What’s the difference between a traditional and Roth 401(k)? Not only is that a question that many millennials ponder, and a question that I receive from readers, but it’s also a decision that many of you must make when it comes to your self-directed 401(k) investing. In this post, I’ll go over the basic difference between the two accounts to help shed light on what separates and connects them. Each account has its advantages and disadvantages. Which one are you going to choose?
The two types of 401(k) accounts
If your employer offers a 401(k), then it would most certainly be a traditional 401(k). However, they may also offer you the opportunity to invest in a Roth 401(k). Not all employers do allow this, but the percentage of employers who do offer the Roth is rising year after year. The primary difference between the accounts is when you pay ordinary income taxes on the money. Still, they are more similar than different. They are similar in that, first, they require withdrawals after age seventy and a half, and two, they are tax favored savings vehicles, and three, there are no income limits, meaning you can make as much at your job and still contribute to either plan (which is unlike with an IRA, where you must begin “phase out” contributions to a Roth IRA as your salary hits a specific upper limit). Also, both accounts can be rolled over into an individual retirement account (IRA) when you leave your job or retire.
The Traditional 401(k)
With a traditional 401(k), you contribute money on a pre-tax basis, which lowers your gross income reported to the IRS. This is a tax-deferred account. When you withdraw the money at retirement, you will pay ordinary income taxes on your contributions, any employer matching contributions, and the earnings on those contributions. Typically, folks chose this account if they expect to be in a lower tax bracket in retirement than they are during their working years. In this account, you get tax savings each year, which you could place into a separate savings account, such as an IRA, to supplement your retirement savings. In a previous post, I showed you how you could save $100,000 by retirement by selecting the traditional 401(k).
The Roth 401(k)
With a Roth 401(k), you contribute money on an after-tax basis, which does not lower your gross income reported to the IRS. When you withdraw the money at retirement, you will not pay ordinary income taxes on your contributions or any earnings on those contributions. However, any employer matching contributions that go into a Roth are taxed like traditional contributions, and you will pay tax on these withdrawals. Still, overall, you get tax-free growth. Usually, you would select this account if you expect to be in a higher tax bracket in retirement than if you are during your working years. You don’t get tax savings each year with this account. However, if you are young and save a lot, this may be the account for you. In a previous post, I wrote about 3 reasons why the Roth 401(k) may be right for you.
Read my upcoming book to learn more!
In my upcoming book, out this summer, I will take you step-by-step on how to differentiate the two accounts and how to select which one to invest in. 401(k)s are self-directed, and the answer isn’t always easy around how to determine which will work best for your tax and financial situation. Choosing the right account up-front can save you the burden of paying too much in taxes if you decide to switch later on in your career. But with From Millennial to Millionaire, you will have the information you need to make the decision on your own with confidence.
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Want to learn more? Pick up a copy of my book …
From Millennial to Millionaire: DIY 401(k) – 5 Do-It-Yourself Steps for the Digital Generation to Design and Manage their 401(k) on Amazon.