Employees didn’t always used to have options when it came to setting up their 401k at work. The traditional 401k used to be the only show in town, until the Roth 401k came on the scene in 2006. In 2007, only 11 percent of employers offered a Roth 401k, which, when considering it became an option in 2006, is a fairly high percentage of early adopters. However, today, over 50 percent of employers offer a Roth as part of their 401k plan and that number is increasing.
So what is a Roth 401k and how does it differ from a Traditional 401k? That is a question that any employer needs to be able to answer for their employees. So let’s dive right in. The primary difference between a Roth 401k and a Traditional 401k is the tax implications between the two. But before we discuss the differences, let’s identify what they have in common.
- They both have the same contribution limits 401k which is set by the IRS to be $18,500 in 2018.
- Withdrawals from each account are limited until age 59 and a half.
- Both accounts must begin RMDs or required minimum distributions at age 70 and a half.
- Both accounts can be invested in the account in the way that the account owner chooses.
When talking about the differences between a Roth 401k and Traditional 401k, there is really only one primary difference between the two accounts. The primary difference is the way in which each option/account is taxed when the money is both contributed initially and then withdrawn at some point in the future. First, when money is contributed to a Roth 401k, the money is contributed after-tax. In other words, an employee must pay tax on the earnings and then the money can be contributed to the 401k. Then as the money grows in the Roth, the growth is considered tax-free growth since it was taxed before the contribution and thus when the 401k participant withdraws the money in retirement, it is withdrawn tax free.
In contrast, with a Traditional 401k, money can be contributed before tax. In other words, the money contributed to a Traditional 401k was never taxed before it was contributed. As a result of not being taxed on the contribution, the growth in the account grows tax deferred...meaning you must pay ordinary income tax on the money as it is withdrawn from the account in retirement.
Knowing the difference between a traditional 401k and roth, the question now becomes, which one should I choose?? This is a great question and unfortunately, the answer depends on what future tax rates will be, which no one can predict with absolute certainty. In other words, the question is...should I pay taxes today, or should I pay taxes tomorrow(in retirement). Are your tax rates higher today or will they be higher in retirement? No one knows and so thats why most advisors would tell you to be diversified between the two options.
Is there anywhere where I can model the difference between the two accounts? Another good question. A roth versus traditional 401k calculator may be your best way to model this. This will help you project the future impact using different tax rates now and in the future. Regardless of whether you choose to have more Roth or more Traditional, you should be diversified in your choice.