Retirement Planning: Traditional vs. Roth 401(k)

There are many types of retirement plans and not one is fit for everyone. Small businesses may use a different type than an employee of a large corporation. We are going to break down the difference between two different types of 401(k) plans. 

Retirement Plan: Traditional 401(k)

Traditional accounts allow individuals to set aside some money from the paycheck before getting taxed. With pulling money pre-tax, the IRS can only tax these funds when individual receives a distribution from the plan. Depending on when you retire and what position you are on the tax bracket, the federal and state taxes will be affected by those factors. If you feel as if you will be on the lower tax bracket when you retire, a traditional 401(k) plan is the best plan for you. However, if you choose to take out money from your 401(k) before you turn 60, there will be an additional 10% tax penalty.

Retirement Plan: Roth 401(k)

For Roth 401(k)s, employees are allowed to put money away after taxes. This allows for no additional withdrawals in the future, but there will a significant amount of money taken from your paycheck. However, after your retirement, you will have access to all the money you saved in your 401(k) tax-free. You may not have a lot of money coming from your paycheck, but you will have more money later without taxes. For example, if you put away $1 million into a Roth account, you will have all $1 million plus investment earnings. Traditional accounts do not have that benefit. 

Along with these benefits, withdrawal rules are a little more lenient. To get the full tax-free benefits, you should only withdraw from your Roth account after 5 years from your first distribution and you have turned 59 and a half years. There are other cases of exception like becoming disabled or dying. Younger employees tend to favor Roth 401(k) over traditional because they are in a younger tax bracket and their earnings will have time to compound. 

How much can I contribute?

Both types of accounts are similar in which they both have the same limits of $19,500 to contribute to annually or $26,000 if you are over the age of 50. The additional contribution annually for those 50 and older is seen as “catch up”. For those that are nearing retirement, you have the opportunity to save as much money as you can to close any savings gaps. If you have both a 401(k) and Roth account, keep in mind that you must split the $19,500 over those two accounts.

No one account is better or worse than the other. Both have their own benefits. Depending on your own situation, it is best to find the best option for you.

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