Find out the critical differences to consider and how they affect your current taxes and future retirement.
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Hi everyone. Thanks so much for downloading the money girl podcast. It’s great to have you here. I really appreciate you spending some time with me this week. My name is Laura Adams.
And I’m a personal finance and small business expert, author and educator. Who’s been hosting this show since 2008. My home base is in Vero beach, Florida. I live on the ocean and I have to tell you today is just an incredibly beautiful, hot and sunny day. And I feel so guilty about it because the rest of the country is freezing right now. So many of my friends are either without power or they’re in Sub-Zero temperatures. It’s just crazy. So if you need a little warmth and sunshine, maybe this podcast will bring it to you. Or maybe you can take a trip and come to Florida where the weather is just amazing here right now. If you’ve been with me for a while, you know that every episode I bring you is like a mini training on a topic that I believe is essential for your financial and personal success.
You’re going to hear solo shows where I talk by myself about topics like debt, credit, saving, spending, investing real estate, running a business, how to make critical money decisions with confidence and lots more. You’ll also hear my interviews with interesting people who have expertise. They’ve got financial experience to share, and our mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, get the answers to the questions that you have, and ultimately have more security and less stress. My goal for each episode is to give you actionable strategies and tips that you can take away and put into practice right after you listened to the show to take your money management to the next level. So be sure to subscribe and I’d love your participation. Many of the topics I cover come from you and the show is all about you. So I want to know what issues you need help with. You can leave a message 24 seven on our voicemail line by calling (302) 364-0308. Or you can send me an email using the [email protected] and the notes for every show. They’re always in the money girl [email protected]. Just look for today’s episode, which is number 672 called what’s the difference between a traditional and a Roth 401k
I’ve podcasted about this topic before, but it’s been quite a while. So I thought it’s really a good time for a refresh here. So this is for anyone who works for a company that offers a retirement plan, such as a 401k or a four Oh three B. Now, if you don’t have one of those or you’ve got a job that does not offer those benefits right now, stick with me. You may work for a company that has one of these retirement plans down the road. And so it’s really important to be familiar with how they work and what your options are. Or you may know somebody close to you who does have a 401k. Who’s just, you know, not sure how to manage it.
So when you got one of these plans at work, in most cases, you have the option of making either traditional or Roth contributions to your account, or you can even do both. And while having more investment options is a good thing. I think in a lot of cases, it leaves people feeling overwhelmed or maybe confused about the benefits of each. And so they just don’t really take the next step to figure out if that is something they should participate in. So in this podcast, we will review critical points about the differences between a traditional and a Roth retirement plan at work. And we’ll also talk a little bit about IRAs that are available. Even if you don’t have a retirement plan at work, you’re going to learn who qualifies to participate, how much you can contribute to these accounts and how they affect your retirement and taxes.
So let’s start by talking about what exactly a 401k or a four Oh three B retirement plan is. The first thing to understand is that with these accounts, only employers can offer these. So just as an individual, let’s say you’re self-employed, you can’t just go out and open a regular 401k. Now there are some plans called solo 401k. Those are special. They’re designed specifically for the self-employed, but you have to be an employer in order to offer these plans to your eligible workers. And on the worker side to participate, you might have to reach a certain age such as 21. Uh, you might have to be employed for a certain period. Companies might say, you’ve got to be there 30 days. Some may even say you got to work for them for a year in order to qualify. So, uh, employers can customize certain features of their retirement plans.
However, for the most part, they do have to comply with a law that’s called the employee retirement income security act of 1974. That gets shortened to eras. E R I S a IHRSA is a federal law that sets minimum standards for most workplace retirement plans, which protects participants. So having a federal law that protects you is a really important, big benefit that you get when you participate in a workplace retirement plan and your employer should provide what’s called a summary plan description every year. This is just a document that explains all of your retirement plans, features and your rights. And when you enroll in a 401k or a four Oh three B, and by the way, the four Oh three B is very similar, but it’s used for nonprofits. So maybe you work for a school, that’s a nonprofit or a church, or, you know, some organization that’s a nonprofit. They probably have a four Oh three B instead of a 401k, but for the most part, they’re kind of think of them like sister accounts.
They’re super similar. When you’re in one of these plans, what you’re doing is authorizing your employer to automatically deduct elected contributions from your paycheck and send them to your retirement account. So they can only take out what you tell them to take out. And you can change it at any time. If, if you have a hardship and you decide I can’t afford to contribute next month, or next quarter, you can always change your contribution to zero. Just, you know, pause contributions. You can raise them, lower them, whatever you want, it’s in your control. Now, if your company offers what are called matching funds, what happens is they contribute additional money to your account for free. This is an amazing benefit. Let me give you an example.
