There are two types of 401(k) and they have certain similarities and some significant differences. In order to maximize your retirement savings, it is important to understand the difference between the two and how they have an impact on your finances. Majority companies that offer a retirement savings plan have a Roth 401(k). Access to it has become very common.
What is a traditional 401(k)?
A traditional 401(k) gives you a choice of investment options. It is an employer sponsored plan and any contribution made by employees is tax deferred. The taxes will be paid when the amount is withdrawn.
What is Roth 401(k)?
A Roth 401(k) is a retirement savings program which enables you to make contributions after the taxes have been considered. Hence, you will enjoy tax free withdrawals at the time of retirement. Its purpose was to combine the features from the traditional 401(k) and the Roth IRA. In case of Roth 401(k), it is possible to take benefit of the company match in the contributions. And you also get to make withdrawals without worrying about the taxes.
Similarities between the two 401(k)
Both Roth 401(k) and traditional 401(k) are options for retirement savings. In any of the plan, it is possible to enjoy the comfort of having your contribution deducted out of the paycheck. Both give the right to have a company match. Most companies that offer a 401(k) offer a match in the contributions of the employee. Hence, if your company gives a match, just take it.
Both have the same limit on contribution. Roth 401(k) has some of the finest features of 401(k) and it has easy contribution methods.
Differences between 401(k) and Roth 401(k)
The major difference between the two is the way your contribution is taxed. To put it in simple words, a Roth 401(k) works like a post-tax retirement savings account and before the contribution enters the account, it has been taxed.
In contrast, a traditional 401(k) is your pretax savings account. The contribution will go in your account before it is taxed and this can reduce the taxable income.
In a Roth 401(k), the money will go in after the deduction of tax and it means you will have to pay tax and will take back a little lower in the paycheck. In case of a traditional 401(k), the contribution is pretax. It will be taken out of the gross earnings before your paycheck is taxed. Understand the impact of withdrawals to understand the benefit of Roth 401(k) on your income.
When it comes to withdrawals from the account, Roth 401(k) offers a huge benefit. Since you have already paid the taxes when you made the contribution, the withdrawals remain tax-free. However, the employer match in Roth 401(k) will be taxable during retirement. However, the money you invested will always remain yours. There will be no taxes applicable when you take out and use the money.
In a traditional 401(k), you need to pay tax on the withdrawals based on the present tax rate. Let us see what it means. Assume you have $100,000 in your account at the time of retirement. Now if you have invested it in Roth 401(k), it will remain tax free but if you have invested it in traditional 401(k), you will have to pay tax on the withdrawal at the time of retirement. Hence, your retirement fund will be high if you do not have to pay any tax on the withdrawals. This is an excellent feature of Roth 401(k).
In Roth 401(k), you will be able to start withdrawing money without penalty at 59.5 years but it is essential for you to have held the account for five years. In a traditional 401(k), you will start receiving the amount at the same age but there is no requirement to hold the account for a minimum period of five years. Hence, if you are close to the 59.5 year mark, you need to remember that if you start a Roth 401(k), you will not have any access to money for the next five years.
Which one is better?
If you have to choose between a traditional 401(k) and Roth 401(k), it is best to go ahead with Roth 401(k) at all times. You can see the benefits mentioned here and the biggest benefit is the withdrawal at the time of retirement.
You are already saving for your retirement, so why not take the advantage of this opportunity and invest it in the right 401? If you make it a practice to contribute to Roth 401(k), you will not even worry about the money that you are paying in the form of taxes. At the time of retirement, you will be happy you made the right decision.