Traditional and Roth 401(k)s
Not sure what the difference is between traditional and Roth contributions for your 401(k)? We’ll explain.
Ever hear the terms traditional 401(k) and Roth 401(k) thrown around and wonder – what are they? Should I be using them? Are these the keys to untold levels of wealth and financial security?!
Easy does it. There are no secret weapons or silver bullets for securing a financially fit future. That said, traditional 401(k)s and Roth 401(k)s can be important tools when building your retirement strategy, so let’s make sure you know what they are. And a fun fact to know right away: you can use both.
What do they have in common?
A traditional 401(k) and Roth 401(k) are tax-advantaged accounts that allow you to save and invest for retirement (the tax advantages given to these types of accounts are not available in many other investing accounts). They’re available to you as a workplace benefit offered by your employer, and they’re funded with contributions from your paycheck – you set the amount, either as a dollar or a percent. The idea behind both is that they make it easier to save and invest for retirement automatically, like a built-in part of your budget.
So what’s the difference?
The difference is in how they are tax-advantaged. Traditional 401(k) contributions are made with pre-tax dollars, while Roth 401(k) contributions are made with after-tax dollars.
Here’s an example. Let’s say you earn $40,000 a year and make contributions into a traditional 401(k). The contributions go into the account before your paycheck is taxed (“pre-tax”), lowering your taxable income. So if you save $3,000 throughout the year, you’d be paying taxes on $37,000 rather than $40,000.
In addition, the money that you contribute—and any earnings—grow tax deferred until you withdraw it in retirement. At that time, your withdrawals are considered ordinary income and you’ll pay federal and possibly state taxes depending upon where you live. And, if you want to withdraw money before you turn age 59 ½, you’ll also be subject to a 10% penalty unless you qualify for an exception.
If you decide to contribute to a Roth 401(k), the money is deducted from your paycheck after taxes have been taken out. So your paycheck is taxed now, reflecting your full salary of $40,000, which includes the contributions into the Roth 401(k) account.
Roth 401(k) tax benefits come into play when you withdraw the money at retirement. Because you already paid taxes, you can withdraw contributions—and any earnings—tax-free if you’re age 59 ½ or older and have held your Roth 401(k) account for at least five years.
Short answer: Traditional 401(k)s can lower your taxes now, but you’ll likely pay taxes when you withdraw the money at retirement. Roth 401(k)s don’t save you on taxes today, but you likely won’t have to pay taxes when you withdraw the money at retirement.
Which type of account should I use?
It ultimately depends on your unique financial situation and retirement goals. Betterment is not a tax advisor, and we encourage you to consult one if you want help reviewing your finances and goals.
As a general rule:
- If you expect to be in a lower tax bracket in retirement, consider contributing pre-tax dollars into a traditional 401(k) account now, and you’ll pay taxes later.
- If you expect to be in a higher tax bracket in retirement, consider contributing after-tax dollars into a Roth 401(k) account, and pay your taxes now.
What if I’m not sure if my tax bracket will be higher or lower in the future?
You’re definitely not alone! In which case, it may make sense to invest in both. You’re allowed to make contributions to both types of accounts, spreading your tax exposure around. 5% in a traditional 401(k) and 5% in a Roth 401(k) would give you a 10% total contribution rate (in line with what many experts recommend).
What if I want to withdraw my money early—that is, before I turn age 59 ½?
Let’s start with the Roth 401(k). Because you already paid taxes on your contributions, you can generally withdraw that portion of the money tax-free.
- The portion of the withdrawal that represents your contributions to the account will generally be not taxed (and not subject to the 10% penalty).
- The portion of the withdrawal that represents earnings will be taxable and potentially subject to the 10% penalty.
Most early withdrawals from a traditional 401(k) are taxed as ordinary income plus a 10% penalty. There are some exceptions, such as permanent disability.
The tax advantages and ramifications of retirement accounts can be complicated. As Betterment is not a tax advisor, we encourage you to consult one to help you make this important decision.
One more fun fact - former U.S. Senator from Delaware, William Roth, is the father of after-tax retirement accounts. Enjoy sharing that little bit of trivia at your next cocktail party, on us.