Traditional 401(k) vs. Roth 401(k): Which One Fits Your Needs?

When planning for retirement, deciding between a Roth 401(k) and a traditional 401(k) is a crucial choice that can affect your financial future. The primary distinction is how each handles taxes: Roth contributions are made with after-tax dollars, while traditional contributions are made with pre-tax dollars. Let’s dive into the details and help you determine which option might be right for you.

What is a 401k?

• A 401(k) is a tax-advantaged retirement savings plan that allows employees to contribute a portion of their salary on a pre-tax or after-tax basis (depending on whether it is a traditional or Roth 401(k)). It’s an employer-sponsored plan, meaning it is set up and maintained by the employer, who often provides matching contributions to incentivize employees to save.

Tax Treatment:

• Traditional 401(k): Contributions are made with pre-tax dollars, which lowers your current taxable income. However, you will pay income taxes on the withdrawals you make during retirement.
  
• Roth 401(k): Contributions are made with after-tax dollars, allowing your investments to grow tax-free. Withdrawals during retirement are also tax-free.

Withdrawals:

• Traditional 401(k):
  
  • When can I start withdrawing from my account?
    
    • You can begin taking withdrawals without penalty once you turn 59½. However, you will still need to pay income taxes on these withdrawals since the contributions were made pre-tax.
      
    • Early withdrawals from a traditional 401(k) are subject to a 10% penalty before age 59½. This penalty applies to both the earnings and contributions of the account.
      
  • Required Minimum Distributions (RMDs):
    
    • At age 72 or 73 (depending on your birth year), you are required to start taking RMDs from your 401(k) or IRA to ensure you receive income throughout retirement.

• Roth 401(k):
  
  • Qualified Withdrawals:
    
    • You can withdraw contributions and earnings tax-free if you’re at least 59½ and have held the account for at least five years. Withdrawals are also penalty-free if you become disabled. If you pass away, the funds will be distributed to your beneficiaries.
      
  • Required Minimum Distributions (RMDs):
    
    • RMDs must start by age 73 (or age 70½ if you reached that age by January 1, 2020). However, the SECURE 2.0 Act of 2022 eliminates RMDs for Roth plans starting in 2024.
      
  • Unqualified Withdrawals:
    
    • Early or unqualified withdrawals (before age 59½ and without a 5-year account history) may incur income taxes and a 10% IRS penalty on a portion of the amount taken out.
      

Contribution Limits:

• Both traditional and Roth 401(k) accounts share the same contribution limits: up to $23,000 in 2024 (or $30,500 if you are 50 or older). You can contribute to both types of accounts within the same year, as long as the total contributions do not exceed these limits.

Choosing the Right Option for You:

Deciding between a traditional 401(k) and a Roth 401(k) hinges on your personal financial situation and retirement goals. Consider the following factors:

• Current Tax Bracket:
  
  • Traditional 401(k): If you are currently in a high tax bracket and expect to be in a lower one during retirement, a traditional 401(k) might be advantageous. This allows you to defer taxes now and pay them at a potentially lower rate later.
    
  • Roth 401(k): If you are in a lower tax bracket now and expect to be in a higher bracket in retirement, a Roth 401(k) could be beneficial. You pay taxes upfront but enjoy tax-free withdrawals later.
    
• Desired Flexibility:
  
  • Roth 401(k) contributions can be withdrawn tax-free at any time (subject to certain conditions). Traditional 401(k) withdrawals are subject to penalties before age 59½. If you value flexibility in accessing your contributions, a Roth 401(k) may be the better choice.
    
• Estate Planning:
  
  • Roth 401(k)s do not have RMDs during your lifetime, which can be advantageous for estate planning. Traditional 401(k)s require RMDs, which might affect the amount inherited by your beneficiaries.

By understanding these factors, you can make a more informed decision about whether a traditional or Roth 401(k) aligns better with your retirement strategy. Remember, there’s no one-size-fits-all answer. Evaluate your personal situation, consult a financial advisor, and choose the option that aligns with your long-term goals.

Advisory Services offered through Nepsis, Inc., An SEC Registered Investment Advisor.

Source: Conversation with Copilot, 8/13/2024

1. What Is a 401(k), How Does It Work, Pros, and Cons – Investopedia
2. Roth 401k vs. 401k: Which account is best for you? – NerdWallet
3. What is a Roth 401(k) And How Does It Work? – NerdWallet
4. Is the Roth 401(k) Right for You? – Investopedia
5. Publication 590-A (2023), Contributions to Individual Retirement Arrangements (IRAs) | Internal Revenue Service (irs.gov)
6. Publication 590-B (2023), Distributions from Individual Retirement Arrangements (IRAs) | Internal Revenue Service (irs.gov)