I have recently started my career and wish to start planning for my retirement. My employer is offering a contribution match for a Traditional 401(k) plan as well as a Roth 401(k) plan, but I am completely unaware of their differences or similarities. How to choose which is the best option for me?
Taking charge of your finances and planning for retirement was a brave decision to start with but dealing with these multitude of options can discourage you from pursuing your financial goals. Fret not, for we have you covered! So, without delaying your plans any further, let us dive right in and break down the similarities and differences between these retirement plans.
What is ROTH 401 (k) and how is it similar to Traditional 401 (k)?
Introduced in 2006, the Roth 401(k) combines the features of a Traditional 401(k) and the Roth IRA.
- Like the Traditional 401(k) account, Roth 401(k) is also an employer retirement savings account allowing employees to contribute a certain amount towards retirement from every paycheck.
- Both the Traditional 401(k) and Roth 401(k) have the same contribution limit — $19,500 per year and if you are 50 or older, $26,000 per year.
- Both plans allow the possibility of a company match if your employer offers one.
Pretty similar, right? But wait, let us not be impulsive and make a decision before we understand the differences between these two plans.
Roth 401(k) vs Traditional 401(k): Differences?
The biggest difference between Traditional 401(k) and Roth 401(k) contributions is how your money is taxed.
Traditional 401(k) is a pre-tax savings account. This means your contributions are taken from your gross pay before they are taxed, thereby making your taxable income lower. Roth 401(k) on the other hand is a post-tax savings account where your contributions are already taxed.
How does this impact your retirement savings?
Since a Traditional 401(k) contribution is pre-tax, you have more money to take home at the end of each month, whereas a Roth 401(k) is post-tax implying your take home pay is slightly less each month. Your first instinct is to go with a Traditional 401(k), because hey, who doesn’t want some extra cash each month? But don’t forget why you’re saving this money – for retirement. The biggest differentiator between the two plans is when you start withdrawing money during retirement.
WITHDRAWALS IN RETIREMENT
Since you already paid taxes on your contributions towards Roth 401(k), any money you withdraw during retirement is tax-free. This includes the money you put in as well as the growth of your portfolio being tax-free. Any employer matching contributions towards 401(k) however, will be taxed.
In case of a Traditional 401(k), since all your contributions were pre-tax, all withdrawals therefore will be taxed.
Let us say you contributed $500,000 towards your retirement nest egg during your work life and your employer matched 50% of your contributions. This makes your nest egg worth $750,000 excluding any growth. If you fall under the 22% tax bracket and all these savings were in a Traditional 401(k), you will end up paying $165,000 in taxes at the time of withdrawal!
On the contrary, if all this money were saved in a Roth 401(k), you would owe taxes only on the employer contributions, making your tax liability $55,000 only from a net worth of $750,000.
That’s $110,000 less taxes compared to the Traditional 401(k).
The choice is yours whether you want to have more money today or during retirement.
ACCESS TO SAVINGS
Finally, a last and small difference between the two plans is the eligibility to access your savings. Both plans allow withdrawals at the age of 591/2 but for Roth 401(k) withdrawals the age of your account must be five years. If you are nearing retirement, this is something to be considered as you will not have access to your savings until you have held the account for five years.
HOW TO CHOOSE BETWEEN TRADITIONAL 401(k) and ROTH 401(k)?
Now that you have complete clarity about the similarities and differences between these plans, the big question is which plan is the best for you? While there is no single right or wrong answer, the decision is based on several factors.
- Do you need more money today to cover additional necessary expenses?
- Are you nearing retirement and don’t expect any changes in your tax bracket?
In the above scenarios you might consider the Traditional 401(k) plan. However, if you are young and progressing in your career, a Roth 401(k) would be a good choice. You will receive fewer dollars today, but your retirement will be much brighter for the following reasons:
- You will not pay taxes at the time of withdrawal
- You will spare yourself the feeling of losing 20% or 30% of your savings to taxes at the time of retirement
- As you progress in life, you would find yourself in the higher income tax bracket. You’re offsetting this uncertainty with a single decision
- You will have a bigger retirement corpus to spend your golden days
- You chose delayed gratification over instant gratification, which is a rare virtue to possess
Making this decision can be hard, especially with the uncertain times we live in. But the good news is you don’t necessarily have to make only one choice! If your employer’s plan permits, you could split your contributions between both these plans. For example, you could contribute $9750 to each plan maxing out on the allowable contribution limit of $19,500 and enjoy the benefits of both worlds.
As time progresses and you gain more clarity about your life and goals, you could decide which option is best suited for you.
It is fantastic that you wish to put some time and effort into choosing the right plan for retirement, but no matter what you choose, your decision to start planning and saving for retirement is the best decision of all!
Financial planning can be a difficult endeavor and if you want to learn more, find an investing professional who can save you from a do-it-yourself investing approach and help you make an informed decision.