Roth vs. Traditional 401(k): Where to put your money for retirement?

When it comes to signing up for your company's retirement plan, you might find yourself facing a decision between a Roth 401(k) and a traditional 401(k). But what exactly is a Roth 401(k), and what sets it apart from the traditional option?

In this blog post, we'll break down the key differences between contributing to a Roth 401(k) and a traditional 401(k). We'll also delve into why these differences matter, especially when it comes to taxes, and help you decide which one could be the better fit for your unique circumstances.

## **What is a traditional 401(k)?**

A 401(k) plan is a retirement savings program provided by numerous American employers, featuring tax incentives for participants. This nomenclature originates from a specific section within the U.S. Internal Revenue Code (IRC).

Under the 401(k) arrangement, employees opt to allocate a portion of their earnings directly into an investment account, typically as a percentage of each paycheck. Employers may elect to match a portion or the entirety of this contribution, effectively enhancing the employee's retirement savings. Within this program, participants are afforded the liberty to select from an array of investment alternatives, typically comprising mutual funds, to suit their individual financial objectives.

## **What is a Roth 401(k)?**

The Roth 401(k) represents an employer-sponsored retirement savings vehicle characterized by its unique tax treatment. It operates on the principle of after-tax contributions, wherein employees allocate a portion of their earnings from each paycheck, and these contributions are subject to immediate income taxation. The distinctive feature lies in the tax treatment of withdrawals upon retirement, where they are entirely exempt from taxation.

This stands in contrast to the conventional 401(k) scheme, which operates on a pretax contribution model. Under this arrangement, deductions from an employee's gross income are made before taxation, and taxes are levied solely at the point of withdrawal from the account.

## **Roth vs. Traditional 401(k): Similarities**

### **Roth and traditional 401(k)s both:**

* Are workplace retirement plans
* Allow you to receive a company match
* Are governed by the same maximum contribution limits set by the IRS
* Offer you the same investment options within your company’s plan
* Require you to start withdrawing your money at 73 years old

### **Roth 401(k) vs. traditional 401(k)**

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## **Which is best for you?**

Let's begin with the contributions. If you'd rather pay taxes on your money upfront and not worry about them later, or if you believe your tax rate will be higher when you retire compared to now, then a Roth 401(k) might be the way to go.

Paying taxes now can safeguard you from potential tax rate increases in the future when you retire. Although your taxable income might decrease in retirement, potentially placing you in a lower tax bracket, you'll have access to the full amount you've saved without worrying about additional taxes.

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However, keep in mind that each contribution to a Roth 401(k) will reduce your paycheck by a greater amount than a traditional 401(k) contribution since it's made after taxes have been deducted. If your main goal is to lower your current taxable income or postpone taxes until retirement, as you anticipate a lower tax rate, then a traditional 401(k) is the way to go.

## **Just be aware that:**

* By choosing a traditional 401(k), you are deferring taxes to a later point when your income and tax rates may be uncertain, possibly higher if your career advances and your earnings increase.
* To make the after-tax value of your traditional 401(k) equal to what you could accumulate in a Roth 401(k), you would need to invest the tax savings from each year's traditional 401(k) contribution.
* If investing that tax savings isn't feasible or desirable for you, particularly if you're in a high tax bracket making maximum contributions, the Roth 401(k) might be a more suitable choice.

In summary, a Roth IRA can be an attractive choice when you seek tax diversification, have a low current tax rate, want flexibility in accessing contributions, and prefer not to deal with RMDs. It's a valuable tool for long-term financial planning and can serve as both a retirement nest egg and a potential legacy for your heirs.

## **FAQs**

### What is the difference between a Roth IRA and a Traditional IRA?

A Roth IRA is funded with after-tax dollars, and qualified withdrawals in retirement are tax-free. Contributions to a Traditional IRA are often tax-deductible, but withdrawals are taxed when you retire.

### Who is eligible to contribute to an IRA?

Both Roth and Traditional IRAs require you to have earned income, but eligibility and contribution limits can vary based on income and other factors. Check with the IRS for current guidelines.

### What are the benefits of an IRA?

IRAs offer a tax-advantaged way to save for retirement. Roth IRAs provide tax-free withdrawals, while Traditional IRAs may offer tax deductions for contributions.

### Are there age limits for contributing to an IRA?

Roth IRAs have no age limits for contributions, as long as you have earned income. Traditional IRAs also have no age limit for contributions, but you must be under age 72 to make contributions.

### Is there a maximum annual contribution limit for IRAs?

Yes, there are annual contribution limits for both Roth and Traditional IRAs. The combined contribution limit for both types may change annually, so check the IRS guidelines for the current limits.

### Can I convert a Traditional IRA to a Roth IRA?

Yes, you can convert a Traditional IRA to a Roth IRA, but you'll pay taxes on the amount converted. This is known as a Roth IRA conversion.

### Do IRAs have required minimum distributions (RMDs)?

Roth IRAs do not have RMDs during the owner's lifetime. However, Traditional IRAs require RMDs starting at age 72 (or 70½ if you reached that age before January 1, 2020).

### Which is better for retirement: a Roth IRA or a Traditional IRA?

The choice between a Roth IRA and a Traditional IRA depends on your individual financial situation and goals. Roth IRAs may be preferable if you expect to be in a higher tax bracket during retirement, as withdrawals are tax-free. Traditional IRAs can be advantageous if you anticipate being in a lower tax bracket in retirement, as they offer potential tax deductions on contributions. It's essential to consider your current tax situation, future retirement income, and financial objectives when making this decision.

### Can I contribute to both a Roth IRA and a Traditional IRA in the same year?

Yes, you can contribute to both types of IRAs in the same tax year, but the total combined contributions must not exceed the annual limits set by the IRS.

When it comes to signing up for your company's retirement plan, you might find yourself facing a decision between a Roth 401(k) and a traditional 401(k).

Roth vs. Traditional 401(k): Where to put your money for retirement?

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