Two options—and a whole lot to consider.
A record number of Americans are participating in employer-sponsored 401(k) plans today. Of the options available, two stand out as clear favorites: plans that offer only the traditional pre-tax account and those that add the optional Roth after-tax account. Both offer unique advantages and tax considerations, but neither is clearly better.
That said, while nearly three-quarters of corporate 401(k) plans offer Roth accounts, under 8 percent of employees actually opt for them. Why? It turns out that they just might be unsure of the differences between the two account types. Below, we’ve spelled out the key differences and considerations employees need to keep top of mind.
Traditional 401(k) Plans
Traditional 401(k) retirement plans allow individuals to set aside a share of their paycheck on a pre-tax basis. This means that the IRS can only tax these funds when the individual receives a distribution from the plan. The federal and state taxes, if any, incurred are based on the retiree’s tax bracket at the time they start receiving their distribution.
In other words, if you expect that you will be in a lower tax bracket by the time you retire, a traditional 401(k) plan might be for you.
Need to dip into those funds early? With traditional 401(k) plans, you’ll face an additional tax penalty of 10 percent if you withdraw money before turning 59½ years old. Yes, the age requirement is that specific.
Roth 401(k) Plans
Conversely, Roth 401(k) accounts allow employees to contribute on an after-tax basis. While that means you won’t be taxed on qualified withdrawals in the future, it also means your contributions will take a more substantial bite out of your paycheck today.
Call it a case of having more money now versus more money later. When it finally comes time for retirement, you’ll have full access to your hard-earned money, tax free. If you’ve put aside a nest egg of $1 million, you’ll be able to keep every penny (including all of the investment earnings!) when you receive a distribution, minus any administration fees. Traditional 401(k) accounts can’t boast that same benefit.
And the Roth 401(k) benefits don’t stop there. Unlike the contributions you make to a traditional pre-tax 401(k) account, withdrawal rules here are a little more lenient. You can dip into your Roth account funds after five years of holding the account, due to a disability, or—you guessed it—turning 59½ years old if your plan permits.
Roth plans shouldn’t be confused with the “after-tax” 401(k) contributions, which are contributions past the contribution limit that are not tax deductible. As mentioned earlier, retirees withdrawing funds from a Roth account won’t need to pay any additional taxes. On the flip side, withdrawals from after-tax plans require account holders to pay a tax on any gains made.
Two Accounts, Same Limit
Both traditional and Roth 401(k) account holders are subject to the same annual contribution limits. As of 2019, employees could contribute up to $19,000 to their 401(k) accounts each year. This is a combined limit, which is important to note in case you contribute to both traditional and Roth accounts. Keep in mind that this limit is subject to an annual update from the IRS.
It should be noted that employees aged 50 or older can contribute a little more—in 2019 ($6,000 more) up to a total of $25,000 annually. This age-based exception is referred to as a “catch up” contribution, because it allows individuals nearing retirement age to help close any potential savings gaps. That’s important to remember given that older generations tend to be less confident about the state of their retirement accounts.
It’s increasingly common for employers to “match” employee 401(k) contributions. Today, nearly half of businesses with retirement plans contribute at least 50 cents for every dollar deferred by employees (generally up to 6 percent of the account owner’s salary). Per some industry studies, a more generous “dollar for dollar” approach is on course to becoming just as popular.
If an employer offers to match contributions made to traditional plans, it tends to do the same for Roth accounts. So does matching work any differently based on the kind of account?
Employer matching contributions are always contributed on a pre-tax basis to a separate account under the plan, regardless of whether you’re making your contributions to a traditional pre-tax account or a Roth account. Generally, amounts distributed to you from the separate employer contributions account are taxed as ordinary income in the year you receive them, similar to how distributions from a traditional 401(k) are taxed.
However, if you have a Roth account, you have the option to transfer some or all of the employer’s pre-tax contributions from the employer contributions account into your Roth account, if your plan permits this. And if you do that, the amounts you transfer are immediately taxed as ordinary income. The good news is that you won't be taxed again on these amounts or the future investment earnings they generate when they are ultimately distributed to you.
While both traditional and Roth 401(k) accounts have their potential advantages, there’s no one-size-fits-all financial solution to retirement. Each type has a different impact on employees’ retirement savings, whether it’s on payday or when it comes time to finally retire.
Your retirement offerings differentiate your business from the competition—so don’t shy away from playing the role of teacher. In addition to spelling out the pros and cons of each account type during your next open enrollment, consider making financial literacy training a part of your overall employer offering.
Whether it’s a traditional or Roth account, Guideline empowers your employees to navigate their options and enroll in the 401(k) they deserve. To learn how our technology makes it easy to manage your retirement plan, compliance, administration, and more, schedule a demo with one of our 401(k) specialists.
The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax advice that considers all relevant facts and circumstances. You are advised to consult a qualified tax professional before relying on the information provided herein.