If you have the option to invest in both a traditional 401(k) and Roth 401(k) at work, here's how to decide which account is better for you.
Most workers are familiar with the benefits of a traditional 401(k):
- It is a retirement savings and investment account in which workers can sock away a percentage of their earnings pre-tax
- Contributions lower their taxable income for the year
- Over time, workers can build their retirement savings through years of contributions and compound interest from their investments
The Roth 401(k) is also a retirement savings and investment account, and comes with a few attractive qualities:
- It has an annual contribution limit of $19,000 in 2019, or $25,000 for those 50 or older (and $19,500/$26,000 for 2020), the same limit as a traditional 401(k) and more than an IRA
- Contributions are made post-tax, so qualified withdrawals are tax-free
- Unlike with a Roth IRA, there are no income limits on a Roth 401(k)
Savers must typically start taking distributions from any 401(k) at age 70½, whereas the Roth IRA has no distribution requirements for the owner.
The main difference between the two 401(k) accounts, experts say, is whether you want to pay taxes now or later. Selecting a traditional 401(k) will put more money in your pocket now, because you are lowering your taxable income by the amount you're contributing. You're taxed when you take the money out in retirement.
With a Roth 401(k), you pay taxes upfront, and all of the money in the account is yours, assuming you follow the rest of the withdrawal rules. This is an especially attractive strategy now because tax rates are, historically, very low.
It can be complicated trying to compare your current tax bracket to what it might be in the future, given how many variables are at play: What will happen to your career, how much money your spouse will earn if/when you get married, how long you will live, how much you already have saved and in what type of account, and on and on.
Typically, early-career workers and those in lower tax brackets are advised to opt for the Roth, while those in higher brackets are advised to invest in a traditional 401(k), Clayton Alexander, a registered investment advisor and founder of Teton Wealth Group, tells CNBC Make It. He says savers in the 10% and 12% tax brackets should go with the Roth 401(k), but, again, it's up to you and your individual financial needs.
"One of the benefits of starting a Roth at an earlier age is the concept of compounding interest that can occur inside the investment, tax free," says Alexander.
Instead of picking one exclusively, you can also split the difference, and invest a bit in each, if your company allows it. (Keep in mind that if your company offers a 401(k) match, those contributions will always go into a traditional, pre-tax 401(k) account.) That will give you tax diversification in retirement, which is a smart strategy for every saver, Jeannette Bajalia, president and principal advisor of Petros Financial, tells CNBC Make It.
"It's not whether you should take a Roth over a traditional 401(k), but what is the right mix of savings to achieve your life and retirement goals," says Bajalia.
Many people also have an IRA or Roth IRA to save for retirement outside of their work accounts, or because they don't have access to any type of 401(k) at work. You can read more about those accounts and how they differ from a 401(k) here.
Like this story? Subscribe to CNBC Make It on YouTube!