The basic explanation is that income taxes are handled differently between Roth and traditional 401(k)s, but there is more to these retirement plans than meets the eye.
When it comes to financial planning, the terms Roth 401(k) and traditional 401(k) are thrown around a lot. And, unless finance is your background, it feels like the two are entirely different. It may seem like it’s too complicated to worry about the difference. A retirement savings account is a retirement savings account: right?
Luckily, the difference between a Roth 401(k) and a traditional 401(K) isn’t all that complicated. Without getting into the nitty-gritty details, the biggest difference between a traditional and Roth retirement account is simple: taxes. Like everything else related to a 401(k), the way they handle income taxes is the single most important factor to understand about them.
According to Money Under 30 the main difference is simple:
With traditional accounts, you don’t have to pay taxes on the money you put in now, but you have to pay income taxes on the money when you withdraw it later.
With Roth accounts, you can only put money in after you’ve paid income taxes on it, but when you withdraw it in retirement, you don’t have to pay taxes on the money.
Largely, the difference between the two is whether you: take the taxes off from the top by investing money that has already been taxed as income by the government, or you wait until you’re in retirement age to be taxed on your earnings. There are obvious benefits to being taxed before contributing, but there are also benefits to investing more and paying taxes later.
Additionally, the 10% early withdrawal penalty only applies to gains made in a Roth 401(k) rather than applying to the entire balance of a traditional account.
So, what’s the best route for the average person?
If tax rates don’t change
In the unlikely scenario that income tax rates don’t go up (or down) between now and when you retire, there will be no difference between a Roth or traditional 401(k) investment. Whether you’re taxed now or later your investment growth and payment will be the same.
David Weliver at Money Under 30 advises not to assume the tax payment will be the same whether you pay now or later.
“Of course, no one knows for sure what taxes will be in the future, but most people assume taxes won’t go down,” he wrote. “If you’re young and professionally ambitious, it’s a good assumption that you’ll be in a higher tax bracket as a successful retiree than you are now on an entry-level salary.”
Pay Later With a Traditional
Despite the tricky negotiation between paying taxes now or later, Personal Capital’s 2019 piece on the subject says if a person believes they will be in a lower tax bracket at retirement, a traditional 401(k) is the best option. Another consideration may be the tax requirements of the state in which you will retire.
It’s also important to remember that contribution types can change over time. For example, if someone plans on retiring early, a traditional 401(k) might be a good option, which leaves their retirement funds available for conversion to a Roth 401(k) between their retirement and withdrawal.
“For example, in some instances, a person that wants to retire early, say [at] age 50, might benefit from purely pre-tax contributions, then once they retire, if they are in a low tax bracket, they can do annual Roth conversions to take advantage of the low tax rate and ideally have little to nothing subject to RMDs [required minimum distributions] by the time they hit age 70 1/2 years old,” according to Personal Capital.
Pay Now With a Roth
Unsurprisingly, most 401(k) experts say Roth contributions are the best option for saving money down the road. As taxes are unlikely to go down and a person’s personal wealth is likely to go up, a Roth 401(k) will probably provide the most financial support in the long run.
For financial expert Grant Sabatier at Millennial Money, the Roth 401(k) is an obvious choice. The money invested is wholly yours and isn’t subject to taxation upon withdrawal, which makes it a much better retirement fund option.
“Roth 401[k]’s compound over time and grow tax-free,” Sabatier wrote. “You pay tax when you put the money in, but not when you take it out likely many years later. This means that all of the compound interest – or money that your money makes – won’t be taxed when you take it out.”
Sabatier also mentioned that those in lower tax brackets are best off taking advantage of a Roth 401(k) now, as their retirement tax bracket is likely to be different. And, even if you’re in a higher tax bracket now, you’re still better off in a Roth because you’re likely to keep gaining personal wealth in the future.
Save Either Way
There is no one-size-fits-all solution to deciding between a Roth or traditional 401(k), but it is important to save for retirement regardless of which method you choose, whether it’s a traditional 401(K), Roth 401(k), or even a Roth IRA (yes, there are more than two types of retirement accounts, all with varying requirements and contribution limits). Depending on your circumstances, you may want to even consider alternative solutions to planning for retirement.
Davidson’s advice is to not spend too much time contemplating your options and simply choose one, so you can benefit later.
“Regardless of which one you pick, contributing to either account is much better than not saving at all,” she wrote. “In fact, your biggest mistake could be taking too long to decide which one to choose since delaying your contributions for even just a few months could actually wipe out any advantage you would get from picking one over the other.”
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