Roth 401(k) vs Traditional 401(k): Which Retirement Plan Is Better?

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Once the sting of the new 2 percent payroll tax hike began to hit workers in January, there was at least one silver lining to soften the blow:

Buried deep within the revamped American Taxpayer Relief act was a provision that would let a lot more workers convert their traditional employer-provided 401(k) savings into a  Roth 401(k). 

The Roth has been around for more than a decade, but old tax laws blocked workers younger than 59 1/2 from making the switch. Thanks to the new deal, that little stipulation will be gone in a few months, and the government is banking on the fact that they'll pocket a ton of new tax revenue when workers scramble to convert. 

Both retirement plans have their pros and cons, which leaves consumers to answer just one question: Should they convert their 401(k) to a Roth or stick it out? 

Here's how to decide for yourself:

Taxes

Here's the main "perk" that a Roth has going for it: Workers pay today's tax rate on their contributions and are later able to withdraw them tax-free in retirement. This can work in many younger workers' favor, given the fact that income levels tend to grow with age, meaning a higher tax bracket.

A traditional 401(k) or Roth works just the opposite.  Workers contribute funds and aren't taxed until they start making withdrawals in retirement –– at whatever tax bracket they fall under then. 

Bottom line: If you've got a couple of decades to save for retirement ahead of you, the Roth is hands down the best option. Since you'll likely b e in a higher tax bracket later in life, it makes sense to choose a Roth now, pay lower taxes on your money at your current rate and then enjoy it tax-free later in life.

Withdrawal penalties

There are no penalties on withdrawals from Roths so long as workers don't tap into their investment gains, according to the IRS. And tax-free withdrawals for people over age 59 1/2 begin after they've had their account for at least five years

On the other hand, early withdrawals from a traditional 401(k) will cost you big. The IRS taxes 10 percent for dipping into your savings. There are a few exceptional circumstances, including if you are disabled or faced with significant medical expenses. 

Bottom line: Again, the winner here is the Roth. You'll escape hefty fees on early withdrawals and won't have to worry about them at all once you've entered retirement. 

Contribution limits

Here's where the difference end. Annual contributions for both Roth 401(ks) and traditional 401(k)s are limited to  $17,500 (or $23,000 for the over 50 crowd) .  

The Verdict:

If you meet the income requirements and think you'll enter retirement earning more than you do today, then a Roth 401(k) is clearly the winner. Not only will you save huge on taxes but you'll have peace of mind when you make tax-free withdrawals in your golden years.

On the other hand, there are workers  who shouldn't bother converting  –– namely, those who expect they'll be in a lower tax bracket when they retire than they are today. 

To that end, the answer may be a partial conversion –– when you leave some of your funds in a traditional 401(k) plan to soften the initial tax blow and put some savings in a Roth.



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