1. Tax Treatment of Contributions
Traditional 401(k): Contributions are made with pre-tax dollars, which reduces your taxable income for the year. This means you pay no taxes on the money you contribute until you withdraw it in retirement.
Roth 401(k): Contributions are made with after-tax dollars. You pay taxes on the money before contributing it to the Roth 401(k), but qualified withdrawals are tax-free.
2. Tax Treatment of Withdrawals
Traditional 401(k): Withdrawals in retirement are taxed as ordinary income. This means you will pay income taxes on both your contributions and any investment gains when you take distributions.
Roth 401(k): Qualified withdrawals, including both contributions and investment gains, are tax-free. To be qualified, withdrawals must occur after age 59½ and the account must have been open for at least five years.
3. Required Minimum Distributions (RMDs)
Traditional 401(k): You are required to start taking RMDs at age 73 (as of 2024). These distributions are subject to ordinary income tax.
Roth 401(k): Roth 401(k) accounts also require RMDs starting at age 73. However, you can avoid RMDs by rolling over the Roth 401(k) into a Roth IRA, which does not have RMDs during the account owner's lifetime.
4. Contribution Limits
Traditional 401(k) and Roth 401(k): Both types of 401(k) plans share the same contribution limits. For 2023, you can contribute up to $22,500, or $30,000 if you are 50 or older. These limits apply collectively to both types of accounts if you contribute to both.
5. Income Limits
Traditional 401(k): There are no income limits for contributing to a Traditional 401(k). You can contribute regardless of your income level, though high-income earners may face limits on deductible contributions if also covered by another retirement plan.
Roth 401(k): There are no income limits for contributing to a Roth 401(k). This contrasts with Roth IRAs, which do have income limits for eligibility.
6. Employer Matching Contributions
Traditional 401(k) and Roth 401(k): Employer matching contributions are typically made to the Traditional 401(k) portion of your account, even if you contribute to the Roth 401(k). The match is made with pre-tax dollars and will be subject to taxes upon withdrawal.
7. Impact on Current Taxes
Traditional 401(k): Contributions reduce your current taxable income, potentially lowering your current tax bill. This can be advantageous if you expect to be in a lower tax bracket in retirement.
Roth 401(k): Contributions do not impact your current taxable income because they are made with after-tax dollars. The benefit is realized in retirement with tax-free withdrawals.
8. Flexibility in Retirement Planning
Traditional 401(k): Provides immediate tax benefits with taxable withdrawals in retirement. This can be beneficial if you expect to be in a lower tax bracket in retirement compared to your current rate.
Roth 401(k): Offers tax-free withdrawals and no RMDs (if rolled into a Roth IRA), which can be advantageous if you expect to be in the same or a higher tax bracket in retirement, or if you want to avoid RMDs.
9. Withdrawals Before Age 59½
Traditional 401(k): Withdrawals before age 59½ are subject to a 10% early withdrawal penalty, in addition to ordinary income taxes, unless an exception applies (e.g., disability, certain medical expenses).
Roth 401(k): Contributions can be withdrawn at any time without penalty or tax, but earnings may be subject to taxes and penalties if withdrawn before age 59½ and before the account has been open for five years, unless an exception applies.
10. Estate Planning Considerations
Traditional 401(k): The account balance will be subject to income tax when withdrawn by heirs. The required distributions could also impact the amount they ultimately receive.
Roth 401(k): Since Roth 401(k) withdrawals are tax-free, heirs who inherit a Roth 401(k) account will not owe taxes on withdrawals if the account has been open for at least five years. This can be beneficial for estate planning.
