In Wednesday’s article, I talked about a traditional 401(k) plan. Much like its sibling, the IRA, the 401(k) also has two possible options, a Traditional version, and a Roth version. Today, I’ll be briefly explaining the benefits and limitations of a Roth 401(k).
Let's start with a quick recap of a 401(k) plan. A 401(k) is offered by employers to their workers. This account allows workers to receive a couple different kinds of tax benefits, meaning they get to pay less taxes one way or another. The contributed money can be put into investments that are usually pre-selected by the employer. Most of these investments are professionally managed funds. One common kind is a target-date retirement fund. Additionally, some employers may match your contributions, meaning they will add some money to your 401(k) as long as you do too. This is as close as it gets to “free money”. More details can be found in this article.
While a traditional 401(k) plan allows workers to invest pre-tax money (meaning you haven’t yet paid taxes on it). The workers can deduct their contribution, reducing their tax rate. But when you decide to withdraw money from the account, you will have to pay taxes on the withdrawals. Additionally, once you reach the age of 70 ½, you have to start withdrawing a certain amount every year.
On the other hand, a Roth 401(k) plan is funded with post-tax money, meaning you’ve already paid taxes on the money you deposit into the account. You can then invest your money into a few different pre-selected assets, just like with a traditional 401(k).
One key difference is the fact that when you decide to withdraw your money from the Roth 401(k), your withdrawals will be completely tax-free because you already paid taxes on the initial contribution. Another key difference is the fact that you do not have to withdraw money from a Roth 401(k), you can leave it untouched for life.
You can contribute up to $19,500 per year in the 401(k). You can contribute an additional $6500 if you're over 50. There are income limitations, meaning if you make too much money (an amount determined by the IRS depending on your tax filing status), the amount you can contribute decreases.
A Roth 401(k) is great for anyone who plans on retiring in a higher tax bracket, or anyone who expects tax rates to go up because any increase in tax rates does not affect your money.
If you expect to earn more money in retirement through, maybe, alternative income streams like real estate or freelance work, a Roth 401(k) is great for you. On the other hand, if you expect to retire in a tax bracket lower than your current one, a Traditional IRA may suit your needs more.
One caveat with both 401(k) plans is the minimum age for withdrawals; if you withdraw money before the age of 59 ½, you will have to pay a penalty and potentially pay taxes on the withdrawal. This is why it’s recommended to keep some emergency funds aside in a separate account so you can access cash quickly without any penalties.
In short, the biggest difference between the traditional and Roth 401(k) is the time you pay taxes. For a traditional 401(k), you'll pay taxes in retirement, after you withdraw, while with a Roth 401(k), you'll pay taxes before retirement and before you withdraw your money. Both versions of the 401(k) plan are excellent ways to save for retirement and enjoy reduced taxes while receiving additional benefits from your employer.