For years, the traditional 401(k) plan has been the most popular workplace retirement account. However, there’s a new alternative that’s been growing steadily in the past decade: the Roth 401(k). According to data from global advisory, broking, and solutions company Willis Towers Watson, 70% of employers who have a 401(k) plan offered a Roth version in 2018, up from just 46% in 2012.
If your employer is one of them, you’ve probably wondered which type of plan is better. As with so many financial questions, the answer is, “It depends.” To understand just what it depends on, you’ll need to dive into some details about how the Roth 401(k) works and what sets it apart from its traditional cousin.
How a Roth 401(k) Works
A Roth 401(k) combines the convenience of a traditional 401(k) with the tax benefits of a Roth IRA. Here’s how it works:
- Contribute. Contributions to a Roth 401(k) come out of your paycheck automatically, just as they do with a traditional 401(k). However, unlike the traditional version, the Roth 401(k) draws money from your after-tax earnings. That means it doesn’t lower your tax bill right away, but it will later on.
- Invest. You can invest your Roth 401(k) contributions in whatever choice of funds your employer offers. You’ll pay no tax on the earnings from your investments as they grow.
- Withdraw. When you reach retirement age, you can start to withdraw the money from your Roth 401(k) without paying taxes on it, just as you would with a Roth IRA. Compared with a Roth IRA, a Roth 401(k) has a few more restrictions on just how much of the cash you can withdraw at what point. However, if you play your cards right, you won’t have to pay another penny in tax on your investments once they enter your account.
For example, say that at age 35, you contribute $10,000 to a Roth 401(k). You cannot deduct any of this $10,000 from your taxes. If you’re in the 24% tax bracket at the time, you’ll pay $2,400 in taxes on the money before contributing it.
However, by the time you retire at age 65, that $10,000 contribution will have grown to $75,000. You can withdraw that entire sum without paying taxes on it. If you’re still in the 24% bracket, that’s $18,000 in taxes that you can avoid.
Pro tip: If you have a Roth 401(k) or a traditional 401(k) through an employer, make sure you sign up for a free analysis from Blooom. They will make sure you have the right allocation and are properly diversified. They’re also going to analyze the fees you’re paying. Sign up for your free Blooom analysis.
Roth 401(k) vs. Traditional 401(k)
The biggest difference between a traditional 401(k) and a Roth 401(k) is the way they are taxed. There are also some differences in the rules governing how and when you can withdraw money from them and what happens if you withdraw money early.
However, in other ways, the two plans are very similar. Here’s a quick rundown of their features and the similarities and differences between them.
The limits on contributions are the same no matter which type of 401(k) you use. For the year 2019, the maximum you can contribute is $19,000. However, if you’re age 50 or older, you can put in an extra $6,000 per year as a “catch-up” contribution, raising the total limit to $25,000.
There’s also no income limitation on either the traditional or the Roth 401(k). You can contribute to either type of plan no matter how much you make.
Both traditional and Roth 401(k) plans shelter some of your income from taxes, but they do it at different times. With a traditional 401(k), you pay no tax on contributions, but you pay taxes on your withdrawals in retirement – precisely the opposite of a Roth 401(k). So choosing between a traditional and a Roth 401(k) is largely a matter of deciding which matters more to you: saving money now or having more money later.
Some experts argue that it makes sense to contribute to a traditional 401(k) if you think your tax rate in retirement will be lower than it is now. For instance, if you’re currently at the peak of your earning power, you probably expect to have a lower income in retirement and thus pay less in taxes. By contrast, if you’re a young worker on a starting salary, you probably assume that your income and your tax rate will be higher in retirement, so it makes more sense to pay your taxes up front with a Roth 401(k).
Unfortunately, predicting how your tax rate will change in retirement isn’t quite that simple. You can’t know exactly what your income will be in the future or how the tax system will change between now and your retirement. For example, many economists argue that tax rates as a whole will need to rise at some point in order to pay for the growing cost of programs such as Medicare and Social Security. If that happens, people who invested in traditional 401(k)s could find themselves paying much higher taxes in retirement than they would have paid during their working years………Read More>>