A typical 401k match might be something like 2% or even 3% of your compensation. So let’s say your salary is $40,000 a year. If you get a 2% match, that would be 2% of 40,000 or $800. That means if you contribute $800 over the course of a year to your retirement account, out of your paycheck, so will your employer. So that means you’ve got a total contribution for the year of $1,600. 800 is coming from you. 800 is coming from your company.
But let’s say you can’t meet that match. You could only contribute $500. Well, your employer would only contribute $500. You’re going to miss that 300, uh, that would have gotten you to the 800 because you didn’t contribute that much. So in that case, if you’re contributing 500, your employer contributes matching a 500 and you’ve got a total contribution of a thousand dollars in your retirement account for the year. Now, stop for a moment and think about that. We’re talking about a way to save for retirement. That guarantees a 100% return on your money before you even factor in the investment returns that your contributions and those matching contributions are going to earn. That is amazing. So always be sure to participate in a workplace plan and max out matching funds when they are offered. Now you might be thinking Well my company took away the match, or my company doesn’t offer match.
I am still a big fan of workplace plans. So don’t let the fact that you don’t have a match, keep you from participating in using that account. It is still just as valuable now. Yeah. If you got matching, that would be even better. Maybe that’s something you could convince your employer to do down the road. Some retirement plans come with a vesting schedule. This is simply a period that you must remain employed to fully own your matching contributions or any other employer provided funds like profit sharing that your employer may have put in your retirement account. Now don’t let that freak you out because your contributions, the money that you put in from your paycheck is always 100% vested. That means you never forfeit your own money that you put in a retirement account. Now that’s unless of course your investments lose money. Um, but in general, they are in, should be in very diversified funds that are going to grow for you.
So remember if you leave the company before the vesting period, you might forfeit the matching portion or the profit sharing portion in the account, not the amount that you put in and I’ll share with you that that’s a point that I did not understand when I was in my twenties, just starting out and working for the first time. I didn’t have anybody explain to me what vesting was or what would happen to my money if I left the company. And I knew I was probably only going to be at my first job for like a year, maybe 18 months at the most. And so I thought, well, why participate? I’m just going to leave. And you know, I’ll risk losing some money that never happens. You are not going to, or to risk losing your own money. So even if you know that you’re not going to stay with a company, long-term, don’t let that keep you from staying out of the retirement plan.
It’s just too valuable, a benefit not to use. The great thing about these retirement plans at work is that the contribution limits are high. They have been slowly increasing every few years and they’re based on current IRS rules. So you want to be sure you understand what’s current right now for 2021, you can contribute up to $19,500, or if you’re over age 50, you can put in $26,000. So that’s over an entire year. That’s a high contribution limit. And it in combination with that, the automatic payroll deductions and maybe some free matching funds, all of those benefits make workplace retirement plans incredibly popular and very, very useful for growing wealth to spend in retirement. Now that you understand the basics of retirement accounts at work, let’s cover the differences between traditional and Roth accounts. That’s really, you know, the crux of what today’s show is all about.
So with a traditional retirement account, it is going to permit you to make pre-tax contributions. That gives you a tax benefit in the year. You make them. So it kind of like right now, miss year, if you make those contributions in that traditional 401k, you’re going to get a tax benefit this year. You don’t pay any income tax on the money you invest. So you’re making money that doesn’t get taxed. Instead you pay income tax on your contributions and any investment earnings that they have accumulated in your account. In the future. You pay tax. When you take withdrawals in retirement with a Roth retirement account, it requires you to make after tax contributions. So that does not give you an upfront tax benefit. However, the massive upside is that you take withdrawals of both the contributions that you made and all the earnings generated in the account entirely tax-free in retirement.
And that’s as long as you own the account for at least five years. So the main differences between traditional and Roth accounts is really when you pay taxes, a traditional account helps cut your current tax bill and a Roth allows you to avoid income tax when you tap the account in the future and with the Roth, because you pay tax on your contributions upfront, you’re allowed to withdraw them at any time again, that’s because you already pay tax on them. However, if you take out earnings, so if you take out the earnings portion of the account before reaching the official retirement age of 59 and a half, you do have to pay a 10% penalty just on the earnings portion, plus income tax on that untaxed portion. But again, you know, if you’re taking out mostly contributions, those are not going to have any tax consequences.
