August 31, 2020
By Rahul Iyer
The traditional and Roth 401K both help you prepare for retirement but have vastly different tax procedures.
Understanding the difference and determining which would leave you with the lowest tax liability is one of the most important retirement decisions you’ll make.
Check out the differences below.
Both traditional and Roth 401K accounts are retirement accounts. You put money away that you can’t (or shouldn’t) touch until you are in retirement.
You can contribute the same amount ($19,500 in 2020) per year and you invest for your retirement. The money grows (hopefully) in your chosen investments, based on your allocation.
You should leave the funds in the account until you’re 59 ½. If you withdraw earlier (in most cases), you’ll pay a 10 percent penalty, plus applicable taxes.
Additionally, your employer may contribute to either type of 401K account. They’ll contribute up to the stated maximum matching your contributions. A common example is a match of up to 3% of your salary.
But what are the differences?
Your traditional 401K contributions are tax-free. You contribute before your employer withdraws taxes. This gives you an advantage as you pay fewer taxes on payday, putting more money in your pocket.
But the tax liabilities are deferred - you pay the taxes at withdrawal on both the contributions and earnings. You pay according to your current tax bracket. If you’re in a lower tax bracket, great, you’ve just saved yourself money. If you’re in a higher tax bracket, you’ll pay more taxes.
Either way, you have less money in your pocket at retirement.
401K contributions are after-tax. You pay your tax liabilities when you earn the money (lower paycheck), but your contributions and earnings grow tax-free. When you withdraw the funds, there’s no additional tax liability as long as you are at least 59 ½ years old and held the account for at least 5 years.
Here’s the biggest question. Both retirement accounts have benefits, and the largest difference is when you pay taxes, so which is better?
Would you rather take the tax break now and pay taxes during retirement or pay taxes now and enjoy the tax break during retirement?
It comes down to your tax bracket. If you know beyond a doubt you’ll be in a lower tax bracket when you retire, the traditional 401K works best. But, if there’s a chance you’ll be in a higher tax bracket (think of how much you’ll withdraw during retirement), you may want to pay the taxes now and enjoy the tax-free withdrawals during retirement.
The good news is that you aren’t locked into one choice or the other. You can contribute to both (if your employer allows it). The same $19,500 limit stands between the two accounts, but you can diversify your retirement funds, reducing your liabilities on both ends.
If you’re unsure, open both accounts and contribute to the one you (or your tax advisor) thinks is the smartest choice for the year given your current circumstances.