401k vs Roth 401k : decide which one is better

401k or traditional 401k vs Roth 401k. Your employer may offer several options to save for your retirement. It is important that you know the pros and cons of these options so that you can make the right decision for your financial future. Like Traditional IRAs and Roth IRAs, traditional and Roth 401k have their own pros and cons.

You can split your contribution into both traditional 401k and Roth 401k if your employer retirement plans allow you to do so. 

Companies offer retirement savings accounts as a benefit for their employees so that they can have financially secure retirement. Retirement accounts are attractive because they offer several tax benefits. However if we need to withdraw money from the retirement account prior to retirement there is usually a large penalty. Hence it is important to be careful to set aside an emergency fund for expenses and not put all the money in the retirement account.

In order to make a better comparison to decide which one is best for you, you should know what is traditional 401k and Roth 401k as well as their advantages and disadvantages.  

The 401k or Traditional 401k

The 401K is similar to the Traditional IRA in that it can help reduce your taxable income with pre-tax contributions. This in turn helps reduce your tax bracket. This may make you eligible for benefits like credit for child care and deductions for student loan interest. Note that when you retire and are ready to withdraw funds from your retirement account, you will need to pay the standard income tax at that time. Many people prefer this because when they retire, they often fall into a lower tax bracket. However everyone’s situation is different and it is wise to consult your investment professional prior to making this or any financial decision.

Let’s look at an example. Assuming that you make $40,000 per year and contribute 5% to your 401K, your annual contribution will be $2000. As a result, your taxable income will be reduced by $2000. Instead of paying taxes on $40,000, you will need to pay taxes only on $38,000.

When investing, usually, the larger your initial investment and the longer your time period of investment, the higher your return. Hence it would make sense to take the tax benefits early in your career and invest as much as you can afford into your 401K. Always do remember to set aside some money in your emergency fund. Also remember that eventually you will need to pay tax when you withdraw money from your account.

The Roth 401k

Similar to the Roth IRA, the Roth 401K allows you to make contributions after-tax. That means that you pay taxes now, but can withdraw your money tax free later on in retirement. You will need to decide if it makes sense for you to pay the tax now, or later.

An example may help illustrate this better. If your salary is $40,000 per year and your tax rate is 20%, your income will be reduced by 20% to $32,000. If you elect to contribute 5% to your Roth 401K, you will be contributing 5% of $32,000 which is $1600. As you can see, with the traditional 401K, your 5% contribution translated to $2000 while it translated to only $1600 with the Roth 401K, since it is after-tax.

With the Roth 401K, you do not get the benefit of lowering your tax rate as with the traditional 401K. You are in effect, electing to defer the tax benefits to the time when you withdraw.

Your initial investment amount is reduced since it is after-tax. However, unlike the traditional 401K, you will not be paying any taxes on your distributions.

In case your retirement plan allows, you can split your contribution between Roth 401k and traditional 401k. But, your combined contributions cannot exceed the deferral limit – $19,500 if age under 50, and $26,500 if age 50 and above in 2021.

401k vs Roth 401k

2021	401k – Traditional 401k	Roth 401k
Tax advantages	Helps reduce your taxable income and can result in lower taxes.	Does not reduce the taxable income. You will pay taxes at the standard rate.
Income limitations	No restrictions	No restrictions
Pre-tax or post-tax	Contributions are made before tax	Contributions are made after tax
Upper limit on contribution	In 2021 and 2020: limited to $19,500 per year for people under 50 years of age, $26,000 for those over 50 years. In 2021: Both employer and employee contribution cannot be more than $58,000 for people under the age of 50 or $64,500 for age 50 and above	In 2021 and 2020: limited to $19,500 per year if age under 50, $26,000 for those 50 and above In 2021: Both employer and employee contribution cannot be more than $58,000 for age under 50 or $64,500 for age 50 and above
Pre-retirement withdraw	Taxable as ordinary tax and 10% penalty on early distribution and earning  if you are under 59 ½  Taxable, but no penalty on withdrawal if  At least 59 ½ or meet IRS exception criteria such as permanently disabled, some levels of unreimbursed medical expenses, deceased, and so on.	Nontaxable and no penalty on your contribution, including earning withdrawals  For individuals whose account has been open for a minimum of 5 years and if any of the following apply: at-least 59 ½ years of age, permanently disabled or deceased. Taxable on earnings for non-qualified distribution.
Requirement minimum distribution (RMDs)	In 2021: RMDs is required when you are age 72 (age 70½ if born before July 1, 1949) 50% penalty on any missed RMDs If you are 72 year olds, but you are still working and your account is still with your current employer, then RMDs may not be required.  If you own 5% or above of the employing company, RMDs must begin at age 72	In 2021: RMDs are required when you reach the age of 72. If you were born before July 1, 1949, then RMDs are required from age 70 1/2. 50% penalty on any missed RMDs If you are 72 year olds, but you are still working and your account is still with your current employer, then RMDs may not be required If you own 5% or above of the employing company, RMDs must begin at age 72
Tax on RMDs	50% penalty on any missed RMDs	RMDs is taxed free  If your employer’s matching  contribution is pre-tax. Then, they are taxed as ordinary income.

401k – Traditional 401k vs Roth 401k – Questions and Answers

1. What is a 401k?

A 401k is a defined contribution plan, an individual retirement account which is offered by your employer. Your employer may match up your contribution. Different companies have different rules for matching up contributions. You do need to meet the vesting period to vest your contribution portions. 

2. Which type of retirement account reduces your taxable income?

With a Traditional 401K, you can contribute pre-tax dollars that reduce your taxable income. You will pay lower taxes but will need to pay taxes when you withdraw. Depending on the tax bracket that you expect to be in when you retire, this maybe a good choice.

3. Which type of retirement account has tax free distributions?

You do not need to pay any taxes when you take distributions from your Roth 401K. However, note that you are contributing after-tax dollars to your Roth 401K and hence will not be able to reduce your taxable income at the time of contribution. If you expect that your tax rate at retirement will be higher, this maybe a good option.

4. Can you have both traditional 401k and Roth IRA?

Yes, you can have both traditional 401k and Roth 401k if your employer allows you to do so.

5. Can you borrow money from your 401k?

Yes, you can borrow money from your 401k. In 2021, you are legally allowed to loan your 401k (s) up to $50,000 or 50% of the total contribution, whichever is lesser. However, you have to pay back within 5 years to avoid tax and a 10% penalty if you are under 59 ½ .

6. How much can you contribute in 401k?

In 2021 and 2020: limited to $19,500 per year if age under 50, $26,000 for those 50 and above

In 2021: Both employer and employee contribution cannot be more than $58,000 for age under 50 or $64,500 for age 50 and above