What’s the difference between a traditional 401(k) and a Roth 401(k)?
A huge benefit of joining your company’s 401(k) is that your investment earnings accumulate tax-free. Rather than paying taxes on capital gains, dividends and interest, your 401(k)’s earnings are 100% reinvested to generate more capital gains, dividends, and interest.
Year after year after year.
This ability to compound investment income is a huge advantage over a taxable account you might open at your local financial institution.
Another advantage of investing in a traditional 401(k) is that your contributions are made with pre-tax dollars. That’s a fancy way of saying that your taxable earnings are reduced by contributions made to your 401(k).
Let’s say you make $50,000 and contribute $5,000 to your 401(k). That $5,000 is tax-deductible and lowers your taxable income to $45,000. So the more you save for retirement in a traditional 401(k), the lower your taxable income. Lower taxable income, as you might imagine, translates into lower income taxes.
But when you take money out of your 401(k) in retirement, those distributions are taxed as ordinary income. So by contributing to your traditional 401(k) you are avoiding taxes today in exchange for paying taxes tomorrow.
Take a walk on the flip side
Notice the term “traditional 401(k)” in the paragraphs above. There is also a type of 401(k) called a Roth 401(k). As with the traditional 401(k), Roth 401(k) investment earnings accumulate tax-free. But unlike a traditional 401(k), contributions to a Roth 401(k) do not reduce your taxable income. If you make $50,000 and contribute $5,000 to your Roth 401(k), your taxable income is still $50,000.
Why consider the Roth option? Because with a Roth 401(k) you pay no taxes on withdrawals in retirement. So the Roth is the mirror image of the traditional 401(k). With a Roth, you get no tax benefit from contributions today in exchange for paying no taxes on withdrawals tomorrow.
What these differences mean to you
A candidate for a Roth 401(k) might be an employee in a low tax bracket who expects to be taxed at a higher rate in retirement. In this scenario, the tax deduction might not be meaningful today, while the taxes avoided at retirement could be significant. This favorable trade-off is why many financial advisors suggest that young employees consider opening a Roth rather than traditional 401(k).
The opposite scenario is an older employee in a high tax bracket who really benefits from those tax deductions from contributions. This employee may prefer the traditional 401(k), particularly if a much lower tax bracket is expected in retirement.
On the other hand…
While the two scenarios above make sense, life can get complicated. So these rules of thumb may not always apply.
For example, an older employee might find tax free distributions in retirement attractive for many reasons. Maybe other sources of income will keep this employee in a high tax bracket after leaving the job. This particular employee might prefer the Roth 401(k) in the years leading up to retirement.
And what about retirees taking a substantial 401(k) distribution to help fund a second home or pay for a grandchild’s education? These large distributions would be taxed as ordinary income if withdrawn from a traditional 401(k). But they would not be taxed at all if taken from a Roth account.
The Roth vs. traditional 401(k) decision can affect other aspects of retirement planning. For example, both traditional and Roth 401(k)s are subject to required minimum distributions (RMDs), which become mandatory at age 70 ½. These withdrawals from traditional 401(k)s become a source of taxable income, while distributions from Roth accounts are not taxable.
And here’s another wrinkle. Since traditional 401(k) distributions are taxable, those distributions can affect the tax rate on your Social Security benefits. This is not an issue with Roth distributions.
There is one more consideration in the Roth vs. traditional 401(k) decision: Paying taxes on accumulated investment earnings.
When enrolled in a traditional 401(k), you get tax deductions equal to your contributions. If you invest $100,000 in your traditional 401(k) over several years, you shrink your taxable income by the same amount.
When it’s time to take money out of your 401(k), that $100,000 will likely have grown significantly. So your withdrawals can ultimately include contributions and their investment earnings. That means if you make enough withdrawals, you will be taxed on contributions and investment earnings as well.
With a Roth 401(k) you get no tax deduction from your contributions, and you pay no taxes on the withdrawals. That means the earnings accumulated from your investments will not be taxed.
So whether you are better off with a traditional or Roth account depends upon several factors including your tax rate today, your tax rate in retirement, your investment returns, and how much of your nest egg you ultimately withdraw.
Hedging your tax bets…
It may seem as if you need a crystal ball to decide whether to enroll in a traditional or Roth 401(k). But you may not have to place all your bets on either. Your employer's plan may allow you to divide your 401(k) contributions between the two options, which will enable you to gain some of the benefits of both.
Or, consider that the contributions you make the first ten years of employment will have more years to compound returns than those you make the last ten years. Therefore, you could contribute more heavily to a Roth account today, and contribute more to a traditional 401(k) 10 or 15 years down the road.
It’s up to you. The most important decision is to join the 401(k) and start contributing. If possible, contribute enough to qualify for any company matching contributions. And if you have questions, don’t hesitate to contact a ForUsAll advisor. Our advisors can help you decide whether a traditional or Roth 401(k), or both, is right for you.
And if you have other questions—about investment options, how much to contribute, or something else— you can contact ForUsAll advisors about those too.