The downside of any retirement account is that you do get penalized for tapping amounts that weren’t previously taxed before you reached that official retirement age of 59 and a half. So they’re meant for long-term growth. You want to think about these accounts as kind of a, you know, invest it, and you really never think about tapping that money again. Um, it’s, it’s really designed for long-term growth thread up is one of the world’s largest online thrift stores offering your favorite brands for up to 90% off estimated retail. You can find J crew and made well pieces for as low as $9. You can customize your search by your size, style and budget to easily find the best deals. Plus returns are easy. So it’s worry free. I am a regular thread up shopper and I’ve gotten some amazing deals. One that comes to mind is a Lulu lemon tank that was new with the tags still on.
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Now let’s talk about five ways that a workplace Roth differs from a Roth IRA. And by the way, if this feels a little confusing, kind of going back and forth with these different accounts, you might benefit from a handy one page resource tool that I created is called the retirement account comparison chart. It covers the pros and cons of these different types of retirement accounts that I’m talking about. And also some of the best places to open them. You can get the free download by sending me a quick text message. Just text the word retire. R E T I R E to the number three, three, four, four, four, again, text retire to the number three, three, four, four, four, and you’ll get the download right away. I think it might help you make the distinction between these accounts and you’ll have a resource to look at as you’re listening to the show.
Or maybe if you listen to the show, again, many people mistakenly assume that a Roth is a rough, you know, it’s important to understand five main differences between a Roth 401k or a Roth four Oh three B and a Roth IRA. Even though they both say Roth, they have some major differences that you need to be aware of. Number one, there are limits on annual income that apply to a Roth IRA, but not a Roth at work. So when your income exceeds yearly limits, you can’t make any new contributions to a Roth IRA for 2021. If you’re a single taxpayer, if you’ve got income exceeding $140,000, or you’re a joint tax filer, and you have household income over $208,000, you get locked out of making contributions to a Roth IRA. However, with a Roth 401k or a Roth four Oh three B, you can contribute no matter how much you earn, you could be the highest paid person in your office, and you can still contribute to a Roth 401k.
All right, the second major difference is the annual contribution limits for a Roth IRA are much lower than for a workplace Roth. For 2021, you can contribute up to $6,000 or 7,000. If you’re over age 52, all your IRAs. Now, as I previously mentioned, the contribution limit is 19,500 or 26,000. If you’re over age 52, your workplace retirement account, that’s a big difference between those two. Again, another reason why I like the workplace retirement accounts best, the third difference is required. Minimum distributions or RMDs do not apply to a Roth IRA. It’s the only account where you can keep the money in the account indefinitely and even pass it along to your heirs. But you must take required minimum distributions from a Roth at work no later than age 72, unless you’re still employed there. And as I’ve mentioned, as long as you own the account for five years, your distributions will be tax-free, but you’ve got to take required minimum distributions.
A lot of people get kind of confused about that because they’re familiar with a Roth IRA, not having RMDs, and they think that’s going to apply to their Roth at work. And it doesn’t. You do have required distributions for workplace plans. The fourth way, these accounts are different is early withdrawals taking early withdrawals of your Roth. IRA. Contributions can be made at any time without triggering income taxes or a penalty. As I mentioned, however, taking withdrawals from our Roth at work typically comes with restrictions, such as having to experience a financial hardship. Like you’ve got to have a reason to take a hardship, withdrawal, maybe unpaid medical bills or funeral. And again, if you take money out of a retirement account before reaching age 59 and a half, you typically get hit with income taxes, plus an additional 10% early withdrawal penalty on the earnings portion.
When we’re talking about a Roth at work, however, there are some exceptions. There is something called a separation from service exemption. This is when employees leave their employer after turning 55. So let’s say you want to retire early. And instead of staying until age 59 or 65, or whenever, you know, you, you think you might retire. You decide to leave early at age 55. If you retire at that age, and you’re no longer working for the company that has your 401k, then you can take penalty free withdrawals and why you leave doesn’t matter. It could be because of your health. It could be because you get terminated or laid off or just you choose to retire early. All right? The fifth way, these accounts are different. Are loans. Loans are typically permitted for a Roth account at work. You do have to pay your account back with interest typically on a five-year repayment schedule.
However, if you’ve got a Roth, IRA loans are not allowed, that’s just a feature of IRAs that doesn’t exist. So you can see that a Roth 401k and a Roth IRA have similar advantages, and they’ve also got differences and how participants can use them. So you might be thinking, well, what’s best for me. Should I choose traditional? Should I choose Roth? What are my what’s my best plan? Well, a significant factor in choosing a traditional or a Roth retirement account is the income tax rates in the future. So what will the rate that I have to pay in the future be, and how much money will I make during retirement? You know, none of us know, none of us can predict the future. So you just have to take your best guess at what you believe will be best. So let’s say you prefer a bird in the hand to cut taxes sooner rather than later than a traditional account may appeal to you.
