Sep 20 · 4 min read
Key Takeaway: In order to maximize your retirement savings, you’ll need to choose the right type of 401(k). Whether it’s a Traditional or Roth 401(k), you’ll want to open the one that makes the most sense for your money!
Setting up a 401(k) is probably one of the last things on your to-do list. But if you want to retire financially free, it’s in your best interest to invest in one. Especially if your job offers a 401(k) plan with an employer match. This is free money towards your retirement so you have to take advantage of it!
When it’s time to set up your retirement account, you’ll be presented with two options, a Traditional 401(k) or a Roth 401(k). Deciding between the two is key so let's Get Whyze and learn more about each.
With a Traditional 401(k), you choose to automatically add a percentage of your paycheck to your retirement account before paying taxes on it. This is why it may even be labeled as a “Pre Tax” 401(k) when you’re setting up your account. While growing your money without paying taxes may sound like an immediate “no brainer”, there is a catch. With a Traditional 401(k), you will have to eventually pay taxes on your money when you withdraw it from your 401(k). The money you withdraw from your account will be taxed based on what income tax bracket you fall into at that time. This could either hurt or help your pockets depending on your income and tax rates during your retirement.
With a Traditional 401(k), you won’t be able to start withdrawing your money penalty-free until the age of 59 ½ (or 55, if you are fired or retire from your job between ages 55 & 59 ½). If you decide to withdraw money before this age, you’ll be charged a 10% penalty and still be required to pay income taxes on the amount you cashed out.
Your other option is a Roth 401(k). A Roth 401(k) lets you automatically add a percentage of your paycheck to your retirement account after paying taxes on it. In return for paying taxes upfront, you will not have to pay taxes when you withdraw money from your 401(k) later in life. This even includes avoiding taxes on the gains of your investments within your 401(k) (take that Uncle Sam!). If you plan to retire in a higher tax bracket than you are now, this could save you a lot of money in taxes.
Although your Roth 401(k) contributions and their gains can be taken out tax-free, any employer match to a 401(k) will actually be taxed later on in life. This is because any employer match to a Roth 401(k) is actually placed into a Traditional 401(k). While this can be very confusing, the reason this happens is because employer matches are made before your job actually pays taxes on this money. So remember, your contributions and its gains won’t be taxed when you withdraw your money but your employer's contributions and its gains will be.
Just like a Traditional 401(k), a Roth 401(k) also has rules for withdrawing your money but they are slightly different. At any point, you can withdraw your contributions from your Roth 401(k) penalty-free. This means that any money you put into your Roth 401(k) is available to you at any time. Your gains from your contributions will have to stay in your Roth 401(k) until you are 59 ½ (or 55, if you are fired or retire from your job between ages 55 & 59 ½) if you want to avoid a 10% penalty though. Roth 401(k)s also require you to have had the account for at least five years before withdrawing any gains. While this won’t affect you if you are decades away from retirement, you’ll want to be aware of this five year requirement if you are starting a Roth 401(k) later in life.
Although you contribute after-tax money to a Roth 401(k), this is not the same as an “After-Tax” 401(k)! If you choose this type of 401(k) instead of an actual Roth 401(k), you will be taxed on the earnings of your 401(k). This will cost you a lot of money in retirement since with a Roth 401(k), you aren’t taxed on your earnings.
Whether you choose a Traditional or Roth 401(k), you will be limited to the same amount of money you can contribute to your account. As of 2019, you are allowed to add up to $19,000 per year to your 401(k). This won’t include employer matching money. If you’re 50 or older, you’ll be able to contribute an extra $6,000, allowing you to add a total of $25,000 per year. If you happen to have multiple 401(k)s (we will get to this in a minute), you can contribute to both accounts in the same year, as long as you keep your total contributions under those limits. Learn more about 401(k) contribution limits here .
So now that you know the key differences and similarities of Traditional and Roth 401(k)s, which one is the right account for you? It really comes down to the dreaded five-letter word: taxes . If you predict your income tax rate will be higher in retirement than what it is today, you may want to get a Roth 401(k). This is a great choice if you are currently in a low tax bracket but plan to move into a high tax bracket by retirement. Choosing a Roth 401(k) in this situation will allow you to pay less in taxes over the long haul, equaling more money for you. If you believe your income tax rate will be lower in retirement, a Traditional 401(k) may be the better option for you. This choice makes perfect sense if you are a high-income earner looking to delay your tax payments until your tax rates are lower.
If choosing between a Traditional or Roth 401(k) is giving you anxiety, you may want to try actually having both. Splitting your 401(k) contributions between both account types will eliminate the guessing of which one is the best for you. Making this move will also help you diversify your tax situation in retirement, just in case your initial prediction about your future tax rate is wrong.