Consider your tax situation and speak with a financial professional before deciding to use a Roth 401(k) as a high earner as retirement planning and tax strategies can quickly get complicated. Roth IRAs have been around since 1997, while Roth 401(k)s came into existence in 2001. Your combined annual contributions to your 401(k) accounts are limited to a total of $19,500 (with an additional catch-up of $6,500 if you’re 50 or older) for 2021, but you can divide those contributions between accounts according to your preference. One major advantage of a Roth — besides the tax play — is that you can tap a large portion of your Roth 401(k) in retirement to pay for, say, a medical emergency without incurring the tax bill you would have with a traditional 401(k). Roth 401 (k)s must be sponsored by an employer, just like a traditional 401 (k) account. Consider consulting with a financial advisor who can help you figure out how to make contributions that make the most sense for your situation and that can maximize your potential tax savings. A little math will demonstrate this. The primary difference between a Roth 401(k) vs. a 401(k) account is how your contributions are made and when you will pay taxes on them. If you’re trying to decide between a Roth 401(k) vs. 401(k), here’s what you need to know to make the best choice for your needs, ensure you have the retirement savings you need and learn more about how to invest money wisely. What do you do after you’ve maxed out your traditional 401(k)? The differences between these 401 (k) plans are similar to the differences between regular and Roth IRAs: the timing of taxes. A Roth 401 (k) is a post-tax retirement savings account. Roth vs. These limits do not apply to a Roth 401(k) (or a traditional 401(k). If you couple this with the ability to convert a traditional 401(k) into a Roth IRA, you can play some really interesting tax games. 1. There’s no real way to make up for the opportunity cost that comes with having your money out of a 401(k) investment account. Right now, federal income taxes are the lowest they've been in a long time. Additionally, with the money in a Roth IRA, there are some other flexibilities in the way you can access the money. The taxes they paid on their conversions were far lower than what they would have paid had they made Roth 401(k) contributions from the outset. As of January 2006, there is a new type of 401(k) - the Roth 401(k). The contribution limit is the same and you have to wait until age 59 1/2 to access your account without penalty. Traditional 401k vs Roth 401k. Notable differences between a Roth IRA and a Roth 401(k) are: Eligibility for the Roth IRA. In general, you have five years to repay your loan. FinanceBuzz.com does not make any credit decisions. But, the only way to find out is to get expert help. Once in the account, your money grows tax-sheltered. Traditional 401k. For Sam to have $58,500 after taxes in retirement using his traditional 401(k), he would have had to contribute $27,857 into his account initially. The important difference is that you will make contributions to this account with after-tax dollars. A qualified distribution from a 401(k) is any distribution that doesn’t come with a penalty from the IRS, such as those made after you reach age 59 1/2, or early withdrawals that meet certain conditions. If your workplace offers a 401(k) plan, it’s usually possible to ask to have your contributions automatically taken from your paycheck before taxes are determined. Because a Roth IRA doesn’t come with RMDs, you can get around the requirement by rolling your Roth 401(k) into a Roth IRA. Despite the lack of optionality in a Roth 401(k), there are a few special cases where a Roth might be the way to go. However, I think your analysis of 401K vs ROTH leaves out two very salient factors for retirees. For those with less familiarity, a “traditional“ 401(k) is funded with pre-tax money while a Roth 401(k) is funded with post-tax money. In that case, using a traditional 401(k) would be preferred as the expected savings in state income tax today are likely to exceed the expected increase in federal income taxes in the future. The added flexibility associated with a traditional 401(k) is what makes it my go-to choice when it comes to employer-sponsored retirement vehicles. There are also RMDs with the Roth 401 (k) when you reach age 72. Thank you for reading! Nick Maggiulli is the Chief Operating Officer for Ritholtz Wealth Management LLC. Both Kate and Kevin end up with $210 in retirement spending because they had the same contributions, the same investment growth, and paid the same tax rates