LAST REVIEWED Sep 04 2020 8 MIN READ
By The Human Interest Team
Getting started with a 401(k) can seem difficult at first, but knowing what your options are will help you make the right decision. Luckily, it’s become even easier to choose a 401(k) plan, as recent research shows that 42% of employers reduced the number of investment options they offered participants over the past three years, and another 41% plan to do so in 2020. This means that employers have been consolidating and streamlining the options they’re providing to participants, giving you clearer access to the best retirement savings options for your needs.
About the Roth 401(k)
First introduced in 2006, the purpose of the Roth 401(k) was to mix features of the Roth IRA with those of traditional 401(k) plans. Contributing to any 401(k) plan means that your company can match your contribution. Adding the Roth component means that you avoid paying taxes on future withdrawals. This makes it a suitable plan for those who estimate that their overall income will significantly increase over time and choose to pay taxes on their current income, as opposed to paying taxes on their projected higher income.
Notable differences between a Roth IRA and a Roth 401(k) are:
Eligibility for the Roth IRA. There are income limits for contributing to a Roth IRA. These limits do not apply to a Roth 401(k) (or a traditional 401(k). If your income is too high for the Roth IRA, then the Roth 401(k) is a great alternative for tax-free future income.
Ease of access to retirement funds. As opposed to the Roth IRA, funds in the Roth 401(k) are more difficult to withdraw. Those with a Roth IRA under the age of 59 1/2 can withdraw their contributions at any time if they’ve had the Roth for at least five years. Meanwhile, in the case of a Roth 401(k) plan, they need to pay a 10% penalty.
What are the Main Differences Between a Roth 401(k) and a Traditional 401(k)?
Both the traditional 401(k)s and Roth 401(k) plans are similar, as they are employer-sponsored retirement savings plans that provide tax advantages to employees who make contributions by saving a portion of their paycheck for retirement.
The two plans also differ in the way contributions and withdrawals are being taxed. The three main differences are:
How contributions are taxed: Traditional 401(k) contributions are made pre-tax. Roth 401(k) contributions are made after paying taxes.
Withdrawal rules and taxation: With a traditional 401(k), all money gets taxed upon withdrawal (i.e. in retirement. Any distributions made before the age of 59 1/2 may be subject to an additional 10% penalty from the IRS for early distributions (though there are a few exceptions). Also, traditional 401(k) distributions are taxed in retirement, as opposed to Roth 401(k) distributions, which are tax-free upon withdrawal.
How the Roth 401(k) and the Traditional 401(k) Are Similar
Although fundamentally different, there are some similarities between the two plans, such as:
They both act as saving options for retirement, and contributions for each can be directly taken out of your salary.
Both can include a company match, with many companies offering matches on employee contributions. This is essentially free money you don’t want to leave on the table.
They have equal limits when it comes to the annual contribution amount. The contribution limit for 2022 is $20,500 per year for those younger than 50 years old and $27,000 for those age 50 and older. Both offer significantly bigger investment opportunities than the Roth IRA, which has a contribution limit of only $6,500 ($7,000 for those age 50 and older).
Ultimately, deciding which 401(k) option is best for you depends on your predicted career and income trajectory as well as your financial situation now and in retirement. Whether you wish to enjoy tax-exempt contributions now, or tax-free withdrawals later in life, it’s good to know what options are available so you can choose the one that is right for you.
Which One Suits You Better — Traditional or Roth 401(k)?
Choosing between a traditional and a Roth 401(k) greatly depends on when you think it would be of greatest benefit for you to pay taxes on your contributions. By paying taxes now, you may benefit if you think you’ll be in a higher tax bracket in the future. However, the risk is that if you end up with a lower income and, therefore, lower tax bracket in the future, you may end up paying more taxes in the long run.
With a Roth 401(k), contributions are taxed now, which will lower your current paycheck more than a traditional 401(k). If your objective is to pay low taxes now because you estimate that your tax rate will go down until retirement, a traditional 401(k) may be best for you.
You might feel like you’re faced with a dilemma if your employer offers both a traditional and a Roth 401(k) and you have to make a choice. Just remember that when choosing between the two, it’s essential to know that choosing a traditional 401(k) means you are postponing your tax payments well into the future. Your future income and tax rates, although partially predictable, are not certain. Career advancement might result in you being placed in a higher tax bracket, but in retirement, that might not matter.
See your traditional 401(k) and Roth 401(k) options at Human Interest. We offer full-service 401(k) plans to small- and medium-sized businesses to improve what they offer to their employees and help them secure their financial future well into retirement. Your company can get a plan that’s perfect for everyone’s needs in just a few minutes with one of Human Interest’s flexible plan options.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.