As it’s name implies, a Roth 401(k) is a 401k plan with features similar to a Roth IRA. It has a variety of benefits over the Traditional 401k, depending on your specific financial situation. Here are some of the features of a Roth 401k and Traditional 401k, and some differences to be aware of:
Compare Traditional and Roth 401k
Features of a Traditional 401k
Most people are familiar with a Traditional 401k because until just a few years ago, this was the only form of 401k plan offered by employers. In fact, you usually won’t even see it referred to as a “Traditional” 401k plan. It is most often simply referred to as a 401k plan.
How a Traditional 401k plan works. Contributions into a Traditional 401k are made with pre-tax dollars and the amount of your taxable income is reduced based on the amount of your 401k contributions. When you retire and begin receiving distributions from a 401k plan, the money is taxed as current income.
A Traditional 401k may offer a matching contribution from your employer. Some match up to 50% or a certain dollar amount of contributions each year. Employers who match contributions to a Traditional 401k are not required to match contributions to a Roth 401k.
Features of a Roth 401k
How a Roth 401k plan works. Just like a Traditional employer sponsored 401k plan, the Roth 401k allows workers to make contributions through payroll deductions. Contributions to a Roth 401k are made with after-tax dollars, which means when you withdraw the money during retirement, you don’t have to pay tax on it again. Withdrawals after the age of 59 and a half years are made tax-free and penalty free, as long as you’ve had the account for at least five years. Money in a Roth 401k plan can be rolled over into a Roth IRA without penalty or fees when you change jobs.
Other Roth employer sponsored Roth plans: If you work in the nonprofit sector, you can open a Roth 403(b) and the government recently announced the addition of the Roth 401K for Thrift Savings Plan, which should launch in 2011.
Which is better – Traditional 401k or Roth 401k?
Comparing Traditional and Roth 401k plans is similar to comparing Traditional and Roth IRAs.
If you are currently in a low tax bracket or expect to be in a higher tax bracket when you retire, a Roth 401(k) or 403(b) offers a better tax benefit tax than the Traditional 401k. Even if you basically stay in the same tax rate, a Roth 401k may have an advantage over a Traditional 401k plan because many people experience higher tax bills when they retire because they may have fewer itemized deductions such as fewer dependents living at home, mortgage interest, etc.
If you don’t think you’ll need access to your money at the age of 59 and a half, you can roll your money from a Roth 401k to a Roth IRA without any tax penalties. Once the money is in a Roth IRA, you don’t have to take distributions until you are age 70 and a half. This means you end up with more tax-free growth of your money, and may possibly have more money to last your retirement or to give to your heirs.
On the flip side, a Traditional 401k may be a better option if you need to lower your taxable income in the present or if you expect your tax bracket to be lower when you retire. You may also prefer to contribute to a Traditional 401k plan if your employer offers a matching contribution for Traditional plans, but not for the Roth plan.
Why not choose both? Finally, it isn’t an all or none proposition. You can contribute to both plans if you wish. Simply divide your contributions as you see fit. This can be a great strategy to take advantage of employer matching contributions and to hedge future taxes.