But if you don’t mind paying taxes in the current year than a Roth has more long-term advantages. And when you’re not sure which type to choose at work, or you want benefits of both types of accounts, you can split contributions between both a traditional and a Roth 401k or four Oh three B in the same year. You can choose any proportion. You like, it could be 50 50, it could be 20, 80, as long as your total does not exceed the allowable limit set by the IRS. So again, come back to what you think your income will be like in retirement. Do you think you’re going to be earning more in retirement than you are now? Well, that would mean paying taxes now makes sense. But if you feel like you’re earning, you know, quite a bit, you maybe you’re kind of at the top of your career right now, and you feel like in retirement, your income can only be less than what it is now than paying taxes in retirement on a lower amount of income may make sense again, you know, the variable here is what will the income tax rates be in the future.
If you think that due to everything going on with coronavirus and you know, the national debt that taxes are only going to increase in terms of, you know, what the, the personal income tax rates are. If you think they’re only going to increase in the future. Well, paying tax now on a lower amount would make more sense than waiting to pay higher amounts later on. Again, none of us have a crystal ball and you really just have to, I think, diversify to make the best choice. So I do think that if you’ve got the option to have a Roth at work, splitting your, your contributions and having both makes a lot of sense, especially if your income is too high for a Roth IRA, having a Roth at work, you know, is an amazing benefit. As I mentioned, there are no income limits on having a workplace Roth.
That means that high earners can use one and enjoy those tax-free withdrawals in the future. Having both taxable and non-taxable income and retirement is a really wise idea. So instead of deliberating between a traditional or a Roth at work, I would encourage you to consider using the benefits of both. Be aware that if you’ve got employer matching those contributions that your employer makes for you are always going to be traditional pretax. They will not give you Roth or after-tax contributions for your matching. So choosing a Roth, 401k, or a Roth four Oh three B is an excellent way to diversify your future income and choices. I hope this has helped you understand these accounts a little bit more deeply and think through your choices. It’s never too late to make changes to your elected contributions at work. So if you need to diversify, you know, just contact your benefits administrator and they can make those changes for you.
And before I let you go, I’d like to invite you to get my short, weekly email. It is filled with tips and tools that I think you’ll enjoy. It’s all about saving more, growing your money, becoming an amazing money manager. If you want to get that email from me, you can either visit Laura D adams.com or text get updates to the number three, three, four, four, four. And if you’re not into email, another great way to stay in touch is to join my private Facebook group called dominate your dollars. You can search for it on Facebook or text dollars to that same number three, three, four, four, four, that’s all for now. I’ll talk to you next week until then here’s to living a richer life. Money girl is produced by the audio wizard, Steve Ricky Berg with editorial support from Karen Hertzberg. If you’ve been enjoying the podcast, take a moment to rate and review it on Apple podcasts. I want to give a virtual high five to everyone who has submitted reviews. Recently, we read all of them, uh, and it really does make a big difference to us. So I hope you will take a moment and do that. Be sure to hit the subscribe button in the Apple podcast app or wherever you listen. You might also like the backlist episodes and show notes that are always [email protected].
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If you work for a company that offers a retirement plan, such as a 401(k) or 403(b), you probably have the option of making “traditional” or “Roth” contributions to your account. While having more investment options is a good thing, it might leave you feeling overwhelmed or confused about the benefits of each.
Today, I’ll review critical points about the differences between a traditional and Roth retirement plan at work. You’ll learn who qualifies to participate, how much you can contribute, and how they affect your retirement and taxes.
What is a 401(k) retirement plan?
Only employers can offer a traditional or Roth 401(k) or 403(b) to eligible workers. You may have to reach a certain age, such as 21, or be employed for a period, such as one or six months, to qualify.
Employers can customize certain features of their retirement plans; however, they must comply with the Employee Retirement Income Security Act of 1974 (ERISA). It’s a federal law that sets minimum standards for most workplace retirement plans, which protects participants. Your employer should provide a Summary Plan Description every year, which explains your retirement plan’s features and your rights.
When you enroll in a 401(k), you authorize your employer to automatically deduct elected contributions from your paycheck and send them to your retirement account. If your company offers matching funds, they contribute additional money for free.
An example of a typical 401(k) match is 2% or 3% of your compensation. For instance, if your salary is $40,000 a year, 2% is $800. If you contribute that much, so will your employer, giving you a total contribution of $1,600 ($800 from your paycheck plus $800 from your company). And if you can only contribute $500, your employer contributes $500, for a total contribution of $1,000 for the year. There aren’t many ways to save for retirement that guarantee a 100% return before you even factor in investment returns! So always be sure to participate in a workplace plan and max out matching funds when offered.
