Traditional vs Roth 401(k)
You may hear of the Roth 401(k) as more companies offer it as a retirement savings plan. In the past, when companies offered a retirement plan, it would be the traditional 401(k) Plan, also known as the Employer 401(k). These days, more than half of companies provide the Roth 401(k) in addition to the Traditional plan.
But which 401(k) plan is “better” of the two? Let’s look at what both plans offer.
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 401(k) plans 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 up to the contribution limit, like the case of a Roth IRA. Contribution limits are based off the age of the participant. The result of paying after tax dollars is, you aren’t subject to taxes upon withdrawal as a distribution.
This is the main difference between the traditional vs Roth 401(k). This makes it the more beneficial plan for individuals who believe they will be in a higher tax bracket at the time of distribution.
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.
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 pre-tax dollars. Taxes are deferred, which means you will pay taxes on contributions and earnings only at the time of withdrawal.
Some employers will match a portion of your contributions – this contribution 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.
Traditional vs Roth 401(k)
Neither plan is necessarily “better” than the other. It all depends on the 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 401(k) is the financially savvier option. That’s why many financial advisors will say, if you can pay taxes now, do so.
The Solo 401(k)
Self-employed individuals have fewer retirement options, like the employer-sponsored 401(k) retirement plan.
In the past, if you were self-employed or a small business owner with no full-time employees, you would 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, with the rise of the Solo 401(k), also known as the Individual 401(k), more self-employed individuals opted for this retirement plan. Compared to the traditional 401(k) and SEP IRA, the Solo 401(k) has higher contributions (you can make contributions as employer and employee); you can also take out a tax and penalty-free loan, and there is a Roth option.
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 with a Self-Directed IRA. When you choose a Self-Directed IRA through a Self-Directed IRA custodian, you can make traditional and alternative investments, like real estate. This creates retirement portfolio diversity, which better secures your retirement funds.
Take control of your IRA today with IRA Financial.
Q for You
Which retirement savings plan would you choose? The Roth 401(k) or the traditional 401(k) Plan? Let us know in the comments or via social media!