When you’re planning your retirement, there are a ton of options to choose from.
Of these, the Roth 401(k) and Traditional 401(k) accounts are two of the most popular choices. They offer plenty of perks and a chance to build a retirement nest egg. However, each has pros and cons depending on your financial needs.
Let’s explore the nuances of these two options to see what’s best for you!
What Are 401(k) Accounts?
We’ve written a detailed guide about 401(k) accounts before, but here’s a quick overview of how they work:
At its core, a 401(k) is a retirement savings plan sponsored by your employer. When you sign up for one, your employer will put a portion of your paycheck into a retirement account.
Depending on whether you opt for a Traditional or Roth 401(k), you can make a contribution before or after taxes. Both have their own set of pros and cons you need to consider for your long-term retirement strategy.
What Are Traditional 401(k)s?
The Traditional 401(k) plan is the grandparent of modern retirement accounts.
You make contributions before taxes, which reduces your taxable income for the year. This plan lets you build up your retirement savings and lower your tax burden at the same time.
Taxes are deferred until you start taking distributions in retirement, at which point withdrawals are taxed as regular income. This setup can be beneficial if you expect to be in a lower tax bracket during retirement, as it allows you to defer taxes when your tax rate may be higher.
Benefits Of Having Traditional 401(k)
- Reducing your income and potentially lowering your tax bill each year
- Investment gains aren’t taxed until you withdraw them, which lets your account grow tax-deferred over time.
- Higher annual contribution limits
- Many employers offer a match (free money!) on your contributions to a Traditional 401(k)
- Perfect for those who expect to be in a lower tax bracket when they retire
How Does A Roth 401(k) Work
On the flip side, a Roth 401(k) combines the convenience of a company retirement plan with the tax-free withdrawal benefits of a Roth IRA.
Unlike a traditional account, you make contributions with taxed income, so you won’t get a tax deduction upfront.
The real benefits start to kick in when you retire. All your contributions and investment earnings are tax-free, provided you meet certain conditions.
This feature makes the Roth 401(k) a great choice if you expect to be in a higher retirement tax bracket or prefer paying less taxes in your golden years.
Benefits Of Having A Roth 401(k)
- You can withdraw your money tax-free in retirement
- No income limits to contribute, unlike a Roth IRA
- Higher earners can enjoy lower taxes
- Withdraw your contributions without a tax penalty under certain conditions
What Do These Two Accounts Have In Common?
Despite their differences in tax treatment, Roth and Traditional 401(k) accounts have a few things in common.
Both types of accounts allow your employer to match contributions, effectively doubling the contribution to the employee’s retirement savings.
Additionally, the contribution limits for Roth and Traditional 401(k) are $23,000, letting you save a decent chunk of change each year. They offer a similar range of investment options, giving you the flexibility to tailor your investment strategy as you see fit.
No matter which one you choose, these accounts will definitely help you build your retirement portfolio without issues.
The Bottom Line
Both Roth and Traditional 401(k)s offer unique advantages and can play an essential role in your retirement strategy.
Before settling on one, think about your retirement plans. If you see yourself earning more and want to pay less taxes, a Roth 401(k) could be the better choice. But if you know you’ll be earning less when you stop working or want to enjoy your tax break now, a Traditional 401(k) may be the way to go.
Ultimately, the best choice comes from your financial goals, tax situation, and retirement plans.
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