Pensions have largely faded from corporate offices around the country and have been replaced by tax-sheltered retirement vehicles like IRAs and 401(k) accounts. In addition to these accounts, different versions of them exist: traditional and Roth. Both have their advantages and disadvantages, and deciding on which account to choose will likely come down to personal preference. Still, there are a number of pros and cons to be aware of when opening a 401(k) account.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
Traditional 401(k) Accounts
One of the most common employer-sponsored retirement accounts is the traditional 401(k), which allows workers to contribute funds to an investment account without paying taxes on the contributions. Traditional 401(k) accounts have limits on the amount a person can contribute annually—the 2020 limit is $19,500 for the calendar year. If you’re over the age of 50, you can contribute an extra $6,500 for a total of $26,000.
Pros and Cons of Traditional 401(k) Accounts
Here are the pros of a traditional 401(k) account:
- Taxes are paid at the time of withdrawal when using a 401(k) account, so all contributions are deposited tax-free. The benefit of this is at retirement, your income will likely be much lower than it was when you were working and the taxes you pay on your investments will be (theoretically) much lower.
- There’s no income limit for opening a 401(k) account, unlike Individual Retirement Accounts (IRAs). To access an IRA, your annual income must be below $122,000. No such limit exists for the 401(k).
- The contributions you make during the year into a traditional 401(k) can be deducted from your taxes. So traditional 401(k) account holders get two different types of tax benefits—an annual income deduction and a tax-free investment deposit.
Here are the cons of a traditional 401(k) account:
- Only certain types of investment products can be purchased in a 401(k) account, mostly mutual funds.
- You’ll need to wait to access the money until you get close to retirement age. In 2020, the minimum distribution age is 59 ½. That means you can deposit the full contribution limit each year, but you can’t begin to withdraw the money until you reach age 59 ½.
Roth 401(k) Accounts
When discussing the Roth variety of retirement vehicles, most savers use the Roth IRA, which has the same rules as a traditional IRA except for taxation. But the Roth 401(k) is also an option offered by certain employers, and it can be a big boost if your income exceeds the limits to open the Roth IRA. The Roth account was developed by Delaware senator William Roth in the late 1990s and originally only gave the post-tax benefit to IRA accounts. However, in 2006, the Roth 401(k) was legislated into existence, allowing post-tax benefits to be applied to employer-sponsored plans.
Pros and Cons of Roth 401(k) Accounts
Here are the pros of a Roth 401(k) account:
- Tax deferments occur AFTER the money is deposited into the account. This is possibly the biggest benefit of the Roth 401(k). The employer match follows the same tax rules as the traditional 401(k), but all investment growth in the account (plus dividends) can be withdrawn free of taxation. Deposits are made with after-tax dollars, but that’s it—no taxes will be owed at any point as long as you withdraw the money after age 59 ½.
- The contribution limits are the same as the traditional 401(k), unlike Roth IRA. IRA contribution limits are ⅓ of the amount allowed by 401(k) accounts, which enables investors to grow a nest egg much more quickly.
Here are the cons of a Roth 401(k) account:
- Roth 401(k)s must be sponsored by an employer, just like a traditional 401(k) account. You can’t open a 401(k) on your own, only an IRA, and that’s just if your income is below a certain threshold.
- The Roth 401(k) must be open for 5 full years before distributions can be withdrawn, even if you’re older than the minimum age.
Which Account Is Better?
An employee can open both a traditional and Roth 401(k), but the contribution limit applies across the accounts. However, you can open both and split the contribution any way you see fit. If you’re choosing between the two accounts, you’ll need to consider your future tax obligations. If you expect your tax burden to be higher in the future, you’ll want the Roth 401(k) so you can pay taxes in the present day. But if you expect your tax burden to be lower when you begin making withdrawals, the traditional 401(k) will allow you to avoid taxes today and pay them later.
Work With an Experienced Financial Advisor
We hope these pros and cons of a traditional 401(k) vs a Roth (401(k) assist you. If you need help creating and working towards financial goals that fit your needs, contact the team at Good Life Financial Advisors of Mount Pleasant today for assistance.