Some retirement plans come with a vesting schedule. It’s a period you must remain employed to fully own your matching contributions or other employer-provided funds, such as profit sharing. However, your contributions are always 100% vested. You never forfeit your own money that you put in a retirement account (unless your chosen investments lose money).
The annual 401(k) and 403(b) contribution limits have been slowly increasing every few years, based on IRS rules. For 2021, you can contribute up to $19,500, or $26,000 if you’re over age 50. The high contribution limits, automatic payroll deductions, and free matching make workplace retirement plans popular and useful for growing wealth to spend in retirement.
Differences between traditional and Roth retirement accounts
Now that you understand retirement account basics let’s cover the differences between traditional and Roth accounts.
A traditional retirement account permits pre-tax contributions, which gives you a tax benefit in the year you make them. You don’t pay any income tax on the money you invest. Instead, you pay income tax on your contributions and their investment earnings when you take withdrawals in retirement.
A Roth retirement account requires you to make after-tax contributions, which don’t give you an upfront tax benefit. However, the massive upside is that you take withdrawals of both contributions and earnings that are entirely tax-free in retirement (as long as you’ve owned the account for at least five years).
So, the main difference between traditional and Roth accounts is when you pay taxes. A traditional retirement account helps cut your current income tax bill. And a Roth allows you to avoid income tax when you tap the account in the future.
With a Roth, you’re allowed to withdraw your contributions at any time. That’s because you already paid tax on them. However, if you take out earnings before age 59.5, you must pay a 10% penalty, plus income tax, on the untaxed portion.
The downside of any retirement account is that you get penalized for tapping amounts that weren’t previously taxed before reaching the official retirement age of 59.5.
5 ways a workplace Roth is different from a Roth IRA
Many people mistakenly assume that a Roth is a Roth. It’s important to understand five main differences between a Roth 401(k) and a Roth IRA.
1. Limits on annual income apply to a Roth IRA but not a Roth at work. When your income exceeds yearly limits, you can’t make new contributions to a Roth IRA. For 2021, single taxpayers with income exceeding $140,000 and joint filers with household income over $208,000 get locked out. However, with a Roth 401(k) or 403(b), you can contribute no matter how much you earn.
2. Annual contribution limits for a Roth IRA are much lower than a workplace Roth. For 2021, you can contribute up to $6,000, or $7,000 if you’re over age 50, to all your IRAs. As I previously mentioned, you can contribute a total of up to $19,500, or $26,000 if you’re over 50, to your workplace retirement accounts.
3. Required minimum distributions (RMDs) don’t apply to a Roth IRA. You can keep money in the account indefinitely and pass it along to your heirs. But you must take RMDs from a Roth at work no later than age 72 (unless you’re still employed there). As long as you’ve owned the account for five years, your distributions will be tax-free.
4. Early withdrawals of Roth IRA contributions can be made at any time without triggering income taxes or a penalty. However, taking withdrawals from a Roth at work typically come with conditions, such as experiencing a financial hardship like unpaid medical bills or funeral expenses.
5. Loans are typically permitted for a Roth at work. You must pay your account back with interest on a five-year schedule. However, taking a loan from a Roth IRA isn’t allowed.
So, you can see that a Roth 401(k) and a Roth IRA have similar advantages and have differences in how participants can use them.
RELATED: What Is a Backdoor Roth IRA?
Should you choose a traditional or Roth retirement account?
A significant factor in choosing a traditional or a Roth retirement account is the income tax rates in the future and how much you’ll make during retirement. None of us can predict the future, so we have to guess what will be best.
If you prefer a “bird in the hand” to cut taxes sooner rather than later, then a traditional account may appeal to you. But if you don’t mind paying taxes in the current year, then a Roth has more long-term advantages.
When you’re not sure which type to choose, or you want benefits of both types of accounts, you can split contributions between both a Roth and a traditional 401(k) or 403(b) in the same year. You can choose any proportion, such as 50/50 or 20/80, as long as your total doesn’t exceed the allowable annual limit set by the IRS.
If your income is too high for a Roth IRA, having a Roth at work is a terrific benefit. As I mentioned, there are no income limits on a workplace Roth. That means high earners can use one and enjoy tax-free withdrawals in the future.
Having both taxable and non-taxable income in retirement is a good idea. So, instead of deliberating between a traditional or a Roth at work, consider the benefits of using both. If you have employer matching, those contributions are always traditional or pre-tax. So, choosing a Roth 401(k) or 403(b) is an excellent way to diversify your future income and choices.
This article originally appeared on Quick and Dirty Tips.
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