A Little 401(k) Education: Roth Versus Traditional
It’s safe to say that most working Americans have heard of a 401(k). Chances are, these same people have also heard of the terms “Roth” and “Traditional.” However, in our experience helping people with their 401(k) plans, many people don’t know the difference between a Roth 401(k) and a Traditional 401(k). That is where some basic 401(k) education comes in.
At Scarborough Capital Management, we specialize in 401(k) management, and this is a common question we are asked.
If your company offers both Traditional 401(k)s and Roth 401(k)s, you may be unsure about which is the right choice for you. The fact is, both types of 401(k)s are excellent retirement vehicles offered by employers. You just need to know the ins and outs to choose whether a Roth or a Traditional 401(k) is right for you, or to make allocation decisions between the two. (You can invest in both.)
To understand the difference between these two plans, it’s important to first look at the similarities. Both offer strong advantages for retirement savers.
1. 401(k)s offer a high level of retirement savings every year
The Internal Revenue Service sets the maximum amounts 401(k) contributors can save in any given year – and the amount is much higher than other retirement savings vehicles. In 2020, for instance, the maximum you can save in a 401(k) is $19,500 every year, $500 higher than the maximum in 2019. Plus, if you are 50 years old or older, you can save an additional $6,500, for a total of $26,000 a year.
In contrast, Individual Retirement Account (IRA) holders can save a maximum of just $6,000 per year in 2020. People who are 50 or older can save $1,000 more, for a total of $7,000 a year.
There’s no question that a 401(k) allows contributors to sock away the most toward their retirement nest eggs
2. Many employers match contributions
When you contribute to a 401(k), you choose a certain percentage of your salary to contribute and how to allocate your contribution between your Traditional and/or Roth 401(k). In a match, your employer kicks in an additional amount, usually ranging from 50 to 100 percent of your contribution. All employer matching contributions will be allocated to the Traditional 401(k), even if you are contributing to only the Roth 401(k).
Let’s say, for instance, that you choose to contribute 6 percent of an $85,000 salary, or $5,100. If your employer has a 100 percent match, your employer will also contribute $5,100, so your total yearly contribution will be $10,200. In essence, your employer gives you free money above and beyond your salary.
3. Your contributions occur automatically
Research shows that the easier and more convenient it is to save, the more people are likely to do so, for any goal. Retirement is no exception.
Contributions to 401(k)s are taken directly out of your paycheck, so they are one of the most convenient automatic savings available.
4. Your money grows tax-deferred
Both your contributions and any employer contributions can grow tax-deferred until you withdraw your 401(k) funds. This means your savings can compound over the decades with no tax being taken out.
Now, for the differences between the two plans.
The Big Difference Between Traditional and Roth 401(k)s: Choosing Pre-tax or Post-Tax
The biggest difference between Traditional 401(k)s and Roth 401(k)s is the immediate tax treatment. In a Traditional 401(k), contributions are taken out pre-tax. In a Roth 401(k), contributions are taken out post-tax.
Traditional 401(k) Contributions Save You on Taxes in the Year of Contribution …
Contributions to a Traditional 401(k) will thus save you taxes on your income in the year in which you contribute.
Using the same example above, let’s say you contribute $5,100 per year to a Traditional 401(k). That $5,100 comes out of your paycheck pre-tax. If you make $85,000 a year, in other words, you will only be taxed on $79,900 of it. Traditional 401(k) contributions have a potential to move you to a lower tax bracket as well.
… While Roth 401(k)s Save You Taxes at Withdrawal
Contributions to a Roth 401(k), on the other hand, will be taxed in your year of contribution. If you make $85,000 a year, you’ll be taxed on all of it.
But don’t think that means Roth 401(k)s don’t offer tax advantages. They do; they just occur later in life. When you withdraw money from a Roth 401(k), the withdrawals are tax-free at that point, whereas a withdrawal from a Traditional 401(k) in retirement is taxed at your existing tax rate.
So, let’s say your 401(k) funds have grown robustly over the decades, and you have $1 million total, half in a Roth 401(k) and half in a Traditional 401(k). You want to retire at age 60, and plan to take $30,000 from your Traditional 401(k) and $30,000 from your Roth 401(k) at that point, for a total of $60,000.
The $30,000 from your Roth 401(k) contributions will not be taxed at all. You’ll receive the full $30,000. (Note that the employer contribution percentage is taxable.)
The $30,000 from your Traditional 401(k) will be taxed. If it’s taxed at 22 percent, for example, you’ll receive $23,400 rather than the whole $30,000, with $6,600 going to taxes.
So, part of the choice when selecting a 401(k) to invest in is deciding the most advantageous time to take tax savings. If you want maximum tax savings when you are working and earning, you might want to choose a Traditional 401(k), with its pre-tax contributions. This may be a prudent choice to save on taxes in your peak earnings years.
If, on the other hand, you want maximum tax savings at retirement, a Roth 401(k) may be your choice. As retirees are on a fixed income, being able to receive withdrawals from a Roth 401(k) without tax withholding may be optimal for you at that point.
It’s wise to discuss your future goals and plans with a professional who understands these intricacies.
Choosing When to Take Withdrawals
Both types of 401(k)s become eligible for qualified withdrawals when the owner reaches the age of 59-½. If you take a withdrawal before that, the IRS can assess a 10 percent tax penalty on early withdrawals. There are exceptions to this rule.
Another age to keep in mind is 72, when you must take withdrawals known as Required Minimum Distributions (RMDs).
Again, it’s a good idea to consult with a financial advisor who specializes in 401(k) plan management to discuss whether a Traditional 401(k) or Roth 401(k) is right for you. A little 401(k) education now can save you a lot of time, money and hassle in the long-run.