When formulating a retirement plan for a comfortable future, choosing a 401(k) can be one way to take advantage of tax-efficient investing. Deciding between the two main types of 401(k) plans, however, can have long-ranging tax consequences.
If you’re trying to decide between a Roth 401(k) vs. 401(k), here’s what you need to know to make the best choice for your needs, ensure you have the retirement savings you need and learn more about how to invest money wisely.
Quick comparison: Roth 401(k) vs. 401(k)
|Tax on contributions||Yes||No|
|Tax on withdrawals||No||Yes|
|Mandatory withdrawal age||72||72|
|Early withdrawal penalties||10%||10%|
|Loans||Depends on employer||Depends on employer|
|Contribution limit (for tax years 2020 and 2021)||$19,500
+$6,500 (if age 50 or over)
+$6,500 (if age 50 or over)
Traditional 401(k): the basics
The traditional 401(k) allows you to receive a tax break today while your money grows tax-deferred in your retirement account until you decide to withdraw the money. In 2021, the 401(k) contribution limits allow you to add up to $19,500 to your account. If you’re at least age 50, you can make catch-up 401(k) contributions of up to $6,500, bringing your total to a potential $26,000. Contribution limits can increase, however. The IRS sets contribution limits each year, taking into account cost-of-living increases.
In general, the 401(k) is offered through your employer. If your workplace offers a 401(k) plan, it’s usually possible to ask to have your contributions automatically taken from your paycheck before taxes are determined. This reduces your taxable income, effectively lowering your tax bill today.
Because your employer usually handles the transaction, it’s relatively easy to start saving for retirement. On top of that, some employers even offer what’s known as a company match and they contribute to your 401(k) as well. For example, your employer might offer a 50% match on up to 6% of your income. To get the maximum employer contribution, you’d arrange to have 6% of your income withheld from your check and deposited into your 401(k).
Let’s take a closer look at this to see what that means in real-world terms:
- Let’s say you get paid twice a month, and each paycheck is $2,500.
- You want to maximize your company match, so you ask to have 6% withheld from your check, which amounts to $150.
- Because your employer kicks in a 50% match on what you contribute, you get another $75 put into your 401(k) account.
- The total that goes into your 401(k) each paycheck is $225, which means you’re contributing $450 per month.
By taking advantage of the employer contributions, every month you get $150 in free money invested, on top of the money you have withheld from your check. Over time, this could grow significantly to help create a bigger nest egg.
Withdrawing money from your 401(k)
With a regular 401(k), once you retire and begin to withdraw money, you have to pay taxes based on your tax rate at the time of the withdrawal. In most cases, you need to wait until you reach age 59 1/2 to begin withdrawing money from your account. Although there are exceptions, if you withdraw money early, not only will you have to pay taxes on what you take out, but you will also have to pay an additional 10% penalty.
It’s also important to note that a 401(k) account comes with required minimum distributions (RMDs) when you turn 72. Once you reach that age, you’re required to begin taking money from the account, based on a formula that considers the size of your nest egg and your life expectancy. You’re taxed on your RMDs, just as you would be on any withdrawal.
Finally, it’s also possible to take out a loan against your 401(k). However, loan terms and whether a loan is even possible is determined by your employer. If your employer allows 401(k) loans, though, you might be able to borrow money without paying taxes or a penalty. In general, you have five years to repay your loan. Because it’s a loan, you have to make interest payments as well as repay the principal, but some like this strategy because it’s interest you pay to yourself.
Even though it can be tempting to get a 401(k) loan and pay yourself interest, it’s important to understand that the interest you pay isn’t likely to replace what you could have earned by leaving that money in the market. There’s no real way to make up for the opportunity cost that comes with having your money out of a 401(k) investment account.
Finally, if you quit your job or are laid off while you’re still repaying a 401(k) loan, it will come due. At that point, you will have 60 days to pay the remaining balance or that money counts as an early withdrawal and you’ll be stuck paying taxes and penalties.
Roth 401(k): the basics
The Roth 401(k) is very similar to the traditional 401(k) in terms of how it works. The contribution limit is the same and you have to wait until age 59 1/2 to access your account without penalty. There are also RMDs with the Roth 401(k) when you reach age 72.
With the Roth version of a 401(k), the main difference is how the contributions and withdrawals are taxed. When you put money into a Roth 401(k), you do so with post-tax dollars. So, you’ll pay income tax before your Roth contribution is taken out of your paycheck.
Although there’s no tax benefit today, you can reap some tax savings later. Because you already paid taxes on your contributions, a Roth allows you to take your distributions tax-free, so you don’t have to worry about paying taxes on your money down the road, no matter how much you take out of your Roth account. For people who believe they will be in a higher tax bracket in the future, the Roth can be a good tax-saving strategy. The main caveat is that your Roth 401(k) must be established for at least five years before you start taking distributions.
With a Roth 401(k), you still have to take RMDs and there are limitations on 401(k) loans, but you get to manage your tax bill in the future. It’s also important to note that if your employer offers a 401(k) match, and you have a Roth account, the employer match won’t be put into your Roth. Instead, you’ll have a separate traditional 401(k) and the employer’s portion will go into that. You’ll still have to pay taxes on the withdrawals from that money in the future.