over time. The only difference between these account types is when you decide to pay your taxes. It’s also important to note that a 401(k) account comes with required minimum distributions (RMDs) when you turn 72. Because your traditional 401(k) contributions were made with pre-tax money, you need to pay taxes when you convert to a Roth IRA. The two plans also differ in the way contributions and withdrawals are being taxed. This simple example demonstrates that the Roth 401(k) is probably the better choice for high savers, as you get more total tax-deferred benefits. Roth 401Ks are relatively new in the world of retirement accounts. Both Roth 401(k)s and Roth IRAs are funded by after-tax contributions. But don’t call the fight yet. FinanceBuzz has partnered with CardRatings for our coverage of credit card products. Roth investors are also making a bet … The Roth IRA grows to … The Roth 401(k) and the traditional 401(k) each offer a different type of tax advantage, and choosing the right plan is one of the biggest questions workers have about their 401(k). Depending on how much room is in your budget for retirement saving after you have maxed out the employer match on your 401k, you should max out the $5000 annual Roth IRA contribution. With a Roth 401 (k) whatever you put in has already been taxed. All else equal, this implies that the Roth 401(k) would be the better option, as you would pay a lower tax rate now (20%) than you would expect to pay in retirement (23%). When considering the Roth 401(k) vs traditional 401(k), many people look at it as an "either/or" decision. However, loan terms and whether a loan is even possible is determined by your employer. In a traditional 401 (k) you make pre-tax contributions and pay taxes in retirement when you withdraw. In general, if you think you’re likely to be in a lower tax bracket in the future, a traditional 401(k) can make sense. It’s possible for a professional to help you work out a plan to convert your traditional 401(k) to a Roth IRA in stages, so you aren’t doing it all at once and the tax bill is easier to handle. But, actually, "You can hedge your bets by doing both," Rob Williams says. You must pay income taxes on the employer match once you make a withdrawal. By submitting this form you agree to receive emails from FinanceBuzz and to the privacy policy and terms. Choosing between a Roth 401(k) vs. 401(k) can make a big difference in your financial future. If you’re at least age 50, you can make catch-up 401(k) contributions of up to $6,500, bringing your total to a potential $26,000. But, you know what’s even better than a dual strategy? Logged JohnGalt. Right now, federal income taxes are the lowest they've been in a long time. 401(k) vs SIMPLE IRA. There are also RMDs with the Roth 401(k) when you reach age 72. Finally, if you quit your job or are laid off while you’re still repaying a 401(k) loan, it will come due. You want to maximize your company match, so you ask to have 6% withheld from your check, which amounts to $150. If you have a Roth 401(k) your contribution is taxed as income and deposited into your Roth 401(k), but the employer match goes into a traditional 401(k). With the Roth version of a 401(k), the main difference is how the contributions and withdrawals are taxed. 401k vs Roth IRA Infographics The Roth version of the 401(k), introduced 10 years ago, has yet to go viral. But, what if all else isn’t equal? For example, let’s assume that you expect your federal effective tax rate to increase from 20% while working to 23% during retirement. With these kinds of benefits off the table for high savers, the Roth 401(k) becomes a more appealing choice. Another difference is that a Roth 401(k) has required minimum distributions beginning at age 70 1/2 while a Roth 401(k) does not have any required minimum distributions. Roth 401(k)s are less common than traditional 401(k)s, but an increasing number of employers offer them. If you think your tax rates are going to go down in retirement, or you need to reduce your taxable income … In round one of Roth IRA vs 401k the 401k is looking better! The tax treatment of 401(k) distributions depends on the type of plan: traditional or Roth. Investor age: 26 in 25% tax bracket. The 401k grows to $1,829,768 by the time we’re 60 years old. Knowing how … Let’s take a closer look at this to see what that means in real-world terms: By taking advantage of the employer contributions, every month you get $150 in free money invested, on top of the money you have withheld from your check. 