My employer started offering a Roth 401(K) option this year. I was pretty excited about it, but it confused most of my coworkers. I walked them through the Roth 401(K) vs traditional 401(K), and my explanation helped them enough that some of them opted to take that route. Let’s look at the differences so you can decide which is right for you.
A traditional 401(K) is tax-deferred, which means you get a tax deduction this year for contributing, and you pay taxes on it in the future when you withdraw it. A Roth 401(K) offers no tax deduction this year, but you owe no taxes when you withdraw it, no matter how much it grows.
What a Roth 401(k) and traditional 401(K) have in common
Both types of 401(K) are a means to save money for retirement. And both of them are designed to provide tax advantages while doing so. The difference between the two is whether you take your tax advantage today, or take the advantage after you retire. Both of them allow you to contribute up to a certain limit, which grows every year. In 2020, the maximum you can contribute to a 401(K) is $19,500.
In both cases, your employer may match a certain amount of your contribution. A common arrangement is to match 50 cents on the dollar, up to 6% of your annual salary. There may be some eligibility requirements for this, such as having worked there for at least 3 years. But note that this employer match is above and beyond your personal contribution limit. If you contribute $19,500, your employer can still contribute 6% of your salary above and beyond that.
If at all possible, try to contribute enough to a 401K to get that employer match if your employer offers it.
Borrowing against a 401(K)
Also, while there are penalties for withdrawing from any type of 401(K) before you reach retirement age, you can borrow against either type. There are rules regarding payback, so you want to be careful and only borrow against your retirement account in the case of a dire emergency. But the option is there if you need it, and it provides a way to put that money to immediate use while avoiding the early withdrawal penalty.
Advantages of a traditional 401(K)
The advantage of a traditional 401(K) is that it’s tax-deferred, so you get a pretty hefty tax deduction for doing it. This means a traditional 401(K) affects your take-home pay less than a Roth 401(K) does. If you’re contributing $500 per pay period, your paycheck doesn’t drop $500 with a traditional 401(K), because your withholding is less.
Pie-in-the-sky financial dudes tell you to always take the Roth 401(K) if you have the option. They’re right, that in the long run, the Roth 401(K) makes you more money. But that’s the ideal. If you’re contributing to a traditional 401(K) right now and you have a balanced budget with no surplus at the end of the month after paying your bills, switching to a Roth 401(K) is going to un-balance that budget because your withholding will increase.
Since the government is subsidizing your savings with a traditional 401(K) in the form of a lower tax rate, this is the only option some people can afford. It’s much better than not saving for retirement at all. I know right now it’s really popular to call people stupid over their financial decisions. Don’t let anyone else tell you that you’re stupid if you use a traditional 401(K). If it’s what you can afford, there’s no shame in choosing it. It takes an admirable amount of intelligence to figure out what you can afford. It doesn’t take any intelligence at all to criticize.
Budgeting for a change
If, after reading about a Roth 401(K), you’re sold on the advantages and want to make a change, here’s my advice. While there are advantages, it’s not a decision to make lightly. I can tell you from my personal experience, it’s a difference you’ll notice.
I recommend you have some money in the bank before making a change, so you don’t put yourself into a financial crisis if you switch. If you’re contributing exactly the amount you have to in order to get your employer match and have a balanced budget, switching to a Roth 401(K) may not be for you. If you’re contributing more, then you have some leeway to lower your contributions a bit to make sure you can balance your budget while saving for retirement.
While you’re getting that budget right, try codifying that budget if you haven’t already, and using something like the envelope system to enforce it. And if you need some help trimming some fat from your budget, here are some more ideas.
Advantages of a Roth 401(K)
The advantages of a Roth 401(K) vs traditional are tremendous, if you can afford it. Whatever you contribute to your Roth 401(K) grows tax-free. It’s an on-shore, completely legal tax haven that the middle class can participate in.
If you contribute $10,000 to a Roth 401(K), you owe no taxes on it when you withdraw. It doesn’t matter if it grows to $100,000 or a million dollars. You owe no taxes on it. You get to keep all of your earnings, which, over the course of several decades, will be significant. Keep in mind that historically, stocks double in value every 7 years. So if you were to contribute $19,500 this year and receive an employer match of $6,000 for a total of $25,500, in 21 years, that investment will probably be worth $102,000. And if it’s in a Roth 401(K) it’s all yours, tax-free.
The exception to this is if you withdraw from your Roth 401(K) before reaching the age of 59 ½. You will pay a 10% tax penalty for early withdrawal, unless you die or become disabled. There are similar restrictions with a traditional 401(K), but I mention this because of the perception that a Roth 401(K) is tax-free. It’s not quite always.
The effect of changing from a traditional to a Roth 401(K)
I’ve had patches of my career when I wasn’t eligible for a 401(K) with any kind of employer match, so I’ve been contributing religiously for the last several years, and I generally contribute as close to the year’s maximum as I can. So I switched to a Roth 401(K) from a traditional and I can tell you exactly how it affected my paycheck. It won’t affect yours exactly the same way, but it will give you an idea what to expect.
In my case, the hit was about 9 percent. I know this because I received about a 9% pay increase the same period as my change. (I had a good year last year.) My post-raise, Roth 401(K) paycheck was $34 higher than my pre-raise, traditional 401(K) paycheck.
So this is a change you’ll definitely feel. Depending on how your withholdings are set up and how much you make, the hurt will vary, but you’ll notice it.
Roth 401(K) vs traditional: In conclusion
Some financial pundits talk like it’s not worth investing in a 401(K) at all if you can’t do the Roth option. That’s misguided. You are far better off taking a traditional 401(K) over not taking one at all. If the Roth option is available to you and you can afford it, great, it’s the better option.
In either case, you want to start as early as you can, contribute as long as you can, and be astute in your asset allocation. I hate to sound dire, but I’ve had times in my career when I didn’t get any employer match. I even had a time at the beginning of my career when my job didn’t offer a 401(K) at all.
So use your option while you have it, and do what you have to do to get that employer match if it’s available. If that means driving used cars instead of new, and keeping them longer, do it. It’s worth it. If you contribute enough to get your employer match, in just the first few years of your career, you’ll retire a multimillionaire. You’ll do even better if you continue that practice throughout your career. If you don’t start until later, don’t fret. If you contribute $19,000 a year starting at 35 and continue for the rest of your career, you’ll still retire a multimillionaire. It takes more sacrifice to do it at that point, but it’s still doable. And once you hit age 50, you can contribute an additional $7,000 a year as a catch-up contribution.