Roth 401k vs Traditional 401k – Which Is Better?

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tugofwarYou’ve probably heard of the Roth IRA, but did you know that there is such a thing as a Roth 401k? Many people make the mistake of thinking that the Roth 401k is an alternative to the Roth IRA. Not so, but they are cousins.

The more relevant comparison would be the Roth 401k vs Traditional 401k. In this article, you’ll learn about what the Roth 401k is and isn’t, and whether it would it be a better investment vehicle than the traditional 401k. But first, let’s quickly examine the Roth IRA vs Roth 401k.

Key Points About the Roth IRA and Roth 401k

  • The Roth IRA is an “Individual Retirement Account” whereas the Roth 401k is an employer-sponsored retirement plan. So your company has to offer a Roth 401k in order for you to participate in such a plan. But anyone can open a Roth IRA as long as their annual income doesn’t exceed certain limits.
  • The Roth IRA was enacted into law in 1997 and the Roth 401k came into existence in 2006.
  • The contribution levels for each plan are different. For example, in 2013 the maximum contribution limit for a Roth 401k was $17,500 and for a Roth IRA it was $5,500 ($6,500 for those age 50 and older).
  • You can contribute to a Roth IRA and a Roth 401k at the same time. The reason why you might want to have both is because your employer will likely have a defined set of investment options for its Roth 401k plan. But you won’t be limited with a Roth IRA.
  • Similar to a Roth IRA, the money and investment profits in your Roth 401k will never be taxed as long as you don’t make any withdrawals prior to age 59.5.

The differences are pretty clear, right? Now, let’s move to the the Roth 401k and Traditional 401k.

Differences and Similarities: Roth 401k vs Traditional 401k

The Roth 401k combines many of the features associated with the Roth IRA and the traditional 401k. Here are some of the specific rules:

  • The contributions you make into your Roth 401k account are done with after-tax dollars. This means that your contributions are taxed in the same year that the money goes into your account. This differs from a traditional 401k where your contributions won’t be taxed until you withdraw those funds later in life.
  • Your employer is allowed to offer a matching amount for their Roth 401k plan just as they can for a traditional 401k. Here’s how matching works. Let’s say that the 401k plan states that it will provide a bonus of 50 cents for every dollar that you contribute into your 401k account, up to 6% of your salary.

If you make $40,000 per year, 6% of your salary would be $2,400. In keeping with the plan, your employer would kick in another $1,200. Pretty sweet, huh?

  • Similar to a traditional 401k, it’s not so easy to make early withdrawals from your Roth 401k. This is very different from a Roth IRA where you are allowed to withdraw your personal contributions any time without being penalized.
  • You can contribute to both a traditional 401k and a Roth 401k, but your combined contribution amount cannot exceed the annual limit. (Note: Some employers offer both.)
  • For both the traditional and Roth 401ks, you must begin taking Required Minimum Distributions at age 70.5. There is no such requirement for a Roth IRA.

Roth 401k vs Traditional 401k – Which One?

First of all, if you’re contributing to either one of these plans, congratulations. You’re smartly saving for your retirement future. And if you’re able to contribute the maximum annual amounts to your 401k and IRA’s, all the better. You get go to the head of the class.

Anyway, I gotta tell you. I love the Roth 401k. Of course, most of my money is in a traditional 401k because the Roth 401k is relatively new and I don’t have access to one.

What I really like about the Roth 401k is that you pay taxes upfront on the money you contribute. After that, you won’t ever have to worry about paying taxes on anything else in the account (including investment profits) if you make no withdrawals prior to age 59.5. The tax man can have his share now and leave you in peace during your retirement years.

If my employer offered a Roth 401k, I would switch my contributions to it for the reason just mentioned.

But it’s also perfectly fair and smart to weigh the tax implications of going with one plan versus the other. If you think you”ll be in a much lower tax bracket when you retire than you are now, then sticking with the traditional 401k would make perfect sense. Otherwise, it might be better to go ahead and take the tax hit now.

Coverting from a Traditional 401k to a Roth 401k

Some companies allow this while you’re employed with them and some don’t. You would have to pay taxes at the time of the conversion. So that is a factor that must be considered.

However, if I left my job and needed to rollover my traditional 401k, I would probably just use a regular Roth IRA. In general, the rules are more flexible than those associated with a Roth 401k.