6 Surprisingly Simple Moves To Boost Your Credit, 5 Must-Have Apps That Will Completely Change How We Invest, How to pick between a Roth 401(k) vs. 401(k). For example, if you experience a year of lower income, you can use this time to convert your traditional 401(k) into a Roth IRA at a lower tax rate. Basis: 401(k) Roth IRA: Definition: A retirement plan, sponsored by employers, allowing employees to make salary deferral contributions. | Charles Schwab Unlike the traditional IRA, there is no up-front deduction of tax to the contributions made to Roth IRA. 401(k) vs. a Roth 401(k) Around half of employers that offer 401(k) plans to their employees offer both a traditional 401(k) and a Roth 401(k). It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. The Roth 401(k) contribution limits are the same as the contribution limits of a traditional 401(k). With a regular 401(k), once you retire and begin to withdraw money, you have to pay taxes based on your tax rate at the time of the withdrawal. Note that this assumes that your 401(k) balance is not greater than a year of your income. For example, I spoke with the in-house retirement group at my firm who typically recommends utilizing a Roth 401(k) early in your career (assuming you earn less) and then switching to a traditional 401(k) later as your earnings increase. In this case, a Roth 401(k) would not be your ideal choice. I understand this complicates the calculus surrounding your retirement contributions, but it is worth noting. For those with less familiarity, a “traditional “ 401 (k) is funded with pre-tax money while a Roth 401 (k) is funded with post-tax money. Consider talking to a tax professional before you move forward with this approach. With a Roth 401(k), you still have to take RMDs and there are limitations on 401(k) loans, but you get to manage your tax bill in the future. As of January 2006, there is a new type of 401(k) - the Roth 401(k). Contributions made are from post-tax income. This strategy is great because it avoids the highest tax brackets in your highest earning years and also provides additional flexibility when making retirement withdrawals. The total that goes into your 401(k) each paycheck is $225, which means you’re contributing $450 per month. While Sally places her $19,500 contribution into a Roth 401(k), Sam places his $19,500 into a traditional 401(k). Therefore, the distributions you take from your 401(k) — and that are included in your income — can impact your Medicare premiums. Say our SS income is $63,900. And, as I mentioned previously, because the tax treatment of retirement withdrawals varies by state, a dual strategy might be the best solution to effectively navigate such a complex landscape. Using both may be a more prudent decision and could allow for even more optionality than using either account by themselves. Now for the second reason to consider a Roth 401k: You can avoid the required minimum distributions (RMD) at age 70-1/2 with Roth 401k accounts, while RMDs apply to traditional 401ks. I'm 25 now and looking to retire by 40. In this video I compare the traditional 401k and Roth 401k plan and discuss when it makes sense to contribute to these plan. The Roth 401(k) offers a much higher annual contribution limit than the Roth IRA ($19,500 for the 401(k) in 2020 vs. $6,000 for a Roth IRA). Mathematically this makes sense because when multiplying a bunch of numbers together, the ordering of the numbers doesn’t matter. Because you already paid taxes on your contributions, a Roth allows you to take your distributions tax-free, so you don’t have to worry about paying taxes on your money down the road, no matter how much you take out of your Roth account. If you’re closer to retirement, a specialist can help you figure out how to coordinate your traditional and Roth accounts with when you start taking Social Security benefits. Because your employer usually handles the transaction, it’s relatively easy to start saving for retirement. Taxation of Social Security benefits, the Provisional Income formula. For some investors, this could prove to be a better option than contributing … We have not included all available products or offers. Given that future tax rates are what’s important when choosing between a traditional 401(k) and a Roth 401(k), your next question might be, “So Nick, what will future tax rates be?”  Unfortunately, I have no idea! On top of that, some employers even offer what’s known as a company match and they contribute to your 401(k) as well. … Instead, you’ll have a separate traditional 401(k) and the employer’s portion will go into that. Retirement planning requires some thought and long-term planning, so keep that in mind as you make contributions to your 401(k) accounts. Roth 401(k) vs Roth IRA. Roth 401(k) vs. Unlike Roth IRAs, both 401(k)s and Roth 401(k)s don’t have income phase-out limits. