For many of us, the first time we ever thought about a 401k was when we got our first full-time job. The overwhelming set of decisions we had to make about income tax allowances and insurance deductibles probably also included how much we wanted to contribute to our retirement plan. Unless you partook in some sort of financial planning course in school, concepts like a traditional 401k versus a Roth 401k likely seemed like a total mystery.
The good news is that understanding the difference between these two types of 401k retirement funds is fairly simple. The somewhat bad news is that deciding how to invest your money is not so cut-and-dry, but once you understand the financial implications of the two types of accounts, you can make an informed decision about how it makes the most sense to invest your retirement savings.
What is a 401k?
The United States is a peculiar country in that some tax codes and form numbers have made their way into our common language. For example, most Americans have heard of the W-2, W-4, and 1099 tax forms and know what they are used for.
The name 401k, often written as 401(k), is similar in that it refers to a type of employer-sponsored retirement plan described in section 401, subsection (k) of the Internal Revenue Code. There are also retirement account plans outlined in subsection 403(b) for non-profit organizations and 457(b) for state and local governments, but they largely work the same way. Because most Americans are employed by the private sector, the term 401k has grown to colloquially refer to all these types of workplace-offered retirement plans.
The primary purpose of a 401k plan is for employees to have a portion of their paycheck automatically placed into an investment account that is permitted to grow tax-free but cannot be touched (without penalty) until you turn 59 ½ years old. Through your company’s 401k administrator, you have a choice of investment products into which you can place your funds which lets you choose how aggressively you would like to invest. If you’re younger, you may want to invest in a mutual fund weighted toward the stock market, which tends to be higher risk but higher reward. Once you get older, you may want to shift your portfolio towards a more stable allocation centered around bonds and precious metals. Target date funds can also help you automatically adjust your allocation as you age. You are allowed to place up to $19,500 per year in your 401k account (the limit is slightly higher if you are over 50).
You may wonder, why should you put a part of your paycheck in a 401k, when you could invest your money yourself and use it whenever you want? The reason is that funds in your 401k fund are allowed to grow tax-free, unlike your other personal investments that are subject to capital gains taxes every year. But that doesn’t mean you won’t pay taxes, which takes us to the difference between a traditional and a Roth 401k.
Traditional 401k plans allow employees to contribute a portion of their paycheck toward their retirement before income taxes are withheld. Contributions to your traditional 401k reduce your overall tax liability. For example, if you earned a $60,000 salary but placed $5,000 in your traditional 401k account, to the tax code, it will appear as if you earned $55,000, which will lower the amount of income tax you will have to pay at the end of the year.
The trade-off is that you will have to pay income tax once you retire and start withdrawing money. So while you avoid paying some income taxes now, you will have to pay income taxes on what you withdraw in retirement.
Those who would rather pay their taxes now and enjoy retirement tax-free would be interested in their Roth 401k. Named for Senator William Roth, a sponsor of the Taxpayer Relief Act of 1997 that established the Roth IRA, Roth 401k plans allow accountholders to place after-tax funds into their retirement account and not pay taxes on those funds withdrawn during retirement.
You may have also heard of Roth IRAs as a retirement investment option, which are individual retirement accounts that any individual may set up to contribute their after-tax money toward retirement. Roth IRAs are more flexible in their investment and withdrawal options, but have a $6,000/year contribution limit, as opposed to the $19,500 overall contribution limit to traditional and Roth 401ks.
When I took a financial planning course back in college, the professor, who was also an accountant, said the best financial decision we could make was to invest in our Roth 401k. Apparently, he was of the opinion that our future selves would thank our younger selves for going ahead and paying those income taxes so we could enjoy our retirement withdrawals tax-free. But is that really the best idea for everyone?
How should you invest in your 401k?
The bigger percentage you can put towards your retirement, the more your future self will thank you. You’ll often see it recommended that you put at least 10% of your paycheck toward retirement, but ideally up to 15% or 20%. Your payroll department will likely allow you to invest some of your retirement contributions in a traditional 401k and some in a Roth 401k. So should you contribute to just one, or to both? And if both, what should the split be?
Note that we are not financial advisors. If you would like some financial planning advice, your company’s 401k administrator likely has a financial advisor who would be happy to speak with you about what makes the most sense for your retirement planning. But here are some factors that may help you think about where it makes the most sense to place your retirement contributions.
Your Income Now vs. Later
The main difference between traditional and Roth 401ks is paying income tax now versus paying income tax later. Your first thought may be that it makes sense to pay the income taxes now and put everything in your Roth plan so you won’t have to pay income taxes when you’re already on a fixed income during retirement.
But consider that as your rate of income will be different between now and retirement, so too will your income tax rate. If you’re making a good salary right now, you would probably pay a higher income tax rate on Roth 401k contributions today than you would during retirement when you’re only withdrawing/earning enough money to live on. On the other hand, if you’ve currently got a low tax liability thanks to child tax credits and other deductions we are privy to earlier in life, you may later thank yourselves for putting what you can into your Roth 401k today and have it taxed at today’s lower rate. These are the types of factors you should discuss with your financial advisor to make sure you’re investing wisely by minimizing your tax liability.
Tax Rates Now vs. Later
Of course, making these decisions based on your personal circumstances is only part of the equation. Income tax rates at a national and state level are certain to vary between now and when you retire. What do you think the income tax situation will be like in 20, 30, or 40 years when you retire? Traditional wisdom might lead you to believe that income tax rates will be higher in the future, but that hasn’t always been the case over the past several decades. If you believe tax rates will go up in the future, you may want to put some more of your contributions toward your Roth fund and pay a lower tax rate today. Or if you know you live in a high tax state today but are planning to move to a state without an income tax (like Florida or Texas) in the future, you may want to defer your taxes with a traditional 401k. Everyone’s situation is and will be different, and that is why we are given choices.
Return on Investment
Income taxes aside, you should also think about the rate of growth your retirement fund can achieve in a traditional 401k versus a Roth 401k. The more cash you can invest into your retirement at an earlier age, the more it will have a chance to multiply between now and when you retire. For example, assuming a 7% rate of growth, an extra $4,000 that you could put in your traditional 401k instead of giving it to Uncle Sam by putting after-tax funds into your Roth will grow into almost $60,000 over the next 40 years. No matter how much the IRS wants to tax that extra $60,000 when you retire, having it taxed is better than not having it at all!
No matter how you choose to split your 401k contributions, at a minimum, you should make sure you’re getting the full benefit from your employee’s 401k match. If your employer offers a 5% match toward retirement, at minimum, contribute 5%. If your employer uses some fancy math to match 100% up to a point and then 50% up to another point, just make sure you’re maximizing your employer contribution. Not doing so would just be leaving free money on the table!