as you can also weigh the benefits between a Roth IRA vs 401k, it’s good to understand the basics between the two most popular company-sponsored retirement plans.
If you already have an IRA, it may be a good time for you to consider converting to a Roth IRA.
In the simplest explanation, the difference between a Roth vs traditional 401k comes down to when you’ll pay tax.
A traditional 401k is an employer-sponsored retirement plan generated with pre-tax money from your salary while a Roth 401k is similar, except it’s funded by post-tax money.
So what are the pros and cons of a Roth 401k vs 401k and which one is the best fit for you?
What is a Roth 401 k?
A Roth 401k is a retirement plan that is funded by post-tax dollars and sponsored by an employer. This type of investment plan is ideal for employees who plan on retiring in a higher tax bracket. The benefit of investing after-tax money now, is that you’ll be paying lower taxes now since your retirement withdrawals will not be taxed again.
Initially developed by the Economic Growth and Tax Relief Reconciliation Act of 2001, Roth 401(k)s are a hybrid plan. They were formulated to take advantage of the employee sponsorship of a traditional 401k and the tax benefits of a Roth IRA.
When it comes to a Roth 401k vs Roth IRA, the Roth 401k makes use of an employer 401k matching plan and has much higher contribution limits than Roth IRAs.
How is a Roth 401k similar to a traditional 401k?
Deciding between a Roth 401k vs 401k can be challenging since they both offer similar features. They are both popular retirement investing schemes that try to minimize the overall tax payment on the plan.
Both plans make use of employer contributions and offer varying tax treatments. However, since it's difficult to speculate the tax rate when someone enters retirement, they might consider opening both types of plans.
What are the primary differences between a Roth 401k vs. 401k?
The primary difference between a Roth 401k vs 401k is when contributions are taxed. If a person plans on retiring in a lower tax bracket or needs access to more liquid funds, then a traditional 401k pre-tax plan might make the most sense. While a traditional 401k will grow tax-free, the deferment ends and is then treated as normal income once the fund is accessed for withdrawal. This ordinary income is then taxed at the current rate.
A Roth 401k takes this tax-treatment and flips it. As contributions are put towards the fund, it is done so post-tax. As the plan grows and begins generating earnings, once withdrawals start, it is done so tax-free.
When it comes down to pre tax vs Roth, the best course for someone is to plan where they will be financially in the future and decide if it makes more sense to pay taxes now or later.
One thing to consider is that by implementing a traditional 401k plan, it’s possible to drop your earned income into a lower tax bracket, which may add to potential savings.
Figuring out your retirement account is just one facet of your overall retirement plan. Check in to see if your retirement plan is on track.
Which option is best for you?
Whether the best retirement plan is Roth, pre tax, or a separate IRA boils down to the greatest savings on taxes.
When deciding between Roth vs 401k saving plans, several factors need to be addressed.
- What are the terms of a company’s employer-match scheme?
- Is a higher contribution limit necessary?
- What are the penalties for early withdrawals?
- Is the potential for company advancement high?
- Will you have the option to convert a traditional 401k to a Roth 401k at a later date?
While these are not the only aspects that need to be taken into account, they offer a baseline of where to begin.
The main factor that will determine the best option is a person's current and future financial standing. If a twenty-something enters a company with a strong potential for advancement, a Roth 401k may be the best option. This is because they can foresee a possibility of retiring in a higher tax bracket and may have fewer financial responsibilities at this stage in their life.
Conversely, someone over 30 might benefit from a traditional 401k as a Roth 401k has greater limitations on when you can withdraw from the fund. Typically, a Roth 401k needs a minimum of five years maturation before it can be accessed even with fees.
Still have questions?
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