Roth 401k vs Traditional 401k
May 25, 2011
Traditional 401ks have been one of the main options for retirement investing for many working Americans over the last thirty years. When the Roth 401k was introduced a few years ago the new type of retirement plan left many long time 401k investors debating the benefits of the Roth 401k vs the Traditional 401k.
The popularity of the Roth IRA and the large numbers of Roth conversions, led Congress to apply some of the Roth rules to the regular 401k. The new rules mean that it is possible to enjoy the higher contribution limits of the 401k, while also taking advantage of the tax benefits of a Roth IRA. It is also worth noting that, unlike the Roth IRA, there is no income limitation on eligibility to contribute to a Roth 401K.
Roth 401k and Traditional 401k Tax Differences
The biggest difference between a Roth 401k and a traditional 401k is the way taxes are handled. Contribution limits are the same for both types of 401k: $16,500 for 2011, and an addition catch-up option of $5,500 for those 50 and older. And, of course, it is possible to have retirement contributions made automatically through your employer if you wish.
Contributions: When you make your contribution to a 401k, the way it is taxed now depends on whether or not you have a Roth option.
- A traditional 401k contribution is made with pre-tax dollars. This means that you are getting a tax deduction now. You don’t pay taxes on the income that you contribute. This lowers your taxable income, and can save you money immediately, since your money grows tax deferred.
- A Roth 401k contribution is made with after tax dollars. You do not get an immediate tax benefit for making a contribution to your Roth 401k, and you will have to pay taxes on that income now, but your contributions grow tax free.
Withdrawals: Later on, you will start taking money out of your account, which will be taxed depending on the type of 401k that you have.
- Because you have not paid income taxes on your contributions to a traditional 401k, you will have to pay taxes on the withdrawals. Any withdrawals that you make during a year will be taxed as regular income.
- With a Roth 401k, you do not have to pay taxes on your withdrawals. You have already paid taxes on the income you used for your contributions, so your money grows tax free, and your withdrawals are not taxed, no matter your income bracket.
Which is Better – Roth 401k or Traditional?
Like so many decisions in personal finance the answer is “it depends”. Many financial experts recommend that you base your decision on what you think is likely to happen later on down the road with your income.
If you are in a low income bracket right now, and you expect that you will retire into a higher income tax bracket, it might be worth it to contribute to a Roth 401k. This way, you will pay lower taxes on the income you use for your contributions, and when you are in a higher bracket during retirement, you won’t have to pay federal taxes on the withdrawals.
If you contribute to a traditional 401k now, and your income increases during retirement, you will have to pay higher taxes since you will be paying on withdrawals.
On the other hand, if you think that you will be in a lower income bracket at retirement, it might be worth it to contribute to a traditional 401k, since you can defer paying taxes on the money.
One other thing to keep in mind is that tax policies can change over time. If you think tax rates will remain relatively steady then it doesn’t much impact the income logic discussed above. However, if you think tax rates will be much higher in the future then a Roth 401k could make more sense.
It’s kind of frustrating that you have to speculate about the future and make your decision based on a best guess but that’s the way a lot of things work in personal finance. Don’t let the decision making process hold you up from getting started. Regardless of whether you’re investing for retirement with a Traditional or Roth 401k it’s better to be putting some money away than none at all.
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