You may have heard of the Roth 401(k) as more companies offer it as a retirement savings alternative. In the past, when companies offered a retirement plan, it would be the traditional, or pretax, 401(k) plan, also known as the employer 401(k). These days, more than half of companies provide a Roth 401(k) employee deferral option, in addition to the traditional plan. What most people don’t realize is that a Roth 401(k) plan is not actually a different type of 401(k) plan; it is essentially a regular 401(k) plan that contains a Roth feature.
But which 401(k) option is the “better” of the two? Let’s look at what both plans offer.
- If your workplace offers a 401(k) retirement plan, you should be contributing to it
- Having the option of traditional vs. Roth plan is a great benefit
- It’s up to you to decide which plan is better – when do you want to pay the tax man?
The Traditional 401(k)
A traditional 401(k) is an employer-sponsored savings plan named after the income tax code that created it. All contributions you make to the plan are made with pretax dollars. Of course, you may choose if and when to contribute to the plan. This is why it’s known as an elective deferral. Taxes are deferred on the contributions you make to the plan, which means you will not pay taxes during the year in which they are made. Taxes will become due (on both the contributions and the earnings) only at the time of withdrawal.
For 2023, you are allowed to contribute up to $22,500 to a 401(k) plan. If you are at least age 50, you may make an additional $7,500 “catch-up” contribution, bringing the annual limit to $30,000. Further, you are limited by your earned income on the year – if that amount is under the annual limits, you may not exceed what you earned. For example, if you made $15,000 working part-time during the year, that is the maximum you could contribute to the plan.
Some employers will match a portion of your contributions (matching contribution) – these funds will also be deferred until you reach retirement age and make a distribution. The traditional 401(k) is a more beneficial plan if you anticipate being in a lower tax bracket at the time you take out your retirement funds. The idea is to not pay taxes while you’re in the peak of your earning potential. Obviously, the more money you make during the year, the more you will owe in taxes. By contributing to a pretax 401(k) plan, you lower the amount of your taxable income.
Read this: Annual 401(k) Contribution Limits
The Roth 401(k)
A Roth 401(k) is an employer-sponsored savings plan that combines the features of a traditional 401(k) and a Roth IRA. The two share many similarities. First, you must be employed in order to qualify for either plan. They both limit how much you can contribute and if you make an early withdrawal, you will be penalized outside of the exceptions for early withdrawals.
However, the Roth 401(k) contributions are made with after-tax dollars. In other words, you pay your taxes upfront before contributing to the plan, like the case of a Roth IRA. The result of using after-tax dollars is that you aren’t subject to taxes when making qualified distributions.
This is the main difference between the traditional vs. Roth 401(k). Younger people, who have yet to reach their peak earnings potential (and have decades to let the money grow) benefit greatly from the Roth option. Depending how your career goes, you might still be at your peak when you are eligible for penalty-free distributions from your retirement plan. Why settle for a smaller tax-break now, when you can postpone until later, when all the funds in your plan will be tax free.
As previously stated, the availability of the Roth 401(k) has increased steadily over the years. As a result, sixty percent of people who have the option of a traditional vs Roth 401(k) choose Roth, with Millennials favoring the Roth 401(k) more than Baby Boomers and Gen Xers.
Traditional vs Roth 401(k)
Neither plan is necessarily “better” than the other. It all depends on each individual plan participant and his or her current and future financial situation. If you expect to be at a higher tax bracket when you take out your retirement funds, you may benefit more from a Roth 401(k).
Many investors and financial advisors do prefer the Roth. Consider this: if you put $5,000 into your Roth 401(k) and you pay taxes on that amount now, that $5,000 may turn into $50,000 through wise investments. Therefore, you can take out that $50,000 tax-free as a distribution.
Let’s apply the same situation to the traditional 401(k). Let’s assume you make wise investments over the years and your $5,000 turns into $50,000 – a large portion of that will go towards taxes once you take your retirement funds out as a distribution. In that respect, in the battle of traditional vs Roth 401(k) plans, the Roth is the financially savvier option. That’s why many financial advisors will say, if you can pay taxes now, do so.
Of course, a viable alternative is to split your contributions. Take a partial tax-break now with a traditional contribution and put some after-tax money into a Roth. A popular strategy is to utilize the Roth IRA in this case. At the very least, you should be taking full advantage of any employer match. Contribute to your 401(k) first, until you receive the full match. After that, you can contribute to your Roth IRA (and then maximize your 401(k) contributions if you so wish).
The Solo 401(k)
Self-employed individuals do not have the advantage of having an employer-sponsored plan available to them. They have to be proactive at start a plan for themselves. That’s where the Solo 401(k) plan comes in.
In the past, if you were self-employed or a small business owner with no full-time employees, you would generally choose the SEP IRA. The features of the SEP IRA are similar to a 401(k), with a much easier set up and administrative rules than the 401(k). Additionally, the SEP IRA is more beneficial for self-employed individuals.
However, since 2001, with the rise of the Solo 401(k), also known as the Individual 401(k), more self-employed individuals opt for this retirement plan in today’s society. The benefits are far superior to those other plans available. Not only can you contribute as the employee (the elective deferral), but you may also contribute as the employer, also known as profit sharing. That means, for 2023, you may contribute up to $66,000 or $73,500 if you are at least 50. No other plan allows you to supersize your retirement savings to that extent.
Not only that, since you are in control of picking the plan, you may decide to include the Roth option. Keep in mind that only the elective deferral can be made as Roth. The profit contribution must always be made with pretax funds.
Another great feature, and something an employer-sponsored plan might not offer, is the loan option. You have the ability to borrow up to $50,000 or 50% of the plan balance, whichever is less. Best of all, you pay back the plan, with the interest that would otherwise go to a bank if you were to borrow from there in an emergency.
The Solo 401(k) must be mentioned, as it’s the ultimate retirement plan for self-employed individuals, such as small business owners and contractors.
At IRA Financial, we help investors take control over their retirement funds. When you choose to self-direct your retirement, you can make traditional, as well as alternative investments, like real estate. This creates retirement portfolio diversity, which better secures your future.
If you qualify for a Solo 401(k) plan, we can help you! If not, it’s up to you, with the help of a financial expert, to decide how you want to save for retirement – traditional or Roth. Either way, as long as you are saving, you’ll be better off.
Q for You
Which retirement savings plan would you choose? The Roth 401(k) or the traditional 401(k) plan? Let us know!