Roth 401(k) or Traditional 401(k): Which is Right for You?

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Understanding 401(k) Plans

Both Roth 401(k)s and traditional 401(k)s are employer-sponsored retirement accounts that offer unique benefits. The primary difference lies in the timing of tax payments on contributions.

What Is a 401(k)?

A traditional 401(k) is a workplace retirement savings plan funded with pretax dollars. This means you pay taxes on your distributions during retirement. Many employers offer matching contributions, which can significantly boost your savings. One key advantage is the reduction of your taxable income while contributing, deferring taxes until retirement when your income is likely lower. However, early withdrawals (before age 59½) typically incur a 10% penalty.

What Is a Roth 401(k)?

A Roth 401(k) is also an employer-sponsored retirement account, but it is funded with after-tax money. Your contributions grow tax-free, and you won’t pay taxes on withdrawals in retirement. Similar to traditional 401(k)s, early withdrawals before age 59½ can result in a 10% penalty. Additionally, you must own the account for at least five years to take qualified distributions without penalties.

Roth 401(k) vs. Traditional 401(k)

Understanding the key differences and similarities between Roth 401(k)s and traditional 401(k)s is crucial for making an informed decision.

Similarities

• Both are employer-sponsored, meaning you can’t open one independently.
• No income limit to participate.
• Annual contribution limits are the same: up to $22,500 for 2023, with an additional $7,500 for those 50 or older.
• Automatic saving through payroll deductions.

Differences

• Taxes on contributions: Traditional 401(k) contributions are tax-deferred, reducing your current taxable income. Roth 401(k) contributions are made after-tax and do not reduce your current taxable income.
• Taxes on distributions: Traditional 401(k) withdrawals are taxed as income in retirement. Roth 401(k) withdrawals are tax-free if qualified.
• Employer matches: Matching contributions for Roth 401(k)s must go into a traditional 401(k) account and are pretax.
• Penalty-free withdrawals: Roth 401(k)s require account ownership for at least five years for penalty-free withdrawals, in addition to the 10% early withdrawal penalty.
• Required minimum distributions: Starting April 2024, Roth 401(k)s will not require minimum distributions, unlike traditional 401(k)s, which require them starting at age 73.

Is It Better to Invest in a Roth 401(k) or a Traditional 401(k)?

The choice between a Roth 401(k) and a traditional 401(k) depends on your tax situation and retirement goals. Traditional 401(k)s allow you to defer taxes now, potentially paying less in retirement if your income is lower. Roth 401(k)s require you to pay taxes upfront, providing certainty about your retirement income and protecting against higher future tax rates.

Can I Contribute to Both a Roth 401(k) and a Traditional 401(k)?

Yes, if your employer offers both options, you can contribute to both types of accounts. This strategy, known as tax diversification, helps manage your overall tax obligation by spreading your investments across accounts with different tax rules.

The Bottom Line

When choosing between a Roth 401(k) and a traditional 401(k), start with what’s available through your employer. If only a traditional 401(k) is offered, consider maximizing your employer match and then exploring a Roth IRA. For personalized advice, consult a financial advisor who can help you create a retirement plan tailored to your financial situation.

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