What are the main differences between a Roth 401(k) and a 401(k)?

Many investors have questions about the investment options of a Roth 401(k) vs 401(k). A Roth 401(k) and a traditional 401(k) are both employer-sponsored financial planning and retirement options available to employees. Differences between the two include when the money is taxed and certain income-limiting qualifications set by the employer. Determining which of the two options is appropriate for each potential contributor basically comes down to current age and future earning potential.

A traditional 401(k) is a plan established by employers for qualified employees to make salary-deferred contributions on a pre-tax and/or post-tax basis. Earning within these plans accrue on a tax-deferred basis, meaning the contributor will have to pay taxes on the lump sum once it is withdrawn. Depending on the employer’s package, some 401(k) plans include profit sharing features and matching or non-elective contributions paid in by the employer on behalf of the employee. Usually, some sort of salary percentage cap is placed to limit the amount of salary that may be deferred into the 401(k), and these limitations may be set by either the employer or by IRS regulations. Restrictions are also placed on how and when assets are withdrawn from the account, with penalties generally levied for early withdrawal. A traditional 401(k) may be a great advantage to employees who meet the pre-qualifications set by their employer and who are unable to sustain increased tax payments in the short run.

A Roth 401(k) is an investment savings account that is funded by after-tax money and is sponsored by the employer. There are no income-limiting pre-qualifications, meaning that participation is available to anyone who wishes to up the contribution limit of the plan. All monies accrued into the account can include investment gains and may be withdrawn free of tax once the investor reaches the age of 59.5 years of age.

Both the Roth 401(k) and the traditional 401(k) offer different advantages and disadvantages. When making a decision about choosing a Roth 401(k) vs 401(k), the most important aspect to consider is short-term cost versus long-term benefit. Younger employees who are likely to progress throughout their careers, and thus make more money in the future, can be strong candidates for the Roth 401(k). This is because at the time their contribution is made they are generally making less money than they will in future, thus qualifying them in a lower tax bracket. Therefore, the money contributed will be taxed less at the time of contribution than it would at the time of withdrawal, when they will most likely be in a higher bracket. Conversely, employees whose future income generating potential may be more evenly matched to their income at the time of contribution might find the added tax cost to outweigh any potential benefit in the future. In these cases a traditional 401(k) may be more advantageous.