Avoiding RMDs with a Roth 401(k)
It’s actually possible to avoid taking RMDs when you have a Roth 401(k) — but you have to take an extra step and open a Roth IRA. Because a Roth IRA doesn’t come with RMDs, you can get around the requirement by rolling your Roth 401(k) into a Roth IRA.
Additionally, with the money in a Roth IRA, there are some other flexibilities in the way you can access the money. Consider consulting with a financial professional about whether rolling your Roth 401(k) into a Roth IRA makes sense for your financial situation and goals.
How to pick between a Roth 401(k) vs. 401(k)
For the most part, choosing between a Roth 401(k) vs. 401(k) is about deciding when you want your tax advantage and what makes the most sense for your personal finances.
In general, if you think you’re likely to be in a lower tax bracket in the future, a traditional 401(k) can make sense. You’ll save money by paying taxes on your withdrawals at a lower income tax rate in retirement.
On the other hand, if you think your future tax rates will be higher, a Roth 401(k) can make sense. You’ll pay taxes today, but your invested money will grow tax-free over time and when you withdraw from your account you won’t have to pay taxes. Many people who are younger and just starting out often choose Roth accounts because their taxes are low right now, so they can sock away money and avoid paying a higher tax on that money later in life.
As your income increases during your working years, it might make sense to shift some of your contributions to a traditional 401(k) in order to take advantage of the bigger tax savings you stand to achieve.
It’s worth noting that you aren’t limited to one account type. Your combined annual contributions to your 401(k) accounts are limited to a total of $19,500 (with an additional catch-up of $6,500 if you’re 50 or older) for 2021, but you can divide those contributions between accounts according to your preference. Consider consulting with a financial advisor who can help you figure out how to make contributions that make the most sense for your situation and that can maximize your potential tax savings.
A note about rollovers and conversions
It’s possible that you have a 401(k) account at an old job or that you want to make a change to your retirement plan. In that case, you may want to roll over your 401(k) to an IRA. Doing this can provide you with the ability to gain more control over your investment options, as well as potentially save money in fees. Before you roll your 401(k) into an IRA, it’s important to pay attention to the type of account you have.
In most cases, experts recommend that your rollovers match in terms of tax treatment. So if you have a traditional 401(k), you’re usually better off rolling it into a traditional 401(k). When you have a Roth 401(k), then you can roll over that account to a Roth IRA without concerns about the tax treatment. Just remember that if you have a Roth 401(k) and your employer has been making matching contributions, the money your employer contributed is considered traditional, and will need to be rolled into a traditional IRA in order to avoid tax issues.
You can still decide to convert your traditional 401(k) into a Roth IRA, but be aware that there are usually tax consequences. Because your traditional 401(k) contributions were made with pre-tax money, you need to pay taxes when you convert to a Roth IRA. Consider talking to a tax professional before you move forward with this approach. You don’t want to be stuck with an unexpected and high tax bill. It’s possible for a professional to help you work out a plan to convert your traditional 401(k) to a Roth IRA in stages, so you aren’t doing it all at once and the tax bill is easier to handle.
Should high earners use a Roth 401(k)?
It depends on your needs and goals. In general, as a high earner, you’re probably paying more in taxes right now than you’re likely to pay in retirement. As a result, you might feel like you will benefit more from getting a tax deduction today, and paying taxes on your withdrawals at the decreased rate later. In this case, a Roth 401(k) would not be your ideal choice.
However, some high earners prefer depositing into a Roth 401(k), paying taxes now, and avoiding taxes on distributions later. This can be a perk if you know you want to eventually use a Roth IRA to avoid required minimum distributions. You can roll a Roth 401(k) into a Roth IRA without worrying about tax differences, and the Roth IRA doesn’t have RMDs, whereas a Roth 401(k) does.
Consider your tax situation and speak with a financial professional before deciding to use a Roth 401(k) as a high earner as retirement planning and tax strategies can quickly get complicated.
Can I have a 401(k) and Roth 401(k)?
Yes, it’s possible to have both a 401(k) and a Roth 401(k). However, your combined contributions to each account can’t exceed the annual contribution limit set by the IRS. It’s also notable that if you have a Roth 401(k) and your employer makes matching contributions, those contributions will be held in a traditional 401(k), even though your own employee contributions will be kept in the Roth 401(k).
What is a qualified distribution from a 401(k)?
A qualified distribution from a 401(k) is any distribution that doesn’t come with a penalty from the IRS, such as those made after you reach age 59 1/2, or early withdrawals that meet certain conditions.
Does a 401(k) affect Medicare?
In general, the premiums you pay for certain Medicare benefits are impacted by your income. Therefore, the distributions you take from your 401(k) — and that are included in your income — can impact your Medicare premiums. You might also want to coordinate distributions from your 401(k) with other accounts, as your RMDs later could impact your Medicare premiums.
Understanding the difference between the Roth 401(k) vs 401(k) is important for both retirement planning and tax planning. Both of these accounts can be great for building wealth for the future and making the most of your money. However, they have different uses and different places in your planning.
Consider speaking with a financial professional before moving forward. If you’re closer to retirement, a specialist can help you figure out how to coordinate your traditional and Roth accounts with when you start taking Social Security benefits.
Retirement planning requires some thought and long-term planning, so keep that in mind as you make contributions to your 401(k) accounts.