Traditional 401k Versus a Roth 401k: Choosing a Plan that is Right for You
By Kelly Harris, Staff Accountant, Tax & Business Services
Since the Roth 401k was first offered in employee benefit plans in 2006, it has joined a Traditional 401k in becoming popular among plans for retirement. The two types of plans have several similarities, but they also have significant differences.
Below is a comparison between a Traditional 401k and a Roth 401k:
| Traditional 401k | Roth 401k | |
| Employer Sponsored | Yes | Yes |
| Income Limitations | Not Subject to Income Limitations | Not Subject to Income Limitations |
| Contribution Type | Contributions are made on a pre-tax basis | Contributions are made on a post-tax basis |
| Contribution Limits for 2014 | Maximum Contribution of $17,500 with an additional “catch up” provision of $5,500 for taxpayers > 50 | Maximum Contribution of $17,500 with an additional “catch up” provision of $5,500 for taxpayers >50 |
| Employer Match Program | May be offered from employers in which contributions are placed in a pre-tax account | May be offered from employers in which contributions are placed in a pre-tax account |
| Taxed on Withdrawals (after age 59 ½ ) | Distributions taxed as current income | Distributions not subject to taxes or penalties if account was held for at least 5 years |
| IRA Rollforward | Can be rolled into a traditional IRA with no tax payment or into a Roth IRA with a tax payment. IRAs subject to income limitations. | Can be rolled into a Roth IRA with no tax payment. IRAs subject to income limitations. |
| Minimum Distribution Requirement | Must start withdrawing funds at age 70 ½ unless still working and not a 5% owner of the company | Must start withdrawing funds at age 70 ½ unless still working and not a 5% owner of the company |
| Early Withdrawal Penalties | Yes-10% penalty plus taxes on early withdrawals including withdrawals for hardships. There are exceptions to early withdrawal penalties. | Yes-Proportion of distribution considered to be earnings will be subject to taxes and penalties. There are exceptions to early withdrawal penalties |
Please note that the above chart discusses the general similarities and differences between a Traditional 401k and a Roth 401k. When choosing a retirement plan, keep in mind that every individual’s situation is different and must be taken into consideration.
Below are key tax implications that should be considered when choosing a 401k plan:
- Pre-Tax Versus Post Tax Contributions
- Traditional 401k
- Contributions are made on a before tax basis which leads to a reduction of a taxpayer’s current taxable income
- Distributions are later taxed at the prevailing ordinary rate
- Contributions are not dollar for dollar meaning that $100 contributed into the plan could result in only $75-$85 in net pay
- Roth 401k
- Contributions are made on an after tax basis meaning that like wages they are subject to federal, state, social security and Medicare taxes before it is contributed into the account
- Distributions are not considered to be income and therefore are not taxed as long as the account was held for at least five years
- Contributions are dollar for dollar; meaning that $100 contributed into the plan results in $100 paid out of pocket
- Current Versus Future Tax Brackets
- Traditional 401k
- Beneficial for taxpayers who have higher tax rates in the short term and expect their income to fall into a lower tax bracket in the future
- Ability to take a deduction for contributions when tax rates are higher, and are subject to a lower tax for distributions
- Ideal for taxpayers who are closer to retirement
- Roth 401k
- Beneficial for taxpayers who have lower tax rates in the short term and expect their income to fall into a higher tax bracket in the future
- Contributions taxed at a lower rate and distributions are not subject to tax when rates are higher
- Ideal for taxpayers who are beginning their careers and expect their income to increase
Please note that unlike a Traditional 401k, which can be converted to a Roth 401k, once money is invested into a Roth 401k, it cannot be transferred to a Traditional 401k. A taxpayer can also choose to contribute to both plans simultaneously as long as the combined annual contribution total between both plans does not exceed $17,500 per individual taxpayer under age 50 and $23,000 per individual taxpayer older than age 50.
Should you have any further questions on the comparison between a Traditional 401k and a Roth 401k and/or choosing the right plan to meet your needs, please contact your Marcum Professional.
