401(k) vs. Roth 401(k): Which One Is Better?
11 MINUTE READ
Trust me, if you want to make the most of your retirement savings, you need to understand those differences and how they affect you. So I’m going to break it down for you, question by question. This is your future we’re talking about, so that’s why understanding the difference between a traditional 401(k) and Roth 401(k) is important.
Access to a Roth 401(k) is becoming more and more common, so you’re in the majority if you have this option at work. Over half of companies who offer some type of retirement savings plan offer a Roth 401(k). The bigger the company, the more likely it is you can contribute to a Roth 401(k).
And guess what? Savers (no surprises here!) are taking advantage of this new option. Among workers who know about the Roth 401(k) and are offered it by their workplace, around six in 10 choose to contribute to it.
If you can contribute to a Roth 401(k) and a traditional 401(k) at work, which one should you choose? I know which one I would pick, but let’s dig into some of the differences between these options so you can make the best decision.
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What is a Roth 401(k)?
The Roth 401(k) is a type of retirement savings plan that allows you to make contributions after taxes have been taken out. Then, you receive tax-free withdrawals when you retire.
The Roth 401(k) was introduced in 2006 and was designed to combine features from the traditional 401(k) and the Roth IRA. With a Roth 401(k) you can take advantage of the company match on your contributions, if your employer offers one, just like a traditional 401(k). And the Roth component of a Roth 401(k) gives you the benefit of tax-free withdrawals.
What Are the Similarities Between a Traditional 401(k) and a Roth 401(k)?
Let’s start with what a traditional 401(k) and a Roth 401(k) have in common.
First, these are both workplace retirement savings options. With either type of 401(k) plan, you can enjoy the convenience of having the contribution drafted out of your paycheck.
Second, both a traditional 401(k) and a Roth 401(k) have the ability to include a company match. Nearly 80% of companies who offer a 401(k) or similar product offer a match on employee contributions.3 If you work at a place that offers a match, take it. Your employer is giving you free money!
Third, both types have the same contribution limit. In 2018, the contribution limit is $18,500 per year or $24,500 if you’re over 50. The opportunity to invest that much every year is a huge perk of traditional and Roth 401(k)s, especially when compared to the Roth IRA’s contribution limit of $5,500 per year.
The Roth 401(k) includes some of the best features of a 401(k)—convenient contribution methods and the possibility of a company match if your employer offers one. But that’s where their similarities end. Let’s dig into the distinct differences between these two retirement savings options.
401(k) vs. Roth 401(k): How are They Different?
The biggest difference between a traditional 401(k) and a Roth 401(k) is how the money you contribute is taxed. I know taxes can be confusing (not to mention a pain to pay!), so let’s start with a simple definition and then we’ll dive into the details.
A Roth 401(k) is a post-tax retirement savings account. That means your contributions have already been taxed before they enter your Roth 401(k) account.
On the other hand, a traditional 401(k) is a pretax savings account. When you invest in a traditional 401(k), your contributions go in before they’re taxed, which makes your taxable income lower.
How do those definitions play out when it comes to your retirement savings? Let’s start with your contributions.
With a Roth 401(k), your money goes in after-tax. That means you’re paying taxes now and taking home a little less in your paycheck.
When you contribute to a traditional 401(k), your contributions are pretax. They’re taken off the top of your gross earnings before your paycheck is taxed.
You may be wondering why anyone would contribute to a Roth 401(k) if it means paying taxes now. If you only look at the contributions, that’s a fair question. But hang with me. The huge benefit of a Roth 401(k) is what happens when you start withdrawing money in retirement.
Withdrawals in Retirement
The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free. Any employer match in your Roth 401(k) will still be taxable in retirement, but the money you put in—and its growth!—is all yours. No taxes will be taken out when you use that money in retirement.
By contrast, if you have a traditional 401(k), you’ll have to pay taxes on the amount you withdraw based on your current tax rate at retirement.
Here’s what that means: Let’s say you have $1 million in your nest egg when you retire. That’s a pretty nice stash! If you’ve got it in invested in a Roth 401(k), that $1 million is yours.
If $1 million is in a traditional 401(k), you’ll pay taxes on your withdrawals in retirement. If you’re in the 22% tax bracket, that would mean $220,000 of that $1 million is going to taxes. That’s a hard pill to swallow, especially after you’ve worked so hard to build your nest egg!
It goes without saying that your nest egg will last longer if you’re not paying taxes on your withdrawals. That’s a great feature of the Roth 401(k)—and a Roth IRA too for that matter.
Another slight difference between a Roth 401(k) and a traditional 401(k) is your access to the money. In a traditional 401(k), you can start receiving distributions at age 59 1/2. With a Roth 401(k), you can start withdrawing money without penalty at the same age, but you also must have held the account for five years.
