Roth 401(k) vs. Traditional 401(k) | Which one will get you to the Finish Line?

Nowadays, it could seem like you are racing to an imaginary finish line called "Retirement." During this race, you gather momentum by setting up retirement funds, like a 401(k), savings, investing in stocks, bonds, CDs, annuities, etc. This race does not have winners or losers, but you encounter several twists, turns, curves, hills, and valleys on the way to the finish line. At times you may feel you are behind the leader or at the end of the pack, but with the help of your financial advisor, you can work your way to the front and over that finish line. 

Let's take some time to train to keep you on track for that BIG finish!

What Is a Roth 401(k)?

While many people are familiar with the benefits of traditional 401(k) plans, others are not as acquainted with Roth 401(k)s.

Since January 1, 2006, employers have allowed workers access to Roth 401(k) plans. And some have introduced offerings as part of their retirement programs.¹

As the name implies, Roth 401(k) plans combine features of 401(k) plans with those of a Roth IRA.^2,3

With a Roth 401(k), contributions are made with after-tax dollars – there is no tax deduction on the front end – but qualifying withdrawals are not subject to income taxes. Any capital appreciation in the Roth 401(k) also is not subject to income taxes.

What to Choose?

For some, the choice between a Roth 401(k) and a traditional 401(k) comes down to determining whether the upfront tax break on the traditional 401(k) is likely to outweigh the back-end benefit of tax-free withdrawals from the Roth 401(k).

Please remember this article is for informational purposes only and is not a replacement for real-life advice; consult your tax professional before adjusting your retirement strategy to include a Roth 401(k).

Often, this isn't an "all-or-nothing" decision. Many employers allow you to divide contributions between a traditional 401(k) plan and a Roth 401(k) plan – up to overall contribution limits.

Considerations

One subtle but key consideration is that Roth 401(k) plans aren't subject to income restrictions like Roth IRAs are. A Roth 401(k) can offer advantages to high-income individuals whose Roth IRA has been limited by these restrictions. (See accompanying table.)

 

Source: IRS.gov, 2022

Roth 401(k) plans are subject to the same annual contribution limits as regular 401(k) plans – $20,500 for 2022; $27,000 for those over age 50. These cumulative limits apply to all accounts with a single employer; for example, an individual couldn't save $20,500 in a traditional 401(k) and another $20,500 in a Roth 401(k).⁴

Another factor to consider is that employer matches are made with pretax dollars, just as they are with a traditional 401(k) plan. In a Roth 401(k), however, these matching funds accumulate in a separate account, which will be taxed as ordinary income at withdrawal.

Setting money aside for retirement can be part of a sound personal financial strategy. Deciding whether to use a traditional 401(k) or a Roth 401(k) often involves reviewing many factors. If you are uncertain about the best choice for your situation, you should consider working with a qualified tax or financial professional.

1. To qualify for the tax-free and penalty-free withdrawal of earnings, Roth 401(k) distributions must meet a five-year holding requirement and occur after age 59½. Tax and penalty-free withdrawals can also be taken under certain other circumstances, such as the owner's death or disability. Employer matches are pretax and not distributed tax-free during retirement. Once you reach age 72, you must take the required minimum distributions (RMD).

2. In most circumstances, you must take the required minimum distributions (RMDs) from your 401(k) or other defined contribution plan in the year you turn 72. Withdrawals from your 401(k) or other defined contribution plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty.

3. High-income taxpayers cannot make Roth IRA contributions. In 2022, the income phaseout limit is $144,000 for single filers and $214,000 for married filing jointly. If you want to qualify for the tax-free and penalty-free withdrawal of earnings, the Roth IRA distributions must meet a five-year holding requirement and occur after age 59½. Tax and penalty-free withdrawals can also be taken under certain other circumstances, such as the owner's death or disability. The original Roth IRA owner is not required to take minimum annual withdrawals.

Source: IRS.gov, 2022

This content comes from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used to avoid any federal tax penalties. Please consult legal or tax professionals for specific information regarding your situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Copyright<script type="">document.write(new Date().getFullYear())</script>FMG Suite.

Take the time before year-end to schedule a review to look over your existing plan(s). Together we will make any adjustments to benefit you in the long run. If required, we can decide whether a Roth 401(k), a Traditional 401(k), or a combination of both would work best with your retirement plans. That finish line is getting closer, and we are here for you before and after you pass it.

David S Dixon, CFP®