Retirement Savings 101: What’s the Difference between a Roth 401(k) and a Traditional 401(k)?

Retirement golden eggs on dollars, IRA in focus, 401k blurryDid you know many employers offer a traditional 401(k) and a Roth 401(k)? Learn the difference between the two to see what’s right for you.

Last week we covered the difference between Roth and Traditional IRAs. This week we look at the differences between Roth and Traditional 401(k)s.

Let’s start by defining the 401(k)…

401(k)s are retirement savings plans sponsored by an employer. Employees can defer all or part of their paycheck to the plan, as long as you are within the IRS limits. You can think of it as a deferred salary. Many companies will also match contributions to the plan.

With Traditional 401(k)s contributions are made from your paycheck before taxes are withheld – this way you are not currently paying taxes on the amounts you contribute.  It is important to note, taxes are paid when the money is withdrawn from the 401(k), and these taxes are applied to both contributions and earnings. Money withdrawn before the age of 59 ½ is subject to an additional 10% penalty (with some exceptions).

Generally, if you are in a fairly high tax bracket now and expect to be in the same or lower tax bracket in retirement, contributing to a Traditional 401(k) can reduce your current taxes and serve as an income source during retirement.

Now let’s look at Roth 401(k)s…

Roth 401(k)s are very similar to traditional 401(k)s. The main difference between the two is, employees contribute to Roth 401(k)s after taxes are withheld from their paycheck – this way, the money you contribute has already been taxed. Unlike the traditional 401(k), no taxes are paid when the money is withdrawn from a Roth 401(k), so any earnings on your contributions are tax-free.

Generally speaking, if you are early in your career, in a lower tax bracket, and a long way from retirement, a Roth 401(k) can be a good choice. Good savers often end up in a higher income tax bracket by the time you retire, so you pay lower taxes now rather than higher taxes later.

How much can I contribute?

Companies that use both plans allow you to contribute to either or both as long as your aggregate contributions are within the IRS limit. Your financial planner will advise you on how much to contribute to which type of plan each year.

For 2015 and 2016, the individual contribution limit for both types of 401(k)s is:

  • $18,000.00
  • Catch-Up Contribution for age 50 and Older: $6,000.00 above contribution limit
  •  (source)

It is important to note, with either type of 401(k), the IRS requires a minimum distribution at age 70 ½ unless you are still working.  If the funds in a Roth 401(k) are rolled to a Roth IRA prior to age 70 1/2, the IRS does not require a minimum distribution at age 70½.

Which type of plan is for me?

By reviewing your current circumstances and tax bracket, as well as your plans for retirement, your Financial Planner can help you determine which type of plan is most appropriate for you. They can also help you to consolidate 401(k)s from various employers to make the most of your investments.

401(k)s and Roth 401(k)s can both be smart ways to save for retirement, but making the best decision for your retirement savings can be challenging. Consider talking with a financial planner to better understand the retirement savings landscape.

Plans Similar to a 401(k)

403(b): For employees of 501(c)(3)s, certain public schools, hospitals, non-profits companies, etc.

457: For certain governmental employees.

Thrift Savings Plan (TSP): For civil service employees and retirees as well as members of uniformed services.

If you are interested in a complimentary consultation, give us a call today at 303.639.5100 or visit shwj.com.

*Research for this post done on IRS.gov

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