401k vs. Roth 401k: What’s the Difference?
A better quality of retirement if you're doing it right.
When it comes to retirement, the only person looking out for you is you (and maybe your spouse if you’ve got a good one). Gone are the days when you could rely on social security, come out comfortably with a pension, or leave your future in the hands of your employer while focusing on middle management. Regardless of whether you’re self-employed, full-time employed, or part of the gig economy, one of these days you’re going to want to stop working and enjoy some time off with your robot butler. So it’s time to start thinking about the portfolio options and packages for retirement investing, which can, unfortunately, be intimidating. IRA? 403B? 401K? Roth? Choosing what’s best for you starts with knowing what the choices represent.
There are three types of retirement accounts: IRA, 401K, and 403B — but 403B accounts are a type that act as a form of insurance for union workers. That’s a special case and one best addressed by union reps. That leaves an IRA or 401K, which now both come with portfolio options to be “Roth” accounts. “Most of us are looking at a 401K from an employer or an IRA that you can have from anyone,” says Dan Egan, Director of Behavioral Finance and Investments at Betterment.“They both come with the option to be a traditional or a Roth portfolio, which basically means taxes now or taxes later.”
With a traditional 401K, you pay taxes when you take your money out of the account. With a Roth, you pay the taxes before you invest the money — so whenever you’re ready to draw your investment savings out during retirement, there are no taxes to pay. According to Egan, the way to choose which option is right for you is to determine which tax bracket you’re in now and which bracket you’ll be in retirement.
“If you’re a high-earner in a high tax bracket now and you plan to be in a lower tax bracket in retirement, a traditional account is the better option, since you’ll be able to save money on taxes later,” he explains. “But if you are in a lower tax bracket now and you pay the money on your investments before putting them into your Roth account, that can save you a lot of money later because your retirement savings becomes tax-free.”
Roth accounts are the obvious best choice for young investors and anyone who has a long time to grow their investments before retirement. But regardless of how much money you have to invest now or how many years you have before retirement, it’s important to stay active in monitoring your retirement funds. Both Roth and traditional accounts need active attention and management to give you the highest returns when you’re ready to throw in the working towel. That means you need to know what kind of money you’ve got and where it is — retirement funds aren’t just something you can forget about for 30 years and expect to be happy with the results.
“Have a consolidated view of your money so you can see what you can do with it,” Egan says. “Change jobs? Use it as an opportunity to do a portfolio review. I roll over my 401k to an IRA when I change jobs and then start a new portfolio with a new employer. You’re going to be responsible for retirement and that brings you a lot of benefits if you’re willing to take on the responsibility. Just remember that when someone manages your money for you it’s convenient, but that doesn’t mean that they’ll manage it in the best way.”
If you’re auto-enrolled in your 401K, your employer could change the amount you’re saving when you get a raise or hit a certain salary benchmark. A raise can increase your investment percentage from three percent to four — and a job switch has the potential to knock your savings back down to three percent. In 25 years, that one percent can make a huge year-over-year dent in your returns. That’s something you would never be aware of unless you’re actively keeping an eye on your account.
“Be aware and keep saving the amount that is right for you,” Egan says. “Set your savings at a pace that grows faster than your income.”
However, no matter how vigilant you are in your attention to a secure retirement, finances and savings can be tough — and stressful. But that’s okay. Keep in mind that being honest and active about your money — not investing here or withdrawing there — is the best thing you can do for your family. “As a parent I plan on sharing and showing my kids that I budget and invest and hold myself accountable with money,” Egan says. “I think it’s important to have them see that their parents plan and take money seriously. It’s just like any other habit you can instill — my daughter sees us reading and she wants to start reading. You can encourage a good relationship with money from the beginning as long as you are open about the realities of finances.”
Setting a good example for your kids doesn’t mean just starting your retirement savings before they’re born, but also showing them how to protect retirement savings. “You need to start saving young and early, but as soon as you become a father, look at life insurance and hedging against downside scenarios so you can protect your money and your family,” he says. “You need to be aware of lifestyle creep — don’t hide that you’re talking about money or struggling with money.” He suggests utilizing a Roth account if you plan on gifting your children money or leaving them an inheritance, so they aren’t burdened with the taxes on the money when it’s withdrawn.
Still, accounts aside, your retirement won’t matter if you can’t set yourself and your family up for it now. As Egan puts it, “A good retirement for yourself is the best gift you can give your kids.”