What's the Difference Between a Roth and Traditional 401(k)?

By Maurie Backman Markets Fool.com

It's estimated that roughly 60% of Americans have the option to participate in a 401(k), yet not all plans are created equal. If you're choosing between a traditional 401(k) versus a Roth, you'll need to understand the key differences between the two plans, which, for the most part, boil down to taxes and rules regarding mandatory distributions. While traditional 401(k) plans are funded with pre-tax dollars, withdrawals in retirement are taxed. Roth 401(k)s work the opposite way -- contributions are made with after-tax dollars, but withdrawals are taken tax-free.

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You may be wondering which type of plan is better, and the truth is, the answer depends on your specific circumstances and needs. Here's a rundown of how both traditional and Roth 401(k)s work, which should help guide your decision.

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Tax differences between a Roth and traditional 401(k)

Roth and traditional 401(k)s are designed to serve the same purpose, and that's to help you save for retirement. They're similar in that both allow you to designate a certain amount of money to invest for the future, up to a given annual limit. This year, that limit is $18,000 for workers under 50, and $24,000 for workers 50 and over.

Once you reach age 59-1/2, you can begin taking withdrawals from your account. If you withdraw funds prior to 59-1/2 from a traditional 401(k), you'll typically face a 10% early withdrawal penalty. With a Roth, however, you may be able to withdraw a portion of your account balance early and avoid a penalty.

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You see, unlike traditional 401(k)s, which are funded with pre-tax dollars, Roth accounts are funded with after-tax dollars. And that's a major strike against the Roth, because you won't get an up-front tax break for contributing. On the other hand, if you save with a Roth, your money will get to grow tax-free, and your withdrawals won't be taxed at all in retirement. Traditional 401(k)s get to grow on a tax-deferred basis, which means you won't pay taxes on your investment gains year after year. But once you start taking withdrawals, your distributions will be taxed as ordinary income.

So let's circle back to those early-withdrawal penalties we just talked about. Because Roth 401(k)s don't offer an immediate tax break, you can actually remove money from your account without penalty at any time, provided you limit your withdrawals to the principal portion of your plan balance. In other words, if you contribute $10,000 to your Roth 401(k), and that amount grows into $20,000 over time, you can remove that initial $10,000 before reaching 59-1/2 and still avoid a penalty. After all, you've already paid taxes on that money, so the IRS sees no reason to penalize early withdrawals in that situation.

That said, because the purpose of a 401(k) is to save for retirement, withdrawing funds early could put you in danger of running out of money later in life. In this regard, the built-in flexibility that Roth 401(k)s offer is both a blessing and a curse, and if you open a Roth, you'll need to avoid the temptation to access that money ahead of schedule.

When do you want to pay taxes?

Deciding between a traditional and Roth 401(k) can be tricky, but the choice really boils down to when you think your tax rate will be at its highest. If you're convinced you'll be in a lower tax bracket in retirement, then it makes sense to fund a traditional 401(k) and take the tax break now. But if you think your tax rate will go up in retirement, then funding a Roth will essentially enable you to lock in your present rate for the future.

Roth 401(k)s also take much of the hassle out of tax planning. If you invest with a Roth, you can rest easy knowing that your eventual balance is yours to keep. With a traditional 401(k), you can't just empty your account over time and retain all that cash for yourself; you'll need to pay the IRS its share in retirement.

Don't forget required minimum distributions

One additional factor to consider is that traditional 401(k) plans impose required minimum distributions (RMDs) once you turn 70-1/2. Though your specific RMD will be based on your account balance and life expectancy at the time, if you fail to take that withdrawal in full, you'll face a 50% penalty on whatever sum you neglect to remove from your account. (Keep in mind that if you're still working for your company by the time your RMDs kick in, you won't have to take them as long as you remain employed. But once your employment arrangement ends, you'll need to start taking withdrawals.)

The good thing about Roth 401(k)s is that they don't come with required minimum distributions. If you open a Roth, you can let your money sit and compound indefinitely while enjoying the tax-free growth I talked about earlier.

Opening a 401(k) is a critical step on the road to retirement savings, but choosing the right type of plan is equally important. If you're torn between a Roth and traditional 401(k), you'll need to consider the immediate and long-term tax implications when making your decision

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