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data, For disclosure information please visit: https://ritholtzwealth.com/blog-disclosures/. Both 401 (k)s and Roth IRAs are popular tax-advantaged retirement savings accounts that differ in tax treatment, investment options, and employer contributions. The Roth 401(k) is a type of retirement savings plan. If it is, then you will be paying the same (or higher tax rates) when converting. So, you’ll pay income tax before your Roth contribution is taken out of your paycheck. Yes, this answer is simple, but it ain’t easy. You'll also receive an extensive curriculum (books, articles, papers, videos) in PDF form right away. An employer-sponsored 401(k) plan offers a tax-advantaged way to grow retirement savings, along with the potential for matching contributions. The central difference between a Roth 401 (k) and traditional 401 (k) is the tax treatment of your contributions. As a result, you might feel like you will benefit more from getting a tax deduction today, and paying taxes on your withdrawals at the decreased rate later. Having these two pieces of information can do a lot to clarify whether you should be contributing to a traditional 401(k) or a Roth 401(k). You are eligible to contribute to either a traditional 401k or a Roth 401k based on what your employer has made available. Ellevest isn’t a tax pro, so we can’t tell you exactly what’s right for you. Because maxing out a Roth 401(k) places more total dollars into a tax-deferred account than maxing out a traditional 401(k). You don’t want to be stuck with an unexpected and high tax bill. Traditional 401(k) With Match Maximum. When you are ready to withdraw money, you will be able to do so without paying any taxes. Although there are exceptions, if you withdraw money early, not only will you have to pay taxes on what you take out, but you will also have to pay an additional 10% penalty. This is why some of the tactics I’ve discussed here could be helpful for you and some could be disastrous. You can try to use historical trends to think about whether federal or state tax rates will be higher or lower over the next few decades, but this is harder than it seems. The Battle: Roth 401k vs. The most well-known employer-sponsored retirement account is simply tabbed a "401(k)," but there are major differences between a pre-tax, or traditional 401(k), and a Roth 401(k) -- … When formulating a retirement plan for a comfortable future, choosing a 401(k) can be one way to take advantage of tax-efficient investing. The whole traditional-vs-Roth 401(k) question has a lot to do with taxes, and everyone’s tax situation is different. At that point, you will have 60 days to pay the remaining balance or that money counts as an early withdrawal and you’ll be stuck paying taxes and penalties. These plans come in two flavors: The traditional, tax-deferred kind, which lets you contribute pre-tax dollars, or a Roth 401(k), which is funded with after-tax dollars but lets you realize tax free growth and retirement income. A SIMPLE IRA is another type of … A Roth 401(k) is a defined contribution retirement plan funded by after-tax dollars. If you don’t expect any material change in your income tax rate between your working years and retirement, it (generally) won’t make a difference whether you choose a traditional 401(k) or Roth 401(k). There is a very lucrative type of retirement savings plan as all the future withdrawals are tax-free. can be utilized for greater tax efficiency. Roth 401(k) contributions are made with aftertax dollars, so you do not receive a tax break today. FinanceBuzz is not a financial institution and does not provide credit cards or any other financial products. FinanceBuzz and CardRatings may receive a commission from card issuers. Any prolonged period of low income (such as spending time to raise your children, going on sabbatical, etc.) For example, in 2012, I was under the impression that U.S. federal income tax rates were likely to increase in the future to be somewhat closer to that of their European counterparts. FinanceBuzz is an informational website that provides tips, advice, and recommendations to help you make financial decisions. The main caveat is that your Roth 401(k) must be established for at least five years before you start taking distributions. In general, the premiums you pay for certain Medicare benefits are impacted by your income. A Roth 401(k) is part of a 401(k) plan offered by an employer, or in some cases, can