401k vs. ROTH 401k: Which One is Better?
So there is a big difference between a 401K and a Roth 401K. How? Well, both accounts are employer-sponsored retirement accounts, meaning you cannot have a 401K unless it is through your employer.
One of the critical differences between the two is how they are taxed or treated from a tax perspective.
Let's dive right in:
Traditional 401(k)s are pre-tax meaning that any contributions you make reduces your taxable income for the year. On paper, if you make $100,000 and put $20,000 into your 401(k), your taxable income will only be $80,000. The 401K contribution is subtracted from your income that is taxed.
If you put that money in a 401(k), it can grow every year until you retire aka compound interest. However, when you reach retirement age and begin withdrawing money from your 401(k) plan, that money will be subject to taxation.
One major difference between the 401K and the Roth 401K:
With a traditional 401K, you have to take what's called a "minimum distribution," which is set to 72 years old at the moment (previously 70 and a half.) When you turn 72, the IRS will require you to start taking money out of your 401(k), whether you want to or not. Because of this, you will lose control of your taxes in the long run.
A Roth 401K, however, is the exact opposite.
With a Roth 401K, you put money in after taxes, which means that you've already paid taxes on it. You don't get a tax break today, which is a bit of a bummer, but the money goes into an account where it grows each year until it's time to retire. Then, if you meet a couple of thresholds, you won't have to pay taxes on that money ever again.
So it's basically all tax-free. You won't have to worry about taxes on that money again once you retire!
Most financial experts say that traditional 401(k)s are the best way to save on taxes, but in our opinion most people are better off with a Roth 401(k). Over the course of your life and career, a Roth 401K will save you more money than a traditional 401K.
With a traditional 401K, you get a tax break right away, whereas with a Roth, you won't see the benefits for a long time. But almost no matter how you do the math, a Roth 401K will be the better choice for most people because it will save them more money on taxes.
Max Out Your 401K!
If you contribute the maximum amount to your 401(k) this year, which is about $20,500, and you are in your 20s or 30s, you will save millions of dollars in taxes over the course of your life.
Still, if your employer doesn't offer a Roth 401(k), a traditional 401(k) is also a good alternative.
Another one to consider: Roth IRA
A Roth IRA is a personal retirement account that is not tied to a certain employer. It is taxed the same way as a Roth 401(k), but you can only put a certain amount of money in it.
Below is a more detailed explanation of the 401K, Roth 401K, and Roth IRA. If you have more questions be sure to reach out!
What Is a 401K Plan and How Does it Work?
A 401K is a retirement savings and investment plan that employers can join. When employees put money into a 401K plan, they get a tax break. Automatic deductions are made from workers' paychecks and put into funds they choose (from a list of available offerings).
In 2022, the yearly contribution cap for 401Ks is $20,500 ($27,000 for individuals over 50).
Employees contribute by designating automatic withdrawals from their paychecks. The tax benefit may be received when you make contributions or when you withdraw money in retirement, depending on the type of plan you have.
How Does It Benefit You?
A lot of companies will match some of the money that you contribute. This is one of the most popular benefits of a 401k. If your company offers to match your contribution, stop reading this right now and go sign up! Most companies match based on how much you give, such as dollar-for-dollar or 50 cents-on-the-dollar up to, say, 6% of your contribution amount. Put at least enough money in your account to be eligible for the free money.
Use this 401K calculator to show how your savings will increase over time with a 401K and the impact that little adjustments, such as any company matches, will have over time.
In addition to helping you save more money, making contributions to a traditional 401K also lowers your taxable income for the year.
Let's say you make $65,000 a year and put $19,500 into your 401(k) plan. You will only have to pay income taxes on $45,500 of the $65,000 you earned instead of the full amount. In other words, you can keep $19,500 from being taxed if you save money for the future.
The money you put into your 401K is safe from taxes as soon as you put it there. In this case, both traditional 401Ks and Roth 401Ks work. You don't have to pay taxes on interest, dividends, or investment gains as long as the money is still in the account.
The traditional 401K won't be able to avoid taxes forever! Your contributions and the growth of your investments are not taxed until you start taking money out of the account in retirement. Then you will have to pay income taxes.
How Do Roth 401Ks Work?
A Roth 401K is a retirement savings account set up by an employer that is paid for with money that has already been taxed. This means that the employee must pay income tax right away on the money that is taken out of each paycheck and put into the account. When you retire, you can take money out of the account without being taxed.
This type of plan is different from the traditional 401K plan, which is paid for with money that has already been taxed.
Their many tax benefits include:
- In addition to providing a means of retirement savings, this plan lowers the employee's yearly gross income. On each withdrawal made during retirement, the employee will be required to pay normal income tax
- The amount designated for savings is deducted from the employee's real net income since the Roth 401K requires that the income tax be paid right away. On withdrawals of either the contributions or the profits made throughout the years, however, no more taxes will be due
Contribution caps for Roth 401Ks are determined by an individual's age. The Internal Revenue Service announces these ceilings and updates them each year to account for inflation (IRS). Individuals are allowed to contribute a maximum of $19,500 in 2021 and $20,500 in 2022. People 50 and older are eligible to make a catch-up contribution of an extra $6,500. There is no upper income cap, in contrast to other programs.
A Roth IRA: What Is It?
You can make after-tax contributions into a Roth IRA, a sort of tax-advantaged individual retirement plan. The main advantage of a Roth IRA is that, if the account has been open for at least five years, your contributions and the returns on those contributions can grow tax-free and be withdrawn tax-free after the age of 59 1/2.
The main difference between a regular and a Roth IRA is how taxes are treated. Roth IRAs are funded with after-tax money, which means that contributions are not tax-deductible but are tax-free if withdrawals are made.
Roth IRAs Explained
The money invested in a Roth IRA grows tax-free, just like it does in other eligible retirement plan accounts. A Roth IRA, however, has fewer limitations than other types of IRAs. There are no required minimum distributions (RMDs) during the account holder's lifetime, unlike with 401(k)s and standard IRAs, so the Roth IRA can be kept open permanently.
Contrarily, pretax dollars are typically used to fund traditional IRA deposits; as a result, you typically receive a tax deduction for your contribution and must pay income tax when you remove funds from the account after retirement.
Several things can be used to finance a Roth IRA:
- Consistent contributions
- Contributions to a spouse's IRA
- Contributions that rollover
Regular Roth IRA contributions cannot be made in the form of securities or other property; they must all be made in cash (including cheques and money orders). The amount that may be put each year into any type of IRA is restricted by the Internal Revenue Service (IRS), with periodic adjustments. Both regular and Roth IRAs are subject to the same contribution caps. Even if you have multiple accounts, you cannot contribute more than the maximum since these limits apply to all of your IRAs.
What Benefits Come With a Roth IRA?
Roth IRAs do not have employer matching contributions, but they do offer a wider range of investing alternatives. Roth IRAs can also be a good choice for people who think they'll be in a higher tax bracket in their later years. You can take your contributions from a Roth IRA tax and penalty-free, but not your earnings. In the end, you have control over your Roth IRA investments by opening an account with a brokerage, bank, or other suitable financial institution.
So Roth IRAs can be a good alternative for people who believe they will be in a higher tax bracket in the future since, unlike 401K or standard IRA withdrawals, the money in a Roth IRA is not subject to taxes when it is withdrawn.
Hopefully, you found this information to be beneficial! If you have any questions, please feel free to reach out here. We are always here to help!