Which 401k is better?
Which is better, a traditional 401(k) or Roth 401(k)? Find out how these 401(k)s compare, and the various situations when each type of 401(k) is a better choice.
When saving for retirement, you may have a choice between a traditional 401(k) and a Roth 401(k). Although these 401(k)s share certain similarities, they also differ in certain aspects. Before deciding which 401(k) is better for you, it is always a smart idea to compare what each retirement offers and when you pay taxes.
A Roth 401(k) is a better option if you anticipate higher tax rates in the future. By paying taxes now, a Roth 401(k) protects you from further tax increases in the future. On the other hand, a traditional 401(k) is a better choice if you are in a higher tax bracket now than you anticipate in retirement, and you want to defer paying taxes until when you retire.
When is a Traditional 401(k) Better?
A regular 401(k) may be a better option in the following situations:
You are in a high tax bracket
If you are in a higher tax bracket now, you may be better off with a traditional 401(k) to get tax breaks on your retirement contributions. When you contribute to a traditional 401(k), you get a tax break, and this helps reduce your taxable income for the year.
You get matching contributions
If your employer matches employee's contributions, this benefit may only be available to traditional 401(k)s due to its tax benefits. If you have a Roth 401(k), you won’t be able to collect the employer match, hence you risk leaving money on the table. You can open a traditional 401(k) to collect the match, and rollover the money to a Roth 401(k) later in the year.
When Roth 401(k) is Better?
You are young
If you started your career only recently, your annual income may fall in the lower tax bracket. As you rise through the ranks, your income will increase, and eventually, you will be pushed to a higher tax bracket. A Roth 401(k) would make sense in this case, since it allows the money to grow tax-free for a longer time.
You will be in a higher tax bracket in future
If you are in a low tax bracket now, you may not be certain how much taxes you will owe in the future. A Roth 401(k) can take away this uncertainty by paying taxes when you are in a low tax bracket so that you can take tax-free distributions in retirement, regardless of how much tax rates will be in the future.
You have a traditional 401(k)
In today’s workplace, you can max out your 401(k) contributions by having both Roth 401(k) and traditional 401(k). If you already have a traditional 401(k), you can open a Roth 401(k) to get greater flexibility with your retirement money. In retirement, you can choose to make withdrawals from the pre-tax or after-tax 401(k).
When Solo 401(k) is Better?
You are self-employed
If you are a small business owner with no employees, you can open a solo 401(k) to save money for your retirement. A solo 401(k) has similar contributions to a 401(k), and you can contribute to the account both as an employee as well as an employer. As an employee, you can contribute up to $19,500 in 2021 and an additional $6,500 if you are above 50. You can also contribute an additional 25% of your compensation as an employer.
You are employed but running a business on the side
If you are an employee of a company, and you run a business on the side, you can have a solo 401(k) alongside a 401(k) from your employer. Combining a solo 401(k) and a traditional 401(k) can help you max your contributions from both ends.
Traditional 401(k) vs. Roth 401(k): Which 401(k) is Better for You?
Your choice of 401(k) will depend on how you want to pay taxes; either on contributions or withdrawals. If you prefer to pay taxes now and avoid taxes when you retire, a Roth 401(k) is a better option. Your money will grow tax-free, and once you retire, you can take distributions without paying any taxes or penalties.
On the other hand, if you want to reduce your taxable income now and pay taxes later when your income will be lower, you can opt for a traditional 401(k). A traditional 401(k) allows you to defer paying taxes and get a tax break on your taxable income. However, you will owe income tax when you take a distribution from the 401(k) in retirement.