5 Differences Between Roth and Traditional 401(k)s

One of the appealing things about saving for retirement via a traditional 401(k) plan is that you're stashing away pretax dollars. This lowers your overall tax burden. For example, let's say you earn $3,000 per month and your tax rate is 30 percent. If you don't save any money for retirement, you'll pay $900 in taxes each month ($3,000 x .30 = $900). But if you make a $200 contribution to a traditional 401(k), that $200 is subtracted from your gross earnings before taxes are applied. So you'd only pay $840 in taxes ($3,000 - $200 = $2,800; $2,800 x .30 = $840).

Roth 401(k)s work differently. You can only contribute to a Roth 401(k) after your salary has been taxed [source: IRS]. So you'd have to pay the full $900 on your $3,000 monthly salary, then take another $200 and put it into your Roth 401(k). But don't let this automatically sway you from considering one. There are other benefits to these plans that traditional 401(k)s don't offer, as you'll soon learn.

Another advantage traditional 401(k) owners enjoy is that contributing to a traditional 401(k) means a fatter paycheck, while using a Roth 401(k) results in a slimmer one. Using the previous example of a $3,000 monthly salary, 30 percent tax bracket and $200 monthly 401(k) contribution, here's how the math works. With a traditional 401(k), your $200 contribution will first be subtracted from your gross monthly earnings: $3,000 - $200 = $2,800. Next, your remaining salary will be taxed: $2,800 x .30 = $840. When you subtract your taxes owed ($840) from your remaining salary ($2,800), you wind up with a monthly take-home pay of $1,960.

If you select a Roth 401(k), however, you'll have a slightly smaller paycheck each month since your taxes will be computed based on your gross salary, not your post-401(k)-contribution salary ($3,000 x .30 = $900). Next, your taxes will be removed from your salary: $3,000 - $900 = $2,100. Now you'll be able to make your $200 401(k) contribution: $2,100 - $200 = $1,900. That $1,900 paycheck is $60 less than what you'd receive if you were funding a traditional 401(k).

What do you do with that extra $60 you have through the traditional 401(k)? If you invest it, you're adding even more to your retirement pot. But if you're like most people you probably spend it. In that case, the Roth 401(k) might actually be more beneficial because that extra money is being captured and allowed to grow. Potentially you might have a higher amount of money to withdraw at retirement time than with a 401(k) [source: Fidelity].

Although 401(k) plans are popular today, there will always be employees who never get around to signing up for one, even if they intend to do so, or who simply don't care about planning ahead. Of course, this can be quite perilous down the road if they end up with little or no retirement savings at age 62. Some companies choose to nudge their employees toward wise retirement planning by automatically enrolling them in a 401(k) plan. If employees don't want to join, they must opt out. When employers have such mandatory enrollment, by law it must be into a traditional 401(k) plan -- so that's where employees' contributions will go, as well as contributions by employers [source: Forbes].

If an employer offers both a traditional 401(k) plan and a Roth 401(k), it's up to the employee to ask to open a Roth 401(k). And even then, by law, any employer contributions will still go into the company's traditional 401(k). That might not be so bad, though. If employees contribute funds to a Roth 401(k) and their employers contribute to a traditional 401(k), that diversifies the employees' savings [source: Forbes].

Here is where the rewards come in when you have a Roth 401(k) -- when it's time to withdraw your savings and subsequent investment gains. Because you paid taxes on your earnings before you siphoned some of that money into your Roth 401(k), no taxes are levied when you withdraw funds, assuming you've held your account at least five years and the withdrawal meets certain criteria. Federal and most state income taxes are levied when you take your money and its earnings from a traditional 401(k) plan, since your deposits weren't taxed when you first made them [source: Internal Revenue Service].

Does it make a difference when your money is taxed? Possibly. If your tax rate is the same percentage during retirement as it was while you were employed, you'd probably end up with the same amount of money whether you had a traditional or Roth 401(k) [source: Ensign]. But if your tax rate is higher at retirement, a Roth 401(k) may be your best bet. If it's lower, a traditional 401(k) will likely net you a better payoff. Of course, who can predict what their tax rate will be in the future, especially if retirement is many years away? Some people hedge their bets by splitting their retirement money between the two options.

Sometimes it makes sense to roll over your 401(k) plan. "Rolling over" your investment funds means transferring them from your company's 401(k) into a traditional individual retirement account (IRA) or a Roth IRA. People often do this when they change jobs because IRAs tend to offer more investment options than 401(k) plans do. If you've got a traditional 401(k) plan, you can roll it over into a traditional IRA tax-free. You can also roll it over into a Roth IRA, although this move would require you to pay taxes, as it would be considered a conversion.

Have a Roth 401(k)? You can roll it over into a Roth IRA without paying taxes. (Although the IRS says you must begin to take withdrawals on a Roth 401(k) at 70 years and six months, the same as a traditional 401(k), there's nothing to stop you from rolling it over at that point into a regular Roth IRA.) The only move that cannot be made is rolling over your Roth 401(k) into a traditional IRA. One other qualifier: Any rollover into a Roth IRA, whether from a traditional 401(k) or a Roth 401(k), can only occur if your adjusted gross income is below a certain amount in the rollover tax year [sources: Investopedia, Vanguard].