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What's the Difference Between a Traditional 401k and Roth 401k?

Saving for your retirement is one of the most important financial hurdles you will be faced with. While there are a number of options including IRAs, chances are you’re most familiar with the 401(k). whats the difference between a traditional 401k and roth 401k

401(k) accounts are one of the most popular retirement plans offered by employers for their employees. Made up of a variety of investments, 401(k)s allow for increasing one’s savings and making your money work for you. 

Usually, 401(k) accounts are managed through a financial investment institution. That means you do not have to be a stock expert to open and contribute to a 401(k). 

When deciding on retirement options, the 401(k) will probably be the one you decide upon initially. However, there are two types of 401(k) accounts that you should keep in mind: the traditional 401(k) and the Roth 401(k).

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If your employer has a 401(k) available, do some research as to whether they include both traditional and/or Roth accounts. Here is some information regarding both 401(k)s so that you can make a more informed decision.

What is a Traditional 401(k)?

A 401(k) is a retirement plan where an employee and, potentially, their employer contribute the same to an investment account earmarked for retirement. They are usually made up of stocks and bonds through mutual funds and/or target-date funds. 

401(k)s have contribution limits, which can be found here. A traditional 401(k) is tax-advantaged, meaning that no tax is paid on any contribution or earnings until the funds are withdrawn during retirement.

Most contributions are made through payroll deductions, which mean a reduced net income. Because traditional 401(k)s are tax-advantaged, investing in a 401(k) often lowers your tax rate since your income is technically lower.

Employees are responsible for managing their own 401(k) account, meaning that they decide what investments to make and what mutual funds to work with. As with any investment, a financial advisor can help you make the best investment decisions that will maximize your benefits. 

Click here to find out more about contribution deadlines, so you do not miss out on savings.

What is a Roth 401(K)?

A Roth 401(k) functions very similarly to a traditional 401(k) account. It is also made of equal contributions from the employee and, potentially, the employer.

The biggest change is that contributions made to the Roth 401(k) are taxed before being invested. So when you want to withdraw any funds from a Roth 401(k), all taxes are already paid and the withdrawals will be tax-free. 

Roth 401(k)s are not offered by all employers, however they have become more popular in recent years. They are usually offered alongside traditional 401(k) accounts, meaning you will have access to both.

Unlike Roth IRAs, withdrawals cannot be made at any time from a Roth 401(k). The account holder can only make a withdrawal once they turn 59 ½ years old or if they become disabled. In either case, the Roth 401(k) must be at least five years old to avoid penalization.

The Difference

The big difference between Traditional and Roth 401(k)s is how they are taxed. With a traditional 401(k), taxes are paid after the funds are withdrawn during retirement, whereas taxes are paid immediately upon investment in the case of a Roth 401(k).

Either way, taxes are unavoidable. It really comes down to paying them now or paying them later.

Which is Best?

Figuring out which kind of 401(k) you want to invest in depends on your own circumstances. However, each type of 401(k) comes with its own set of unique benefits you should keep in mind before deciding.

A financial advisor can help weigh the pros and cons of both kinds of accounts. Additionally, they can help decide if a 401(k) is enough or if other retirement plans should be considered.

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Benefits of a Traditional 401(k) 

A traditional 401(k) allows for a tax deduction each year a contribution is made. When contributions are made directly from an employee’s payroll, their net income is lowered which means their tax rate is lowered. 

Your income greatly impacts which kind of 401(k) you should choose. For instance, if you are earning more now than when you will retire, a traditional 401(k) might make more sense now.

Disadvantages of a Traditional 401(k)

One of the biggest pitfalls to the traditional 401(k) is that you are essentially kicking the can down the road in terms of taxation. You can never be 100 percent certain of your future tax rate, so by investing solely in a traditional 401(k) you might be locking yourself into a higher tax rate. 

Benefits of a Roth 401(k)

A Roth 401(k) is a great option for anyone who expects to be in a higher tax bracket when they retire compared to their current tax bracket. Since the taxes are paid upon investment, if you expect greater income at the time of retirement, paying the taxes now will mean a lower overall tax rate.

Paying the taxes immediately also helps make it easier to plan for your retirement. You will not have to worry about setting additional savings to account for taxation. This will give you peace of mind knowing that the value of your account is the final value of your retirement savings.

Additionally, a Roth 401(k) shines when you have an already diverse retirement portfolio. By adding on an additional 401(k) or diverging funds from your traditional account into a Roth, you can have greater security with a base of retirement income that is not muddled by potential taxes. 

Disadvantages of a Roth 401(k)

However, paying those taxes now means less available funds for other potential investments. You never want to put yourself in a poor financial position today in hopes that it pays off tomorrow.

Roth 401(k)s also cannot be withdrawn from like Roth IRAs, so keep that in mind when making an investment decision. Their similarity in name has been known to cause some confusion.

Learn more about IRA’s here

Making a Decision

Granted, if both kinds of 401(k) accounts are available to you through your employer, you might feel stressed over making a decision. Worry not, as both of these account types are more flexible than you would think.

A diverse retirement portfolio covers all of your bases, so if you feel conflicted or just cannot make up your mind you can always diverge your investments into both a traditional and a Roth 401(k). Keeping in mind the contribution limit, you can split your investment into both kinds of accounts.

Retaining several retirement accounts best allows for fluctuations in your financial situation. By starting out younger, you can visualize the change in each account and make changes based on performance.

For younger savers confident that their income will increase as they get closer to retirement, Roth 401(k)s should definitely be looked into. On the other hand, for older investors to whom it is unlikely that their income will be any different when they retire, a Roth 401(k) might not hold the same benefits.

Overall, making a decision about your retirement savings is better than waiting. The earlier you start investing the better off you will be down the line. It might seem complicated, but that’s why a financial advisor can help make that decision with you for a steady today and a secure tomorrow.

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Figure it Out with NextGen Wealth

Wherever you are on your retirement journey, here at NextGen Wealth we are committed to helping ensure a retirement you can really enjoy. Whether you have been saving for decades and are ready for the transition into retirement, or are looking for ways to begin investing, we have you covered.

The sooner you prepare the better, so feel free to contact us today for a Free Retirement Checkup. There is no cost and no commitment. Take 15 minutes now and clear up any anxiety about your retirement situation. 

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About the Author

Aurtho Clint Haynes, CFPThis article was written by Clint Haynes, CFP®. Clint is a Certified Financial Planner® and Founder of NextGen Wealth. You can learn more about Clint by reading his full bio here.

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