Traditional vs Roth 401k: Which Is Better?

David Bolton

/

September 29, 2020

Retirement Wealth
Traditional vs Roth 401k: Which Is Better? | Retire Fearless

If you are saving for retirement, you should know how a Roth 401K is different from a traditional 401K in detail. Otherwise, you could lose money.

If two people save the same amount of money for retirement, but one person invests their money better, they can retire much better than the other. There are many differences between a Roth 401K and a traditional 401K, and you need to understand them to make the right choice. The main difference between a Roth 401K and a traditional 401K is how the two investments are taxed.

If you invest in a Roth 401K, your income is taxed now but is tax-free after you retire and withdraw it. If you invest in a traditional 401K, you can deposit income without taxes, but your income will be taxed after you retire and withdraw it.

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Which one of the two is better?

It depends on how your future spending compares to your current income. Let's assume that your current income is high. That puts you in a high tax bracket, so you are currently losing a lot of money to taxes.

Let's also assume that your taxable income will be relatively low in the future, including all the money you withdraw from your retirement accounts. This means you will be in a lower tax bracket in the future.

If you are going to be in a lower tax bracket in the future, you want to pay taxes on your income in the future and not today. Today you will lose a lot of money on taxes, after retirement, not nearly as much.

Lower future income means that you are better off with a traditional 401K, not a Roth 401K. With a traditional 401K, you can avoid paying taxes now, when your taxes are high, and pay taxes later when your taxes are lower. A traditional 401K has other advantages as well, so Roth 401Ks are not replacing traditional 401Ks.

What are the advantages of a Roth 401K?

Many people expect their future income to be higher and not lower than their current income is. In that case, they want to pay taxes on their retirement savings now, when they are in a lower tax bracket, and then withdraw their money tax-free in the future.

If you gain a lot of interest on your money, you might end up being heavily taxed on your interest if you have a traditional 401K. You will not be taxed until you withdraw the money, but you will be taxed nonetheless. With a Roth 401K, you do not have to worry about this, as you have already paid your taxes, and your future withdrawals will be tax-free.

Knowing which one to pick is about rightfully guessing what your financial future will be like. You cannot know for sure. You will have to do your best to estimate what your income will be in retirement.

A Roth 401K is usually better early in your career

If you are wise enough to start saving when you are young, you probably expect your income to increase by a great deal long before the end of your career. In that case, your retirement income might exceed your current income, so you want to pay your taxes now.

Later in your career, a traditional 401K is usually a better idea. An average retired person's taxable income is usually lower than their income was late in their career.

One fortunate thing about retirement saving is that you can contribute to both a traditional 401K and a Roth 401K. This way, you can put money into a Roth 401K when you are younger and into a traditional 401K when you are older and expect your income to decrease after retirement. When estimating your post-retirement income, make sure you take social security payments and everything else into consideration.

In 2020, you can only contribute $19500 per year to your 401K accounts before you turn 50. While you could theoretically contribute to both a traditional 401K and a Roth 401K each year, you could only contribute $9750 to each account, and not $19500 to each account. Being able to open both types of accounts is advantageous because you might use one account when you are younger and another account when you are older and have a better income.

Is there an income limit to contribute to these accounts?

Thankfully, these accounts are for anyone who wants them, no matter how high their income is. Don't confuse a Roth 401K with a Roth IRA.

A Roth IRA is different from a Roth 401K and has an income limit. Neither a Roth 401K nor a traditional 401K has an income limit.

Traditional VS Roth 401K: How are they similar?

Both traditional 401Ks and Roth 401Ks are very common retirement savings plans. They are different from IRAs, which have income limits and lower maximum contribution limits.

IRAs do have their advantages, but you cannot usually save enough for retirement if all you have is an IRA. 401Ks are enough for a much above average retirement as long as you contribute the maximum amount for many years.

Both the traditional 401K and the Roth 401K have the same limits on how much you can contribute each year. After age 50, it is $26000 per year and $19500 before that.

The contribution limits are rather generous, much higher than what a lot of retirement savings plans you can find outside of your employer offer. Your contribution limit might be less than half or less than a quarter as much money with a private savings plan.

The two accounts are not similar if you are looking for an employer to match all of your contributions to your account. With a traditional 401K, your employer might add another $5000 (or any other amount of money) to your account whenever you contribute $5000.

