If you're fortunate enough to have an employer who sponsors a 401(k) plan, you have a real opportunity to set aside a nice amount of money for the future. That's because annual contribution limits are far more generous in 401(k)s than they are in IRAs. Currently, you can set aside up to $18,500 a year if you're under 50, or $24,500 if you're 50 or older. With an IRA, these limits max out at just $5,500 and $6,500, respectively.
But not all 401(k) plans are created equal, and these days, an estimated 67% offer a Roth savings option, according to new data from T. Rowe Price. If you're saving money in a 401(k), it pays to explore the benefits of a Roth plan and see if it's right for you.
Traditional versus Roth 401(k)s
The annual contribution limits for 401(k)s are the same whether you save in a traditional account versus a Roth-style account. It's the way that money goes into your account that differs substantially.
With a traditional 401(k), your contributions are made with tax-free dollars, which means you save money on your IRS bill immediately. When the time comes to take distributions in retirement, however, you'll pay taxes on your withdrawals. And that, frankly, can be a pain, especially during the early years of retirement when you're not sure what your tax rate will be and don't know how much of your savings you'll actually wind up with in hand.
The beauty of the Roth 401(k) is that it allows you to take tax-free withdrawals during retirement. While you'll forgo the up-front tax break on your contributions, you'll also get to rest easy knowing that whatever sum your account balance grows to is yours free and clear of taxes once you stop working. You won't have to worry about paying the IRS its share, and you'll have more flexibility later in life, when your options for generating income might be limited.
Saving in a Roth 401(k) can be especially beneficial if you expect your tax bracket to be higher in retirement than it is at present. This could be the case if you wind up with a large nest egg or are planning on multiple income streams in retirement that could raise your effective tax rate. Interestingly enough, the above data set found that participants aged 20 to 40 were more likely to save in a Roth 401(k) than their older counterparts, which tells us that many younger workers would rather get their taxes over with now and enjoy more leeway with their money later on.
Is a Roth 401(k) right for you?
Aside from tax-free withdrawals, another benefit of saving in a Roth 401(k) is getting more flexibly with your money. Since you don't get an immediate tax break for funding a Roth, you can technically withdraw your principal contributions prior to retirement without penalty. With a traditional 401(k), you'll face a 10% early withdrawal penalty if you remove funds prior to reaching age 59 1/2. This option could come in handy if you're faced with a financial catastrophe and want stress-free access to cash.
As an example, imagine your heating system gives out during the coldest month of the year, and you don't have thousands of dollars on hand to replace it. With a traditional 401(k), you'd face a 10% penalty for withdrawing funds to pay for that repair if you're not yet 59 1/2, but with a Roth 401(k), that's not a worry.
That said, anytime you remove funds from a retirement plan when you're younger, you leave yourself with less money to work with during your golden years. Not only do you lose out on the principal amount you withdraw, but you also miss out on whatever growth it could've achieved. And all told, that could constitute a major setback when you're older. Still, while it's generally best to leave your retirement funds alone until you're no longer working, if you need that money in a true pinch, you'll have easier early access to it with a Roth-style account.
If your 401(k) comes with a Roth savings option, it pays to see if it's right for you. On the other hand, saving in any type of plan is a smart move, so if you go with a traditional 401(k) and make contributions consistently, you'll be doing a good thing for your future as well.
The Motley Fool has a disclosure policy.