Editor’s note: The calculator data will be updated for 2023 in early February.
Roth vs. Traditional 401(k) and your Paycheck
The 401(k) is a popular workplace retirement plan, with more than 60 million active participants. Named after the section of the income tax code that created it, the 401(k) allows you to make regular contributions through payroll deductions to a tax-advantaged workplace retirement plan. Your company may match your contributions.
Today’s workplace gives you two choices for saving with a 401(k) — a traditional 401(k) and a Roth 401(k).
What’s a traditional 401(k)?
A traditional 401(k) plan allows you to defer taxes on your contributions and earnings until you tap them at retirement. Your contributions lower your taxable income, which, in turn, lowers your income tax bill.
Deferring taxes on your earnings can be a powerful boost to your returns, particularly if you invest in mutual funds, many of which distribute taxable gains and interest every year. By postponing those gains, you won’t have to pay taxes on those distributions until you retire, when you may be in a lower income tax bracket.
A traditional 401(k) also makes it easier to save. Because your traditional 401(k) contribution is excluded from your taxable income, it is untapped by the tax man. For example, consider a single filer who has $50,000 in income and pays 22 percent in federal and state taxes. A 5 percent contribution to her 401(k) would be $208 a month but would reduce her paycheck by just $162.
What is a Roth 401(k)?
A Roth 401(k) plan is named for senator William Roth (R-Delaware), who created the Roth IRA in 1997. Contributions to a Roth 401(k) are not deductible; however, earnings and withdrawals from a Roth are not taxable at retirement, provided you follow the rules for taking money out. Although this might seem onerous when you are contributing, you’ll appreciate having all your distributions tax-free at retirement.
What are the contribution limits in 2023?
Contribution limits for Roth and traditional 401(k) plans are the same. You can contribute as much as $22,500 to a 401(k) plan in 2023, an increase of $2,000 from 2022. Those 50 and older will be able to add another $7,500 — an increase of $1,000 over the catch-up contribution in 2022 — for a maximum contribution of $30,000. These limits are adjusted every year.
Your employer may contribute to your 401(k), too, and there is a limit to the combined amount you and your employer can contribute to 401(k) plans. For those age 49 and under, the limit is $66,000 in 2023, up from $67,500 in 2022. For those 50 and older, the limit is $73,500 in 2022, up from $67,500 in 2022. You can’t contribute more than your earned income in any year.
When can I take withdrawals from a traditional 401(k)?
You can make penalty-free withdrawals from a traditional 401(k) when you are age 59½ or older. You’ll owe state and federal income taxes on the amount you withdraw.
In most cases, if you withdraw before age 59½, you’ll owe a 10 percent tax penalty on your withdrawal. And you’ll still owe income taxes on the total amount you withdraw. If you were 58 years old and in the 20 percent income tax bracket, you’d owe $3,000 on a $10,000 withdrawal — $2,000 in income taxes and $1,000 for the early withdrawal penalty.
You can, in some cases, take penalty-free withdrawals before age 59½ — for unreimbursed deductible medical expenses that exceed 10 percent of your adjusted gross income, for example, or if you’re permanently and totally disabled. You may also take penalty-free early distributions for health insurance and for the purchase of a first home. You’ll still owe taxes on the withdrawals though.
You must start taking withdrawals by age 72, whether you need the money or not. Required minimum distributions (RMDs) depend on your age and the amount of money you have in tax-deferred retirement plans, including 401(k)s.
When can I take withdrawals from a Roth 401(k)?
You can take any contributions tax- and penalty-free if you are age 59½ or older and if you made your first contribution at least five years earlier. The five-year rule supersedes the age rule. If you violate either rule, your withdrawal is subject to a 10 percent tax penalty.
If you move your Roth 401(k) into a Roth IRA, the five-year clock starts ticking on the day of the rollover. Why would you roll over to a Roth IRA? Typically, you’ll have more investment choices in a Roth IRA. Roth 401(k)s, unlike Roth IRAs, are also subject to RMDs at age 73. RMD requirements will vanish for Roth 401(k)s in 2024.
You can withdraw your contributions tax-free at any time. After all, you’ve already paid taxes on them. However, if you take an early withdrawal, the IRS will prorate your withdrawal between your tax-deferred earnings and your contributions. Unlike a Roth IRA, you can’t just claim that your entire withdrawal is from your contributions. Suppose you withdraw $10,000 from a Roth at age 50. Of that $10,000, $7,500 was contributions and $2,500 was earnings. You’d owe taxes and penalties on the $2,500.
Can I borrow from my 401(k)?
This depends on your employer, but in most cases, you can borrow from a traditional or Roth 401(k). You can’t borrow more than the lesser of $50,000 or 50 percent of your balance, and you must repay the loan within five years. The loan can be longer if it’s for the down payment on a home. You will owe interest on the loan (payable to yourself).
The drawback: If you can’t repay the loan, it’s considered an early withdrawal; taxes and penalties will apply.
Which is better: A Roth or a traditional 401(k)?
Traditional IRAs make it easier for you to save, because you’re contributing pre-tax income. If your biggest interest is saving as much money as possible, the benefits of tax-free earnings in a traditional 401(k) are hard to beat.
If you’re a great saver, a Roth 401(k) might be better for you. Although you’ll pay taxes on your contributions, they will come out tax-free, provided you follow the rules for withdrawals at retirement. It’s nice to look at your 401(k) balance and not have to worry about how much goes to taxes and when you have to send your checks.