A CFP explains the differences
What's the Difference between a Roth and a Traditional 401k?
by Paige Estigarribia
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A 401(k) is a fairly typical retirement account, but did you know that there are different types of 401(k)s? We wanted to learn more about both traditional and Roth 401(k) accounts, so we reached out to Austin, Texas CFP Chris Cyndecki. Here's what he had to say:
Q: What is a Roth 401(k)?
Mr. Cyndecki: A Roth 401(k) is an employer-sponsored retirement account. The Roth 401(k) is similar to a traditional 401(k) in several ways: employees can make contributions via payroll deductions, employers can match employee contributions, investments are not taxed as they grow, and funds within the account enjoy bankruptcy protection.
Q: How is a Roth 401(k) different from a traditional 401(k)?
Mr. Cyndecki: Contributions to a traditional 401(k) are pre-tax, meaning the employee receives a tax deduction for the amount contributed. When money is withdrawn in retirement (after age 59 1/2), the employee reports ordinary income and pays federal income taxes on the amount distributed. Starting at age 70 1/2, the employee is forced to withdraw a percentage of funds from the 401(k). This is known as a Required Minimum Distribution (RMD).
Contributions to a Roth 401(k) are after-tax, meaning the employee pays tax today on funds contributed at the applicable marginal tax rate (no deduction). When money is withdrawn in retirement, the employee pays no taxes. Although RMDs also apply to Roth 401(k)s, the participant will not need to report the distribution as ordinary income for tax purposes.
Q: Are certain people better candidates for a Roth 401(k)?
Mr. Cyndecki: Each situation is unique. Participants in the early stages of their careers, expecting to have higher income in the future, may be good candidates for a Roth 401(k). Traditional 401(k) contributions typically make sense for individuals at the peak of their earning years looking to defer federal taxes to lower marginal rates in retirement.
Q: What are some certain rules that anyone considering a Roth 401(k) should be aware of?
Mr. Cyndecki: Unlike a Roth IRA, there is no income phase-out for the Roth 401(k).
The maximum contribution amount between both traditional and Roth 401(k)s is $18,000 for 2016. Participants over age 50 can make an additional $6,000 catch-up contribution.
Qualified distributions occur when the individual has reached age 59 1/2, died, or become disabled AND at least 5 years after the first Roth contribution has been made.
The Roth 401(k) is subject to RMDs at age 70 1/2. However, the taxpayer can avoid RMDs and maintain tax deferral by rolling the Roth 401(k) into a Roth IRA.
Employer matching contributions are made on a pre-tax basis and are placed in a separate tax bucket. The money in this bucket will be subject to ordinary income taxes when distributions are taken in retirement (just like a traditional 401(k) or IRA). However, some employers allow Roth conversions within the plan.
Q: Is there anything that people often forget to consider when they are considering a Roth 401(k)?
Mr. Cyndecki: Expectations of federal income tax rates should be considered. If one expects federal tax rates to increase in the future, then contributing to a Roth 401(k) and paying taxes today may make sense.
Because future tax rates are unpredictable, having the flexibility to withdraw between pre-tax and after-tax accounts in retirement is a great advantage.
Chris Cyndecki is a Certified Financial Planner® and works with Pioneer Wealth Management Group, a fee-only firm based in Austin, Texas.
Paige Estigarribia is a writer for The Dollar Stretcher who enjoys writing about food, frugal living, and money-saving tips. Visit Paige on Google+.
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