Traditional VS Roth: Which 401k Retirement Plan Should You Choose?
An increasing number of employers are offering their employees the option to choose between a traditional 401k and a Roth 401k. If this option is available to you, you will need to fully understand the key differences between each type of 401k before you can make an informed decision. Understanding the key differences will allow you to properly evaluate the pros and cons associated with each type of retirement plan.
Key Differences Between A Traditional And A Roth 401k
Your Contributions Are Taxed At Different Times
- Your contributions to a traditional 401k are not subject to state or federal income taxes during the year in which they are made. Instead, your contributions are allowed to grow tax deferred until you pull money out of the account at retirement. When you withdraw money from the account at retirement (or before if you withdraw funds early), you will have to pay federal and state income taxes on the withdrawn funds. The tax rate you will pay will depend on which tax bracket you fall into when you make the withdrawal.
- With a Roth 401k, your contributions are subject to federal and state income taxes in the year you make the contribution. You will be taxed at the tax rate you are at when you make the contribution. However, you do not have to pay any income taxes on the funds when you withdraw them at retirement. Because your contributions are taxed before they hit your account, your take home paycheck will be less if you opt for a Roth 401k than it would be for a traditional 401k.
Annual Required Minimum Distributions?
- If you have a traditional 401k, once you turn 70 ½ years old, you are required to withdraw a minimum amount of funds from your 401k each year.
- Technically, Roth 401ks have annual required minimum distributions. However, if you roll your Roth 401k into a Roth IRA before you turn 70 ½ years old, you can avoid having to take minimum distributions. (For more information on Roth IRAs, see Differences Between Roth And Traditional IRAs.)
Similarities Between The Two 401k Retirement Plans
- Same Contribution Limit: Both are subject to the same annual contribution limits. For 2012, this limit is $17,000 if you are under 50 years of age and $22,500 if you are 50 years of age or older. If you contribute to both a traditional and a Roth 401k during the same year, your total annual contribution across both accounts cannot exceed the annual contribution limit.
- Same Investment Structure:Both types of plans have the same investment set up. You can generally choose from a buffet of investment options. Many plans offer age based investment options which make your portfolio more conservative as you get closer to retirement.
- Same Early Withdrawal Penalties: If you pull your money out early, you will likely be subject to an early withdrawal penalty. However, many 401k plans will allow you to take out a loan from your 401k funds without incurring a penalty. (To learn more about early 401k withdrawals, see 6 Things You Didn't Know About Early 401k Withdrawals.)
Which Plan Should You Pick?
There are two important factors to take into account when making this decision.
What Do You Think Your Tax Rate Will Be When You Retire? Given that no one can predict the future, there is no way to be certain about what your tax rate will be when you retire. However, you may be able to make an educated guess based on your career trajectory, life plans and the current actions of Congress. The bottom line is that if you think you will be in a higher tax bracket when you retire, you might want to consider a Roth 401k since you will be taxed now at a lower tax rate. If you think that your tax rate will drop when you retire, you should consider a traditional 401k. If you want to hedge your bets, you can contribute to both types of accounts. Just remember that your total annual contributions to both accounts cannot exceed the annual limit.
Do You Care About The Required Minimum Distributions? If you have a traditional 401k, you will be required to take a minimum amount of money out of the account every year after you turn 70 ½. If you would prefer that your money stay in an investment account to grow and earn additional interest, you might want to look into a Roth 401k which can be rolled into a Roth IRA.
If your employer offers both types of 401k plans, you should do your homework before making a final decision. This will allow you to get the best tax benefit when you retire.