If you’re still decades away from retirement, you don’t have anything to worry about! But if you’re approaching the 59 1/2 year mark and thinking about starting a Roth 401(k), it’s important to be aware that you won’t have access to the money for five years.
Why I Recommend the Roth 401(k)
If you’re investing consistently every month—whether it’s in a Roth 401(k), a traditional 401(k) or even a Roth IRA—you’re already on the right track! The most important part of wealth building is consistent saving every month, no matter what the market is doing.
But if I’m choosing between a traditional 401(k) and a Roth 401(k), I’d go with the Roth 401(k) every time! We’ve already talked through the differences between these two types of accounts, so you’re probably already seeing the benefits. But just to be clear, here are the biggest reasons the Roth 401(k) comes out on top.
It may be tempting to delay paying taxes so you can get slightly more in your paycheck now. I get that. But think about it this way: You’re already doing the hard work of saving for retirement. If you can get that money to go even further, wouldn’t you want to take advantage of that opportunity? I don’t know about you, but I want to make that money go as far as I can.
Here’s another thing to consider: No one can know how the tax brackets or tax percentages will change in the future, especially if you’re still decades away from retirement. Do you want to take that risk? I don’t.
Like it or not, it’s hard to separate emotions from investing. Imagine getting to your retirement years and watching your $1 million-dollar nest egg reduced to less than $800,000 because of taxes! I don’t know about you, but I’d much rather pay taxes now than see all that money fly out of my hands later. I’m going to miss $100,000 a lot more than I miss a $100 on a paycheck now.
I promise, if you can get into the habit of contributing 15% of every paycheck to your Roth 401(k) early on, you won’t even miss the money you’re paying in taxes. And when you get the retirement, you’ll be glad you don’t owe the government part of your hard-earned nest egg.
Who Is Eligible for a Roth 401(k)?
If your employer offers it, you’re eligible. Unlike a Roth IRA, a Roth 401(k) has no income limits. That’s a fantastic feature of the Roth 401(k). No matter how much money you earn, you can contribute to a Roth 401(k).
If you don’t have access to a Roth 401(k) at work, you can still take advantage of the Roth benefits by working with your investing pro to open a Roth IRA. Just keep in mind that income limits do apply when you contribute to a Roth IRA.
What Are Roth 401(k) Contribution Limits?
For 2018, the 401(k) contribution limit is $18,500. This contribution limit applies to any 401(k) contributions, whether they are in a Roth 401(k) or a traditional 401(k). That means if you’re contributing to both, the combined total of your contributions can’t exceed $18,500.4
If you’re 50 or above, the contribution limit increases to $24,500.
How Much Should I Invest in a Roth 401(k)?
I recommend investing 15% of your income into retirement savings. If you have a Roth 401(k) at work with good mutual fund options, you can invest your entire 15% there. Let’s say you make $60,000 a year. That means you would invest $750 a month in your Roth 401(k). See? Investing for the future is easier than you thought!
What Kinds of Mutual Funds Should I Choose for My Roth 401(k)?
Diversifying your portfolio is key to maintaining a healthy amount of risk in your retirement savings. That’s why I recommend balancing your investment among four types of mutual funds: growth and income, growth, aggressive growth, and international funds.
If one type of fund isn’t performing as well, the other ones can help your portfolio stay balanced. Not sure which funds to select based on your Roth 401(k) options? Sit down with an investing pro. They’ll be able to help you understand the different types of funds, so you can choose the right mix.
Should I Roll Over My Traditional 401(k) to a Roth 401(k)?
There isn’t a one size fits all answer when it comes to rolling over your retirement savings to a Roth account. If it makes sense for your situation, it’s a great way to take advantage of tax-free growth on your accounts. But keep in mind that rolling over a traditional 401(k) means paying taxes on it now. If you’re rolling over $100,000 and you’re in the 22% tax bracket, that means you have to come up with $22,000 cash to cover the taxes. I don’t want you to pull that money out of the investment itself!
If you can pay cash for the taxes without taking money out of your nest egg and you’re still several years away from retirement, it may make sense to roll it over. But before you roll over accounts, make sure to sit down with an experienced investing professional. They’ll help you understand the tax impact of rolling over your 401(k) and how you can be prepared for it.
Who Can Help Me Make Decisions About a Roth 401(k)?
If you want to learn more about your Roth 401(k) or other investing options, find an investing pro in your area. A financial advisor can help you understand your investments and make confident decisions.
A do-it-yourself approach to investing is never a good idea. I know all about investing, and even I work with a financial advisor! Your family’s future is too important to wing it.
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