One of the most common questions I get is, “am I saving enough?” and it’s probably one you’ve asked yourself more than once. You’ve got your 401(k), your Traditional IRA, maybe a ROTH IRA, and who knows, you might even have a non-qualified investment account. There is another option that’s becoming more popular, however, and that’s the ROTH 401(k). If your employer offers a ROTH 401(k) option, it’s important to know how the ROTH version matches up to the traditional 401(k).
Both the traditional and ROTH 401(k) are funded with contributions from your paycheck. While traditional 401(k) contributions are made pre-tax, ROTH contributions are made after you have been taxed.
What does that mean to you? Any pre-tax contributions you make into a traditional 401(k) will be taxed at your income tax rate when you make a withdrawal (typically in retirement). After-tax contributions into a ROTH 401(k) will get to grow and be withdrawn tax free since you’ve already paid the tax on that income. Tax free withdrawals can be very beneficial when you’re collecting Social Security during retirement as they won’t increase your taxable income and, therefore, jeopardize taxing your Social Security benefits.
The contribution limit is $18,000 in 2017 for both the 401(k) and ROTH 401(k). If you’re 50 or older, you can make “catch-up” contributions of $6,000 on top of the standard limit. One thing to note here is that combined contributions to both a traditional and ROTH 401(k) cannot exceed the $18,000/$6,000 limits. Split up the contributions however you like, but you’re capped at those amounts.
While we’re talking about contributions, another thing to consider is that you can be limited or restricted from contributing to a ROTH IRA due to your income level ($118,000-$133,000 for single filers, $186,000-196,000 for married filing jointly). “What does this have to do with traditional vs ROTH 401(k)s?” I hear you ask. Well, ROTH 401(k)’s are not subject to income restrictions. If your income exceeds the limits for a ROTH IRA, but you still want to contribute money into a ROTH vehicle, the ROTH 401(k) is very appealing.
You’re probably very familiar with how your employer matches the contributions you make to your traditional 401(k). You deposit money, they deposit money, your account balance goes up. But, if you contribute to the ROTH offering, how does the employer match those funds since they’re made after-tax? The easiest way possible, that’s how. They make their match into a traditional 401(k) account in your name while your money goes into the ROTH.
Both traditional and ROTH 401(k) participants can begin taking penalty free withdraws at age 59 1/2. However, the ROTH 401(k) needs to have been established for at least 5 years for you to avoid penalty and taxes. If you’re looking at retirement in the near future, make sure you have funds available in other types of accounts in order to be as efficient as possible.
It bears repeating, you’ll always owe tax on your traditional 401(k) withdrawals no matter when you receive them. But, a ROTH 401(k) distribution to a 55 1/2+ year old owner from an account that has been established for 5+ years will be tax free.
Required Minimum Distributions (RMDs) apply to both types of 401(k)’s, as well. That means when you hit age 70 1/2, you’re required to take a calculated percentage of your account value as a distribution every year. You can receive it monthly, quarterly, annually, or as you want, just don’t forget to take it, because the penalty is STEEP (50% of your minimum distribution).
Can RMDs be avoided? Not in a traditional 401(k), sadly. ROTH 401(k)’s are another story, however. Simply rollover the ROTH 401(k) into a ROTH IRA, and the money can continue to grow without any RMD requirements.
I know it can be a struggle to understand all of the different options you have available when it comes to saving. It becomes less taxing (sorry) when you keep your ultimate goal in mind, a stress-free retirement. Which one, traditional 401(k) or ROTH, should you use? I like both types for different reasons:
Use the Traditional 401(k) When…
Use the ROTH 401(k) When…
Based on the above, it may look like I favor using the ROTH flavor of 401(k) over it’s Traditional sibling. In reality, a balanced approach to your contributions probably makes sense for most people. Having resources in both account types offers flexibility that should prove valuable when it comes time to use them.