There you are, being responsible and signing up for your work’s 401(k) plan. Then you are faced with the decision: Traditional 401(k) or Roth 401(k)? What’s the difference? Does it really matter? Is one superior to the other?
Fear not. That’s what this article is all about. If you have already signed up for a plan without really knowing the difference, don’t worry! Both help you save for retirement, and you can always change where your contributions go down the line. You can even contribute to both a Roth and Traditional 401(k)! But let’s not get ahead of ourselves.
First, we’ll explain what a 401(k) is and which features are common to both Roth and Traditional plans. Then, we’ll compare the two plans to help you figure out which contribution strategy could be right for you.
What is a 401(k) Plan?
A 401(k) plan is a retirement savings plan offered through an employer that allows you to set aside money from each paycheck to save for retirement. 401(k) plans have contribution limits, though. The 2021 contribution limit for 401(k) plans is $19,500 if you’re under 50 or $26,000 if you’re over 50. The contribution limits generally increase from year to year with inflation. Note that this contribution limit only applies to the amount you contribute and doesn’t include any money that your employer contributes to your account.
While we’re talking about limits, you may have heard that Roth accounts have income limits. Not so with a Roth 401(k). Unlike Roth IRAs, Roth 401(k)s have no income limits for making contributions. This means that if your employer offers a Roth 401(k), you can take advantage of the long-term tax benefits regardless of your current income.
401(k) Employer Match
One benefit of 401(k) plans is that some employers will match your contributions. For example, say your employer matches your contributions up to 5%. If your salary is $45,000, that means your employer would match up to $2,250 in annual contributions to your 401(k). That’s essentially free money for you, and it really adds up over the years. In this example, you could totally contribute more than 5% of your paycheck. The 5% match just means your employer would stop matching your contributions after 5%.
401(k) Investment and Returns
A 401(k) will generally provide you with a limited number of different investment options, and in most cases, includes a default investment option. So, unless you elect otherwise, your money is invested for you, split between various stocks and bonds to reduce risk and maximize returns. Companies will generally partner with a professional financial institution to manage the money you contribute to your 401(k) plan. Often, they will allocate your investments according to your age, taking a more conservative or aggressive approach depending on how long you have until retirement.
Although you are encouraged to look at where your money is, don’t micromanage your account, especially if you aren’t confident in the world of stocks and bonds. Your investments will get different returns from year to year. That’s normal. Your rate of return will vary, but a well-rounded investment portfolio could see an average of 6%-8% returns over your lifetime. The most important thing is to be consistent with contributions to your 401(k) plan.
Roth 401(k) vs. Traditional 401(k)
So, if both Roth and Traditional 401(k) plans share the features listed in the paragraphs above, what’s the difference? The short answer is that the type of plan you choose will ultimately determine when you pay taxes which can also impact how much you pay. With a Traditional 401(k), you contribute money to your plan before income taxes are taken out and elect to pay income taxes when you make withdrawals in the future. However, with a Roth 401(k) plan, you contribute after income taxes are taken out to avoid paying income taxes on the principal and the returns when you withdraw the money. The difference between these two types of 401(k) plans may seem insignificant, but it can have a big impact on how much money you end up with, depending on how your tax situation changes between now and retirement.
Roth vs. Traditional 401(k) Example
Say you have $10,000 during the year to contribute to either a Traditional 401(K) or Roth 401(K). With a Traditional plan, that entire $10,000 goes into your plan before taxes. However, with a Roth plan, you would contribute that same $10,000 to your 401(k) after taxes. So, if you are in the 12% tax bracket, you would end up with $8,800 to invest after taxes.
Here’s that math: $10,000 – ($10,000*0.12).
If both investments grew 8% each year for ten years, you would end up with $18,999 in the Roth plan and $21,589 in the Traditional plan. Don’t forget. You still have to pay taxes with the traditional plan when you withdraw money. If you are still in the 12% tax bracket, you will end up with the same amount of money either way. However, if you are in a different tax bracket when you withdraw, that is where things get interesting.
Say you were in the 12% tax bracket when you contributed to the plan, but now you are in the 22% tax bracket. That means if you withdraw from a traditional plan now, you are left with just $16,834. That’s over $2,000 less than what you would have with the Roth plan.
However, if you moved to a lower tax bracket during that time, a Traditional 401(k) could save you money over a Roth plan. This scenario is less common.
Something else to note here is that employer match contributions on Roth plans are treated as pre-tax contributions. So, while you won’t have to pay taxes later on the money you contribute to a Roth 401(k), you will have to pay taxes later on the money your employer contributed.
Which Plan is Right For Me?
When considering which plan is right for you at this time, ask yourself, “Is it likely that my income will increase in the future?” or “Is it likely that tax rates will go up in the future?” If the answer is yes to either of those, then a Roth plan is a good bet. However, if you think your income is likely to stay the same or decrease in the future, a Traditional plan might be a better fit.
If it feels presumptuous to make assumptions about your future income, here’s a helpful rule of thumb: invest in a Roth 401(k) while you are younger and transition to a Traditional 401(k) as you get older. The reason for this is that your income generally increases as you grow older and gain more experience in your field. For this reason, it is in your best interest to take the tax savings of a Traditional plan when you are in a higher tax bracket. For example, you might make $40,000 in your first job out of college and contribute to a Roth 401(k) while you’re in a lower tax bracket. Then, as you start making more money and move up a tax bracket, you could switch to a Traditional 401(k).
However, the fact is that we don’t know how all the variables will line up in 10, 20, 30 years. We can make some educated guesses, but there will still be some inaccuracies. For that reason, it can often be valuable in retirement to have both Roth and Traditional contributions. Having a mix gives you more flexibility to pull from one or the other based on your income need and tax bracket in a given year.
Hopefully, this article has given you something to think about. Just remember that whichever plan you choose—or if you choose both—the important thing is you are saving for retirement. Don’t get caught up in the details. Just work on increasing your savings rate and everything will fall into place.
If you have questions about what you should do in your specific circumstances, sign up for a financial plan with Savology. We have coaches on standby to help when you need it.