Roth 401(k) vs. Traditional 401(k)
As the popularity of Roth 401(k)s continues to increase, we have received a growing number of client inquires regarding whether they should take advantage of this option in their 401(k) account (Note: Roth 401(k)s became available to employers on January 1, 2006, but are not offered as an option on all 401(k)s). While your employer may not have a Roth 401(k) option available to you now we expect that you will likely be presented with the opportunity in near future. With that in mind, we thought we’d outline the main factors to consider when deciding between a Roth 401(k) and traditional 401(k).
First, let’s look at the major differences between the two options. With a traditional 401(k) account, contributions are made on a pretax basis. This means money is taken out of a paycheck before any taxes are taken from it and put in your retirement plan. Later, when you retire and take the money out, the withdrawals are taxed as income. In a Roth 401(k), contributions are taken after taxes have already been deducted. You’re in essence paying the taxes up front. So the biggest difference between the two is when you pay the taxes – now or later.
You’re probably asking yourself “Well, how do I know if it’s better to pay now or in the future?” If you’re someone who is nearing or at the peak of their earnings potential (i.e. you are earning more now than you will in retirement), it would probably make sense to contribute on a pre-tax basis to your 401(k). Not only would you reduce your earned income, but, later when you’re retired, you will be earning less and likely be in a lower tax bracket.
The opposite holds true for a Roth 401(k). If you’ve recently entered the workforce or expect to be earning more during retirement than you are now, a Roth 401(k) would likely be appropriate. The reason for this is that you’re already in a relatively low tax bracket and there will be less of a benefit from reducing your earned income further.
However, a Roth 401(k) is not recommended if you have five years or less until you plan to retire. This is due to the fact that if a distribution is made within five years of starting the Roth 401(k), it is considered an unqualified distribution (e.g. a withdrawal of part or all of the accounts value) and could be subject to additional income tax. Several factors will effect how much will be withheld for taxes, such as the source the funds are withdrawn from, your age and tax bracket. According to IRS tax laws, an equal ratio of contributions to earnings has to be taken when a distribution occurs. Any portion that is considered earnings will be accessed a tax of 20% prior to the individual receiving a distribution. If the individual is in a tax bracket that is higher than 20% an additional tax will be levied. In addition, if the individual is under the age of 59 ½ they will also have to incur a 10% early withdrawal penalty.
For example, let’s say you are 60 years old and have $20,000 in your Roth 401(k). Your account balance is comprised of an equal amount of contributions and earning (e.g. $10,000 of contributions and $10,000 of earnings). If you decide that you want to take a partial distribution of say $10,000, the distribution will consist of $5,000 in contributions that are not subject to taxation and $5,000 of earnings.
Prior to the distribution being made an initial tax of 20% or $1000 ($5000 * 20%) would be deducted from the distribution amount. If you are in a tax bracket that is higher than 20% you would be responsible for the difference at the time you file your taxes. For instance, if you are in the 28% tax bracket you would need to pay an additional $400 ($5,000 * 8%) in taxes. This would leave you with a distribution of $8,600 not the $10,000 that you expected.
The problem with this scenario, other than the lost $1400, is that you paid taxes on earnings that are meant to be tax free which defeats the purpose of investing in a Roth 401(k).
In addition, for anyone that cannot contribute to a Roth IRA because of income restrictions, a Roth 401(k) could provide flexibility to their retirement saving. According to IRS guidelines, single filers making between $101,000 and $116,000 and those who are married and filing jointly and making $159,000 to $169,000, cannot contribute to a Roth IRA. Fortunately, there are no income stipulations/restrictions for a Roth 401(k). Once the contributor retires they can move the funds to a Roth IRA and take full advantage of the benefits of a Roth IRA.
Regardless of which type of 401(k) you choose, the most important decision that you can make is to start/continue saving and the worst decision that you can make is to stop/not start investing. As always, we are available to answer any questions you might have about this. Please feel free to call us at, 877-627-8401 or email us at
info@smart401k.com.