If one has a 401K at work (or other type of retirement plan), it allows one to put money from their paycheck automatically and put it in an account for retirement down the road.
This is a form of automatic investing. It doesn’t require a lot of thinking (Once it is set up) and can take some of the anxiety out of investing. In fact, check out my other blog, “Why Automatic Investment Plans are Awesome” to learn more.
Okay, back to 401k’s. Many employers now offer a traditional 401k as well as a Roth 401k. There are similar versions offered in 403b’s which are usually offered at nonprofits like hospitals and these work pretty much the same way. Lastly, the rules can also apply to 457 plans which are usually available for government employees. For this blog, I’ll be using the term “401k” to simplify things.
So, what’s the difference between the traditional 401k and the Roth 401k and which one should you use?
A 401k is simply a retirement plan offered by an employer. On the traditional side, one defers money from their pay directly into the 401k on a pretax basis. This means, any money that goes in, reduces their taxable income, and grows tax deferred. When one takes money out in retirement, they pay ordinary income tax on whatever they withdraw.
In fact, with these traditional 401k plans, there are Required Minimum Distributions that must begin at age 72 if one is no longer working at the company.
Conversely, if one puts money in a Roth 401k, there is no tax benefit today and therefore, deposits into your plan do not reduce your taxable income today.
So, why use the Roth 401k option? Well, there is no tax benefit today BUT it allows this money to grow tax free (assuming certain rules are met) and there are no Required Minimum Distributions to worry about (See Rick’s Tip #1). You can leave this money in as long as you live. And, if you are married, you can leave this account to your spouse, and they can leave the money in to continue to grow over their life.
Rick’s Tip #1: If you leave your job and have a Roth 401k, to avoid the Required Distribution rule at age 72, the account should be rolled over to your individual Roth IRA.
Rick’s Tip #2: Because of the five-year rule*, If you have a Roth 401k, you should also open and fund an individual Roth IRA ahead of rolling over your Roth 401k.
The reason a Roth 401k is attractive to higher income earners is there is no income limit like in an individual Roth IRA. Bill Gates, for example, could contribute to a Roth 401K even if his annual salary was $1,000,000. Now that he is single, and files his taxes single, he wouldn’t be allowed to make an individual Roth IRA contribution if his income was more than $129,000. He could however, sock away up to $27,000 each year in a Roth 401k. ($20,500 plus an extra $6,500 as Bill is over 50). Bear in mind, Bill wouldn’t be a low income earner so he may prefer the tax deduction a traditional 401k offers.
There are definitely pros and cons to both Roth 401k and a traditional 401k.
The Roth 401k might be a good option for you if:
- Your income is on the lower side and your tax rate is also low. The tax savings for using a traditional 401k might not be as compelling as one that earns 600k a year for example.
- You are young and aren’t in a field where your income has the opportunity to increase dramatically. Bear in mind, with a lower income, one could contribute to an individual Roth IRA as they wouldn’t have the income test to worry about. However, the 401k Roth allows for higher contributions and falls under my “Automatic Investment” plan. “Why Automatic Investment Plans are Awesome”. (In fact, if one meets the income limits and has the available cash flow, they could contribute into their Roth 401k as well as their individual Roth IRA)
- Socking away money in an account that can grow tax free over many decades and then comes out tax free can be pretty powerful.
- You expect your income to increase down the road, but it is low now. This gives you the opportunity to put money away on a tax-free basis and then when your income goes up, switch to a traditional pretax 401k contribution.
One thing to keep in mind, once money is in the Roth (individual or 401k) it can stay invested indefinitely even if you are no longer eligible to contribute. (Bear in mind the Rick’s Tip #1 for Roth 401k’s above). And, you aren’t limited to one or the other. You can contribute to both the Roth 401k and traditional 401k as long as the total is under the contribution limit.
Feel free to reach out to me if you have any questions. I’m here to help.
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All the best.
Rick Fingerman, CFP®, CDFA™, CCPS®
*The five-year rule says that one must have opened and funded a Roth account at least five years before withdrawals of earnings happen and you must be at least 59 ½. If taking money out of a retirement plan it is always best to speak with a Certified Financial Planner practitioner first.
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.