Understanding the Differences Between Roth 401(k) and Traditional 401(k)

When planning for retirement, choosing the right savings plan is crucial. Two popular options are the Roth 401(k) and the traditional 401(k). Both are employer-sponsored retirement accounts, but they differ significantly in terms of tax treatment and other features. In this blog, we will explore the key differences between these two types of accounts and help you decide which one might be the best fit for your financial goals.

What Is a 401(k)?

A traditional 401(k) is a workplace retirement savings plan that allows employees to contribute a portion of their salary on a pre-tax basis. Many employers offer 401(k) plans and may even match a portion of employee contributions, providing an additional incentive to save. One of the main advantages of a traditional 401(k) is that it reduces your taxable income while you contribute, allowing you to defer taxes until you withdraw the money in retirement. However, if you withdraw funds before age 59½, you may face a 10% early distribution penalty.

What Is a Roth 401(k)?

A Roth 401(k) is another type of employer-sponsored retirement account, but it is funded with after-tax money. This means that while you won’t get an immediate tax break, your money grows tax-free, and you won’t have to pay taxes on withdrawals in retirement. Similar to a traditional 401(k), early withdrawals from a Roth 401(k) before age 59½ can incur a 10% penalty. Additionally, you need to own the account for at least five years to take qualified distributions without penalties.

Roth 401(k) vs. Traditional 401(k)

To decide which type of retirement account is right for you, it’s essential to understand the key differences and similarities between the two.

Similarities Between Roth 401(k) and Traditional 401(k)

• Employer Sponsored: Both types of 401(k)s are employer-sponsored, meaning you can’t open one on your own. If you don’t have access to either plan through work, you might consider a Solo 401(k) or a Roth IRA.
• No Income Limit: Neither type of 401(k) has an income cap for participation.
• Annual Contribution Limits: For 2023, you can contribute up to $22,500 to either type of 401(k), with an additional $7,500 in catch-up contributions if you’re 50 or older.
• Automatic Saving: Contributions are automatically deducted from your paycheck, making it easier to save consistently.

Differences Between Roth 401(k) and Traditional 401(k)

• Taxes on Contributions: Traditional 401(k) contributions are tax-deferred, reducing your adjusted gross income during your working years. Roth 401(k) contributions are made after-tax and do not decrease your current adjusted gross income.
• Taxes on Distributions: Withdrawals from a traditional 401(k) are taxed as income in retirement. In contrast, qualified distributions from a Roth 401(k) are tax-free.
• Employer Matches: Employers can match contributions to both types of 401(k)s, but matching funds for a Roth 401(k) must go into a traditional 401(k) account and are pretax.
• Penalty-Free Withdrawals: Both types of accounts have a 10% early withdrawal penalty, but Roth 401(k)s require you to own the account for at least five years to take penalty-free withdrawals. Early withdrawals from a Roth 401(k) also incur taxes on a prorated amount of earnings.
• Required Minimum Distributions (RMDs): Starting in April 2024, Roth 401(k)s will no longer have RMDs. Traditional 401(k)s require you to begin taking RMDs at age 73.

Is It Better to Invest in a Roth 401(k) or a Traditional 401(k)?

The choice between a Roth 401(k) and a traditional 401(k) depends on when you prefer to pay taxes on your money. Here are a couple of considerations:

• Traditional 401(k): If you think your income level and tax rate will be lower in retirement, deferring taxes now could mean paying less in taxes later.
• Roth 401(k): If you expect to earn more throughout your career and have a higher taxable income in retirement, paying taxes now can protect you from potentially higher tax rates in the future. This provides more certainty about your retirement income.

Can I Contribute to Both a Roth 401(k) and a Traditional 401(k)?

Yes, if your employer offers both types of plans, you can contribute to both a Roth 401(k) and a traditional 401(k). This strategy, known as tax diversification, allows you to invest in accounts with different tax rules, potentially lowering your overall tax obligation.

Tax-deferred accounts like traditional 401(k)s and IRAs reduce your taxable income now and defer taxes until retirement. After-tax accounts like Roth 401(k)s and Roth IRAs require you to pay taxes upfront, but your earnings grow tax-free, and you don’t pay taxes on distributions in retirement. Fully taxed accounts, such as general investment accounts, are taxable but can be part of a larger tax diversification strategy.

The Bottom Line

When choosing between a Roth 401(k) and a traditional 401(k), start with what’s available to you. Not all employers offer a Roth 401(k), though many do. If you have access to a traditional 401(k) but not a Roth 401(k), consider contributing enough to your 401(k) to take full advantage of any employer match. After that, you might explore the benefits of a Roth IRA.

If you need help navigating your retirement investing options, consider reaching out to a financial advisor. A financial advisor can help you create a retirement plan tailored to your financial situation, weighing the benefits of a traditional 401(k) against a Roth 401(k) to make the right choice for you.

At O1ne Mortgage, we are committed to helping you achieve your financial goals. For any mortgage service needs, call us at 213-732-3074. Our team of experts is here to assist you every step of the way.