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Roth 401(k) vs. Traditional 401(k): Will a Roth 401(k) Benefit Your Business?

employee reviewing retirement plans

If your company sponsors a 401(k) plan, or if you are considering doing so, you likely know about the plan's benefits, including its ability to attract and retain employees and employer tax advantages. However, you may not know that most plans can also offer a Roth 401(k) option.

In some instances, a Roth 401(k) may provide more benefits than a traditional 401(k) and could help advance your long-term HR strategy. Let's explore the ins and outs of Roth 401(k)s, and how they can benefit you and your employees.

What is a Roth 401(k)?

A Roth 401(k) is an employer-sponsored retirement savings plan where contributions are made post-tax and investments grow tax-free. Roth 401(k) distributions taken in retirement are tax-free as well, provided that the individual withdraws funds at age 59½ or older, faces economic hardship, or other outlined exceptions.

What is a traditional 401(k)?

A traditional 401(k) is a tax-qualified employer-sponsored plan that allows employees to withhold a portion of their pay on a pre-tax basis. Contributions into a 401(k) plan grow tax-free until retirement, when distributions of both contributions and earnings are treated as taxable income.

Key differences between a Roth 401(k) vs. traditional 401(k)

Both Roth 401(k)s and traditional 401(k) accounts are vehicles for your employees to save toward retirement. One of the primary areas where the two plans differ is in their treatment of taxes.

Traditional 401(k) vs. Roth 401(k): Key Features and Plan Differences

 

Traditional 401(k)

Roth 401(k)

Employee Contributions

Made using pre-tax dollars

Made using after-tax dollars

Employer Matching Contribution

At employer's discretion.  Treated as a pre-tax contribution, taxable at distribution

At employer's discretion.  Treated as a pre-tax contribution, taxable at distribution

Withdrawal Rules

Withdrawals of both employee and employer contributions and earnings are taxed.

Employee after tax contributions are never taxable. Earnings on Roth contributions are not taxable for a "qualified distribution" - when the participant is at least age 59 1/2, and the account has been open for at least five years.  Employer contributions and earnings are taxable.

Penalties

10 percent penalty on early withdrawals

10 percent penalty on earnings taken through early withdrawals

 

Taxes

With a traditional 401(k), contributions come out of each paycheck pre-tax, which means taxes are owed only when the money is withdrawn, typically at retirement. Individuals can enjoy the benefit of reducing their tax liability for that year in which they contribute.

Alternatively, contributions put into a Roth 401(k) are made with post-tax dollars, allowing benefits to be fully realized once distributions are made (in all likelihood, at retirement age). So, while Roth 401(k) contributions will not lower taxable income in the current year, individuals will have already satisfied their tax obligations for this account by the time they're ready to retire.

Withdrawal rules

When comparing a Roth 401(k) vs. a traditional 401(k), there are distinct withdrawal rules for each of these plans that may appeal to different employees. In a traditional plan, withdrawals are taxed as income in retirement, and may be penalized if taken before age 59½.

Alternatively, qualified distributions in a Roth 401(k) aren't taxed, provided that the individual is at least 59 ½ and has had the account for five years or more.

Deciding how to contribute

For most participants, the decision to contribute to a traditional or Roth 401(k) account is a matter of comparing taxes you are paying today with projected taxes in the future.

If participants are paying lower taxes today than they think they will be in the future, they should  consider contributing to a Roth 401(k). Alternatively, if taxes at retirement are projected to be lower than during the working years, pre-tax contributions may be a better option. Using a Roth 401(k), participants may pay more in taxes now, but may save more for retirement in the long run.

Roth 401(k) contribution limits

Both the traditional 401(k) and Roth 401(k) plans are subject to the same contribution limits: in 2021, participants can contribute a maximum of $19,500, with an additional catch-up contribution of $6,500 for those age 50 or over. While individuals may make both traditional 401(k) and Roth 401(k) contributions, the total amount they can contribute to both accounts cannot exceed the annual limit.

Offering both a Roth 401(k) and traditional 401(k)

Having a mix of taxable and non-taxable income sources in retirement has its benefits. Roth balances are not taxed upon withdrawal so even if participants are paying fairly high taxes, there may be potential to make use of a Roth benefit mid-career.

As always, situations vary, so consult a qualified investment advisor and tax planner whenever making financial plans.

Can you still match with a Roth 401(k)?

Yes, matching is still applicable just like with a traditional 401(k). As an employer, you make contributions pre-tax and these funds will go in the taxable portion of the individual's  401(k). So, by contributing to Roth 401(k), participants will have some funds in the post-tax bucket and some in the pre-tax bucket.

Making the choice

Adding a Roth 401(k) option into your 401(k) plan may offer you and your employees the choice and flexibility you're looking for in your company's retirement benefits. When considering a Roth 401(k), it's important to do your research. Consult with retirement providers, as well as tax and financial advisors, who can help you find plan options that best fit your needs.

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* This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.

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