Everyone's heard of Roth IRAs, but Roth 401(k)s are a bit more mysterious. Part of the reason for this is that they've only existed for 12 years, and many workplaces still don't offer them to employees. But if your employer does, it's worth considering. Depending on your age, income level, and other factors, it could be the most efficient vehicle for growing your retirement savings.
Here's a closer look at the differences between traditional 401(k)s and Roth 401(k)s, along with some advice on how to choose the right retirement account for you.
Traditional vs. Roth 401(k)s
Both types of 401(k)s enable you to contribute up to a maximum of $18,500 in 2018, or $24,500 if you're 50 or older. If you have both types of accounts, you should keep in mind that $18,500 is the maximum contribution limit across all of your 401(k) accounts. Both types are subject to early-withdrawal penalties if you take the money out before age 59 1/2 (with some exceptions), and both require you to begin taking distributions no later than age 70 1/2.
The differences between traditional and Roth 401(k)s are very similar to the differences between traditional and Roth IRAs. In essence, it comes down to when you pay taxes on the money in the account. In a traditional 401(k), your contributions are spared from income tax when you put them in, reducing your tax burden up front. But when you withdraw money from a traditional 401(k) in retirement, you'll pay taxes on your distributions. With a Roth 401(k), your contributions will be hit with income tax, but you won't pay any tax when you pull funds from the account, provided you're 59 1/2 or older and you've had the account for at least five years.
There are a few exceptions to those tax-free withdrawals, though. First, if you've had the Roth 401(k) for less than five years, the money will not qualify for tax-free distributions. The same is true of Roth IRAs. Second, if your employer matches your Roth 401(k) contributions, the matching dollars will go into a pre-tax account, and you will have to pay taxes when you withdraw them.
Who a Roth 401(k) is good for
When choosing between a traditional or Roth 401(k), you have to think about how you expect your income to change between now and retirement. Roth IRAs and Roth 401(k)s are generally recommended to young adults who are just beginning their careers, because they're often in a low tax bracket, and there's a greater likelihood that their income -- and thus their income tax rate -- will be higher in retirement. It makes sense for them to pay the taxes now while they're in a lower tax bracket. If you expect your income to be higher in retirement than it is at present, then a Roth 401(k) is the way to go.
A Roth 401(k) is also a great choice if you're trying to grow your retirement savings for as long as possible. Like traditional IRAs and 401(k)s, a Roth 401(k) requires you to begin taking a minimum distribution starting at age 70 1/2. But you can avoid this by transferring that money to a Roth IRA, which has no minimum distribution requirement.
Who a Roth 401(k) is bad for
A Roth 401(k) isn't a good choice if you expect your income in retirement to be lower than it is now. In that case, you may want to invest through a traditional 401(k) and thus save the income tax hit for when you're retired and in a lower tax bracket. This is usually the smartest option for those who are in the prime of their careers and those who are in a high tax bracket.
A Roth 401(k) may not even be an option for you if your employer doesn't offer one. In that case, it's wise to continue contributing to your traditional 401(k), especially if your employer matches your contributions. If you want to contribute some money to a Roth type account, you can open an IRA instead.
It doesn't have to be one or the other
One of the reasons people debate endlessly between traditional and Roth retirement accounts is that there's no way to predict which way federal income taxes will go or which tax bracket you'll wind up in as a retiree. If you retire when taxes are high, you could end up paying more on your traditional 401(k) distributions than you anticipated. Similarly, if taxes are lower when you retire, you may have paid more on the money in your Roth 401(k) than you would have if you'd kept it in a traditional 401(k).
Many people choose to hedge their bets by having both traditional and Roth retirement accounts. You can still favor one or the other, depending on which option is the best for your situation. Check with your employer to see if this is an option for you. If not, it may be wise to have an IRA as well.
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