What’s the Difference Between a Traditional and Roth 401(k)?
Understand the differences between workplace retirement plans and which one might be better for you.
Over the past two weeks I wrote about the differences between traditional and Roth IRAs. That topic sparked a lot of e-mail questions about investing in traditional or Roth 401(k)s. These days, more people have the option to invest in either type of account at work, and they’re confused about which choice is best. So I’ll make the leap from IRAs to workplace plans in this post.
What is a 401(k) and a 403(b)?
A 401(k) and its sister, the 403(b), are special retirement plans offered by some companies and organizations to their employees. Most companies and businesses can set up a 401(k), but only certain organizations—like hospitals, churches, public schools, and other tax-exempt groups—can use a 403(b). A 403(b) is also known as a tax-sheltered annuity plan, or TSA. In order to qualify to participate in your organization’s 401(k) or 403(b) you usually have to be at least 21 years old and have worked for your employer for a set period of time.
How Does a 401(k) or 403(b) Work?
When you participate in a workplace retirement plan, you authorize your employer to contribute a portion of your compensation to the plan for you. They make payroll deductions and send the money directly to your account. There’s nothing to worry about if you leave your job because you can roll over the money into an IRA or into a new workplace plan without having to pay any tax.
How Much Can You Contribute to a 401(k) or 403(b)?
The amount you can contribute to a typical 401(k) or 403(b) for 2010 is up to $16,500 or up to $22,000 if you’re age 50 or older. These high contribution limits are one of the reasons workplace retirement plans are so popular. Another reason people love them is for the matching funds that some employers pay when you contribute up to a certain amount.
How Employer Matching Works
For example, let’s say your employer fully matches your contributions up to 2% of your compensation. If you make $40,000 a year, 2% is $800. So any amount you contribute up to $800 gets doubled. If you only contribute $500 for the year, your employer would also contribute $500, for a total annual investment of $1,000. There aren’t too many ways to save for retirement that guarantee a 100% return on your money before you even factor in a return on your investment!
What is a Workplace Retirement Plan Vesting Schedule?
It’s important to note that some plans may have a vesting schedule. Vesting is the amount of time you have to stay employed before you fully own the money that your employer contributes. That’s an incentive for you to stay with the company at least through the vesting period. However, your contributions are always vested; you never forfeit any money that you contribute to the plan, unless of course, your investments lose money.
Differences Between Traditional and Roth Retirement Accounts at Work
Now let’s cover the differences between a traditional and a Roth account for workplace plans. A traditional 401(k) or 403(b) allows you to make pre-tax contributions. Just like with a traditional IRA, you don’t pay income taxes on the money you put in—you pay it on the money that you take out. On the other hand, a Roth account at work allows you to make after-tax contributions—just like you do with a Roth IRA.
You can make contributions to a Roth account or you can split your contributions between both a Roth and a traditional, pre-tax account in the same year. You can split contributions in any proportion you like, but the total can’t exceed your allowable limit.
How is a Workplace Roth different from a Roth IRA?
A workplace Roth and a Roth IRA are very similar because, as I mentioned, you pay tax in the year you make contributions. Because you’ve already paid the tax, you can withdraw your contributions from either a workplace Roth or a Roth IRA at any time. However, you can’t take out the earnings or growth portion from a Roth, before you’re 59½, because you haven’t paid tax on that amount yet. The penalty for taking an unqualified or early withdrawal from any kind of Roth account is a hefty 10%!
However, a Roth IRA and workplace Roth do have three important differences:
There’s no income limit to participate in a workplace Roth. Hopefully you remember that you can’t contribute to a Roth IRA if your income is too high. However, anyone can contribute to a Roth 401(k) or 403(b), regardless of how much money you make!
You must generally take required minimum distributions (RMDs) no later than age 70½ with a workplace Roth, unless you’re still working. With a Roth IRA, there’s no requirement to take distributions at any age.
You may have more options to withdraw money from a workplace plan if loans or hardships withdrawals are allowed. Generally, taking out funds for a financial hardship is limited to specific circumstances, such as unpaid medical bills, funeral expenses, or the cost of higher education.
More Tips on Workplace Retirement Plans
So you can see that a Roth at work is a little different from a Roth IRA. But the basic advantages and disadvantages of traditional and Roth accounts (that I wrote about last week in post 174) are still the same. If you prefer to get your tax liability over with now, rather than postponing it until you make a withdrawal in the future, you should lean toward the Roth. But if you can benefit from having less taxable income and a lower tax bill in the current year, then you’ll want to think about sticking with a traditional workplace account. Use the Roth 401(k) vs. Traditional 401(k) Calculator at dinkytown.com to help you analyze which option may work out best for you.
A final quick and dirty tip is that each workplace retirement plan can vary; so you should read the Summary Plan Description. Employers are required to give you a copy of this document each year.
If you're thinking about converting from one Roth plan to another, please read my Quick Tip on how Roth conversions are taxed.
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401(k) Egg image courtesy of Shutterstock