be contained in a Solo 401(k) opened by someone who is self-employed. It’s also notable that if you have a Roth 401(k) and your employer makes matching contributions, those contributions will be held in a traditional 401(k), even though your own employee contributions will be kept in the Roth 401(k). When you fund a traditional 401 (k), whatever you put into it has not been taxed (pretax income). Even though it can be tempting to get a 401(k) loan and pay yourself interest, it’s important to understand that the interest you pay isn’t likely to replace what you could have earned by leaving that money in the market. A special retirement account is allowing people to save post-tax income for future financial commitments. You’ll save money by paying taxes on your withdrawals at a lower income tax rate in retirement. It’s actually possible to avoid taking RMDs when you have a Roth 401(k) — but you have to take an extra step and open a Roth IRA. Sally placed more total dollars into the tax-deferred account to begin with. Let’s look at two different investment scenarios (low to high tax bracket and high to low tax bracket) to see why a Roth 401k is a better investment choice for a young investor who plans to be taxed at a higher rate in the future. The main difference between a Roth 401 (k) and a traditional 401 (k) comes down to taxes. I have friends who used this tactic while they were in business school because they knew they would be temporarily earning next to nothing. Both of these accounts can be great for building wealth for the future and making the most of your money. The ROTH is ignored and Provisional Income is less than $32,000 so no tax is owed on the SS or the ROTH … The Roth 401 (k) must be open for 5 full years before distributions can be withdrawn, even if you’re older than the minimum age. No taxes in your earnings from returns! See the percentages used in the example above where both Roth and pre-tax funds within the same self-directed 401k were used to invest in the same … As with a 401(k), a savings cap is applied on an annual basis. No taxes in your earnings from returns! However, a Roth 401(k) vs. a Roth IRA has higher annual contribution limits. In a Roth 401(k) vs. Roth IRA comparison, both offer tax-free growth & tax-free retirement income. All else equal, if you think your income taxes will be higher now, then contribute to a traditional 401(k), otherwise contribute to a Roth 401(k). However, your combined contributions to each account can’t exceed the annual contribution limit set by the IRS. However, some high earners prefer depositing into a Roth 401(k), paying taxes now, and avoiding taxes on distributions later. Ellevest isn’t a tax pro, so we can’t tell you exactly what’s right for you. A Roth 401(k) is part of a 401(k) plan offered by an employer, or in some cases, can be contained in a Solo 401(k) opened by someone who is self-employed. For example, your employer might offer a 50% match on up to 6% of your income. Although there’s no tax benefit today, you can reap some tax savings later. Roth 401(k) contributions are made after paying taxes. Despite all the back and forth on which 401k account is right for you, the only right answer is to talk to a tax advisor. However, this isn’t an easy question to answer because you have to consider how your federal, state, and local income taxes might change over time. On the other hand, a traditional 401 (k) is a pretax savings account. Florida)? The main difference between the Roth 401(k) and the traditional is when the money is taxed. Ultimately, you are responsible for your financial decisions. With a Roth 401 (k), you pay taxes up front. Though there are a few scenarios where a Roth 401(k) would be preferred to a traditional 401(k) [see below], I generally recommend contributing to a traditional 401(k) because it has one thing that a Roth doesn’t have—optionality. How contributions are taxed.Traditional 401(k) contributions are made pre-tax. It's almost always better to go with a Roth. Withdrawal rules and taxation. Traditional 401(k) Calculator A 401(k) contribution can be an effective retirement tool. Although everyone says that it depends on tax rates now vs retirement, please remember the other huge advantage of a Roth 401k. It is an employer-sponsored plan that employees can contribute to throughout their careers. … What if you are working in a state with high income taxes now (i.e. For the most part, choosing between a Roth 401(k) vs. 401(k) is about deciding when you want your tax advantage and what makes the most sense for your personal finances. 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