If you’re overwhelmed by the variety of retirement accounts available to you, know that you’re not alone. I often work with clients who are confused when choosing between a 401(k) or a Roth 401(k). They want to maximize their retirement earnings and whatever 401(k) match their employers offer, while keeping plenty of money accessible in the short term.
Now that it’s common for major employers to offer both a Roth 401(k) and a traditional 401(k), many American workers are being asked to choose between the two. The Roth 401(k) is a relatively new kind of retirement account. While functionally similar to a traditional 401(k), a Roth account has benefits that may be especially attractive to young workers.
What is a Roth 401(k)?
Like a traditional 401(k), a Roth 401(k) is a kind of employer-sponsored retirement account. All 401(k) plans function in roughly the same way. An employee contributes to their own 401(k) while working. Their employer may contribute to the account too. The money grows over the course of the employee’s career, and they start taking distributions from the account once they retire. The difference between a traditional 401(k) and a Roth 401(k) comes down to when the money in the account is taxed.
A Roth 401(k) combines the benefits of a traditional 401(k) and a Roth IRA. The Roth IRA, first introduced in 1997, is a type of retirement account that has historically been especially popular with young workers. With a Roth IRA, you pay taxes on contributions in the year that you add them to the account—then, as long as certain conditions are met, you enjoy tax-free distributions in retirement.
The same principal applies to a Roth 401(k). Contributions are made with post-tax dollars, while distributions in retirement are tax-free. Meanwhile, a traditional 401(k) is funded with pre-tax dollars. That means you pay no taxes when contributing to the account but pay taxes on money you take out. (Note, though, that with a Roth 401(k) any matching contributions offered by your employer will go into a traditional 401(k), so you will pay taxes on this money when withdrawing it.)
Both kinds of 401(k) accounts have restrictions. Both have the same annual cap on contributions, and both set 59 1/2 as the age at which withdrawals may begin. It’s possible to take early withdrawals from a traditional 401(k), but you’ll pay a 10 percent penalty in addition to taxes on the money you take out early. With a Roth 401(k), the account holder must also have the account for at least five years before taking distributions. Early withdrawals may be taken without penalty if the account owner becomes disabled or dies.
Why Choose a Roth 401(k)?
We typically recommend Roth accounts for people who expect to be in a higher tax bracket in retirement than they are now, or who are in a fairly low-income tax bracket right now. Taking the tax hit upfront could net you more cash overall if you have a higher tax rate later on. Plus, taking taxable withdrawals during retirement from a traditional account could actually push you into a higher tax bracket, increasing your tax liability even more. That won’t happen with a Roth account.
A Roth 401(k) isn’t the ideal savings tool for everyone, of course. You may need to weigh a few different factors and compare some possible scenarios when choosing what kind of account to use. With a Roth, you’ll pay taxes upfront on contributions—if you went with a traditional 401(k) and invested that money instead, how much could it turn into by the time you’re ready to take distributions? How confident are you about what tax bracket you’ll be in when you reach retirement? What if you end up needing to withdraw money early? If you’re married, does your spouse have a 401(k)? These are all issues I address with my clients when comparing their 401(k) options.
One thing to keep in mind: you don’t necessarily have to choose between a traditional 401(k) and a Roth 401(k). Many employers offer both, and you may decide to contribute to both types. Because so many factors are at play here, it’s hard to know whether the traditional or Roth 401(k)—or both!—makes the most sense for your specific situation until you sit down with your financial planner and compare some projections.
Your advisor at Sachetta will work with you using real numbers to determine what kind of account would best serve your short- and long-term financial goals. Have more questions about whether a Roth 401(k) is a good fit for you? We’re here to answer all of your financial planning questions. Contact us today.
Matthew Stead joined Sachetta Callahan in 2014 in an intern. He now serves as a financial advisor, the go-to office IT person and the host of Sachetta's podcast Fine Answers.