You will not be able to find a Roth 401K where your employer matches your contributions. Roth 401Ks are separate from your employer, so your employer will never help you with these savings plans.

If you invest $10000 into your 401K, your employer might be willing to invest another $10000, matching your investment. Your employer may also match an investment of $19500 or $26000 if you are contributing that much each year.

A 401K that the employer matches is a fantastic employer benefit. One other thing you should know is that any contributions your employer matches will be taxed after retirement. The half of the money you contribute is taxed; your employer's half is not.

Traditional 401Ks and Roth 401Ks are popular, with many Americans having most of their retirement savings in 401K plans. Other options have their advantages, but non-employer retirement savings plans often have low contribution limits, and stocks are riskier investments. 401Ks are popular because they are a safe investment with a high contribution limit.

Going with both accounts can be a good idea

Some people prefer to put money into both a traditional 401K and a Roth 401K. This way, you can withdraw a bit of money from both each year to avoid ending up in a high tax bracket.

If you withdraw everything from a traditional 401K, you might end up losing a lot of money to taxes, but might not lose much if you withdraw half from a Roth 401K. This is not in everyone's best interest; sometimes, you should put everything into one account type.

Traditional VS Roth 401K: What are the differences?

There are more differences between traditional 401Ks and Roth 401Ks than whether you pay your taxes now or later. A lot of money is at stake, so you should know what you are doing before deciding.

It is not as easy to withdraw from a Roth 401K

With a traditional 401K, you can begin withdrawing your money as soon as you turn 59 and a half. With a Roth 401K, there are some restrictions.

If you start investing in a Roth 401K later in life, you cannot withdraw until the account has been open for at least five years. You must both 1) Be over the age of 59 and a half, and 2) Have had your account open for at least five years. Usually, this isn't a big deal, but you might not want to put money into an account that you can't withdraw from for five years if you are saving later in life.

If your employer offers matching contributions on a traditional 401K, you are very likely better off with it. Generous matching contributions are the best thing about a traditional 401K. A Roth 401K may be a better idea if there is no option to get matching contributions.

Withdrawal rules for Roth 401Ks

Whether or not your withdrawals from your Roth 401K are tax-free depends on the circumstances. Ideally, your distributions are "Qualified," and therefore, tax-free. If, however, you are withdrawing money at the wrong time, they may be "Non-Qualified" and accordingly taxed.

If you are over 59 and a half and have had your account open for at least five years, you can take out qualified distributions without taxes. If you do not meet these criteria and need to withdraw early, you will have to pay a 10% tax on some of the withdrawal. This tax will be in addition to whatever you lost to taxes back when you invested the money, so do what you can to avoid having to withdraw early.

For early withdrawals, you are only taxed on part of what you withdraw. Some of the money you have in your account is contributions (money that you put into your account previously), and some of what you have is earnings (the interest you gained).

If you have contributed $50,000 to your account and earned another $25,000 worth of interest, then one-third of your money is earnings. Only earnings and not contributions are taxed for early withdrawals. If you withdraw $5000, you would only pay a 10% tax on a third of the money you withdraw.

The risk of being taxed twice if you withdraw from a Roth 401K early is not so severe that you should go with a traditional 401K instead. You will usually not lose a huge amount of money if you have to withdraw early. Get a Roth 401K if it is in your best interests for other reasons.

If you have to withdraw early for specific reasons, you might be able to withdraw tax-free. Some plans offer hardship withdrawals. For example, if you have to pay a large medical expense - more than 10% of your yearly income - you might be able to withdraw without paying taxes.

Every retirement plan is different, and some might offer hardship withdrawals for disability, military service if you are called to active duty and other reasons. If you die, your relatives will inherit everything in your Roth 401K without taxes, even if you die before retirement age.

No minimum withdrawals with a Roth 401K

With a traditional 401K, you are obligated to start withdrawing money from your account after a certain age. This is not the case with a Roth 401K, which you can keep for the rest of your life and give to someone else in your will if you choose to do this.

If your spouse inherits your Roth 401K after you die, they will have to make minimum withdrawals, but this does not happen otherwise. Neither age nor retirement status means you must make minimum withdrawals.

Borrowing money from your own 401K funds

If you have a Roth 401K, and you cannot withdraw any money yet, not even as an early withdrawal, you might be able to borrow money from your 401K account and pay it back later. With a traditional 401K, you do not have this advantage.

