A 401(k) is one of the best ways to save for retirement, but there’s more than one type of employer-sponsored retirement account and knowing the differences can give you more options in the long run.
One of the biggest perks of contributing to a traditional 401(k) is that doing so can save you money on taxes. Any money you put in a traditional 401(k) goes straight from your paycheck before taxes are applied, so it reduces your taxable income.
But financial expert Suze Orman says there’s a better way to invest for your retirement. Instead of investing in a traditional 401(k), Orman recommends investing in a Roth 401(k). Now you’ve probably heard of the individual retirement account option, the Roth IRA, but there’s now a 401(k) version as well that functions in roughly the same way.
With a traditional 401(k), you don’t pay taxes on the income you’re funneling into your investments. But when you retire, you pay taxes when you withdraw money from that account.
With a Roth IRA, you contribute the money after-taxes, so while you don’t get the immediate tax break, you don’t have to pay any taxes when you retire. About 70% of employers offer Roth 401(k)s, according to Plan Sponsor Council of America’s 2019 annual survey of employers.
“In my opinion, you should absolutely be putting every single cent into the Roth version of your retirement account,” says Orman who recently released her new book, “The Ultimate Retirement Guide for 50+.”
Roth retirement accounts offer more options
Why does Orman like Roth retirement accounts so much more? Because they offer more flexibility than a traditional 401(k). With a Roth 401(k), you don’t ever have to take the required minimum distributions. Meanwhile, a traditional retirement account requires you to start taking money out at age 72. If you miss this deadline, or don’t take enough money out, the penalty can be severe: The amount not withdrawn is taxed at 50% rate.
Meanwhile, if you’re planning to leave retirement savings as an inheritance, Orman says a Roth 401(k) is better here, too. What if your kids are in a higher tax bracket than you ever were in, and you leave them money in a traditional 401(k)?
They’re going to lose a lot of that money, Orman says. But with a Roth, they get it without income taxes, she says.
If you don’t have the option to invest in a Roth 401(k) at work, you can always invest in a Roth IRA if you earn under the income limit, Orman says. In 2020, you can put away $6,000 in a Roth IRA if you’re under age 50 (a bit more if you’re older), but you can only make full contributions to these accounts if your individual modified adjusted gross income is less than $124,000 this year ($193,000 for those who are married and filing jointly).
Orman’s advice: If you have a retirement account at work that matches your contribution, invest up to the point of the match. After that, fully fund your Roth IRA.
Plus, with a Roth IRA, you can take out your contributions at any time without penalty, regardless of your age or how long the money has been there. “There are so many advantages for you to do a Roth versus a traditional,” Orman says.
“So please don’t go for the tax write off today so that later on in life you have to pay taxes on a traditional retirement account. Go for a Roth,” Orman says.