Taking out one of these loans is risky because if you end up losing your job, you will have to pay the loan off shortly. Taking out one of these loans is risky. However, it is still an advantage to have this option, as long as you are careful with it.

A Roth 401K is safe if your employer goes out of business

If you have a traditional 401K and your employer goes out of business, you can usually keep all of your money. Your money quite likely won't be lost. However, it can be a hassle to access your money - if the company you work for is in legal trouble, you might have your money frozen for years while the business is investigated.

It is also easier to communicate if you have a private Roth 401K. With a traditional 401K, it might be more of a hassle to know what your money is invested in.

Where can you invest your money if you have maxed out your 401K?

First off, good for you if you make so much more than you spend that you are adding $19,500 or $26000 to your 401K each year. However, you might want to save even more money, and you might be trying to catch up for not saving when you were younger. There is no way around the $19,500 limit, so you will have to look into other options.

Learn about health savings accounts

If you are looking for a great place to put your money after you max out a 401K, a health savings account might be the right way to go. After you retire, you will probably have to spend a lot of money on medical expenses. You can easily pay hundreds of thousands of dollars in total lifetime medical bills after you retire.

Health savings accounts are excellent tax-wise. At best, none of the money you put into your account, none of the interest you earn on your account, and none of the money you withdraw from your account (for many but not all medical purposes) will be taxed. You can also use a health savings account before you retire.

Another advantage is that you can even take money out of your health savings account for non-medical purposes if you are over 65. If that sounds too good to be true, the catch is that you will have to pay income taxes if you withdraw it for non-medical reasons.

Too many people don't bother with a medical savings account. Don't miss out on one of the best ways to save tax-free money for retirement.

Another drawback is that the maximum contributions are low compared to what you can put into a 401K each year. Health savings accounts are, nonetheless, a great choice. They might be your first choice after you max out your 401Ks.

Invest in an IRA or Roth IRA

IRAs are retirement savings plans that you get privately and not through an employer. While the amount you can contribute to IRAs each year is relatively low ($6000 or after age 50 $7000), you can invest in IRAs in addition to 401Ks.

When choosing between a Roth IRA and a traditional IRA, use the same strategy as when choosing between 401Ks. With Roth IRA, you get taxed now rather than taxed later, so get it if you expect your post-retirement income to be higher.

IRAs are not for people who make a lot of money. If you have a personal income over $118,000 or a household income over $186,000, you cannot contribute to an IRA at all. Those who can afford to max out their 401Ks often make too much money to get an IRA, so many people need other investments.

Taxable investments

While you will not get any tax breaks if you are investing in mutual funds after putting money into your company's retirement plan, you can still make money on your taxed investments. Relatively safe investments with investment management companies are a great way to grow your retirement savings.

Unlike with 401Ks, you can keep your money invested and collect interest for as long as you want. With a traditional 401K, you have to start taking money out after a certain point; you cannot keep it saved forever. Investments are different - you can take them out at any age.

Investments are also for high-income earners. No matter how much you make, you won't have any trouble opening an account with an investment management company.

You can also invest a lot, little, or nothing each year, depending on what you can afford. You can also choose how much of your money goes toward riskier investments.

Investing in real estate

If you think outside the box, there are countless other ways to invest. Real estate is not low risk - remember the 2008 housing crash, after all. There is a high risk and a relatively low-risk way to do real estate investing.

If you want to make money buying a house that will increase in value, you have to compete with other real estate investors that are trying to do the same. Like the stock market, it is competitive, and you have to outsmart other people to succeed. Your odds are good only if property values increase faster than inflation, which might not happen.

If other people investing in real estate can make better predictions about future prices than you, you will lose money. Nonetheless, many people make a fortune buying a house that increases in value.

You can also buy a house and then rent it out to people as a retirement plan. This can easily work, but you may have to deal with bad tenants, as well as the risk of a property values crash. There is a bit of time investment involved if you want to manage a rental property yourself.

High-interest savings accounts

Normal savings accounts offer almost no interest, and even most "high yield" savings accounts offer a poor rate of interest as well, even if it is high compared to a normal savings account. High yield savings accounts are not a good way to earn interest on your money.

However, you can take money out of a savings account through an ATM immediately whenever you want. Money in a savings account is as liquid as money ever is.

Keep some, but not much, of your money in your savings account so that you can spend some of your money immediately. Don't let your money pile up in an account with little interest on it; inflation will shrink your savings that way.

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