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Traditional or Roth 401(k) – Which One is Better?

traditional or Roth 401(k)

If you are self-employed, a Solo 401(k) is an essential retirement planning tool.  But what choice is better – a traditional or Roth 401(k)?  Each option offers its own unique tax advantages.  In the following, we’ll discuss each plan and compare the two.  Depending on your financial goals, one might be a clear winner.  If you are on the fence, hopefully dissecting each plan will give you a better idea which is right for you.  As always, this article is for educational purposes and it’s up to you to decide which plan is better.

The Traditional Solo 401(k)

A Solo 401(k) plan is a standard 401(k) that is designed specifically for self-employed individuals.  It may also be referred to as an Individual 401(k), Self-Employed 401(k) or One Participant 401(k).  The only way you can open and fund one is if you have self-employed income.  This can be from an owner-only business or from other forms of income such as contractor work, Uber driving or through an Amazon store.  The one caveat is that you cannot have any full-time employees, except a spouse.  One you hire full time employees, you can no longer utilize the plan.

The most important aspect of all retirement plans is when you pay taxes.  This is the main difference between traditional and Roth plans.  A traditional 401(k) is funded with pre-tax money.  This means any contributions you make to the plan are not taxed.  The taxes are deferred until you start taking distributions during retirement.  For 2019, you can contribute up to a maximum of $56,000, or $62,000 if you are at least age 50.  This includes both an employee contribution of $19,000 ($25,000 for those age 50+) and an employer profit sharing contribution of up to 25% of your compensation.

Here’s an example of how the traditional plan works:  Mary earns $75,000 as a consultant and decides to contribute $20,000 annually to her Solo 401(k).  That pre-tax contribution lowers her taxable income for the year from $75,000 down to $55,000.  When Mary reaches age 59 1/2, she’s free to withdraw funds from the plan at no penalty.  Any amount she withdraws will then be added to any income she earns that year.  Taxes will be due on all income for the year (both that earned and that which is withdrawn from her traditional 401(k).

The Roth Solo 401(k)

A Roth Solo 401(k) has the same eligibility rules and contribution limits as the traditional plan.  The major difference is when taxes are paid.  A Roth is funded with after-tax money.  Therefore, there is no immediate tax break on your contributions.  However, all qualified distributions from the plan are tax-free.  For a distribution to be “qualified,” the account must be open for at least five years and you must be at least age 59 1/2.  Essentially, a Roth Solo 401(k) combines the best aspects of a Solo 401(k) and a Roth IRA.

Let’s see how Mary does with a Roth 401(k) – She still earns $75,000 for the year, but contributes the $20,000 into a Roth Solo 401(k).  Since the plan is funded with after-tax money, she will owe taxes on her entire $75,000 income.  However, when she decides to withdraw from the plan at age 59 1/2, all funds are tax-free (assuming the plan has been open for five years).  By contributing after-tax money, not only is that money now tax-free, but so are all the earnings the plan has accumulated throughout the years.

Read this on Forbes: Tax-Free Wealth With The Roth 401(k)

Traditional or Roth 401(k)?

So, which plan is better for you – the traditional or Roth 401(k)?  Let’s take a moment to compare the two plans –

When you pay taxes – A traditional plan offers an up-front tax break, while a Roth does not.  Roth withdrawals are tax-free and traditional withdrawals are treated as taxable income.

Required Minimum Distributions – Both plans are subject to mandatory withdrawals, also known as RMDs.  Once you reach age 70 1/2, you must start distributing money from the plan, whether you need to or not.  The difference is that you may opt to roll over your Roth 401(k) funds tax-free into a Roth IRA.  A Roth IRA is not subject to RMDs so the money can continue to grow unhindered.

Tax Rates – Since future tax rates are unknown, there is a variable for both plans.  You may choose to pay taxes now at a known rate, or wait until the future, where it’s anyone’s guess what will happen with taxes.

Age Matters – The consensus is that the younger you are, the more you can take advantage of tax-free growth.  On the other hand, if you are in the prime of your earning potential, an immediate tax-break may be worth it for you.

The Final Verdict

Saving for retirement as a self-employed individual is an imperative step you must consider. Choosing between a traditional or Roth 401(k) is just as important. Many factors, including your age, income and financial goals must be considered. Which one is better? The easy answer is: they both are! So long as you are saving for retirement, it really doesn’t matter which plan you choose. In fact, contributing to both a Roth and traditional plan will help better diversify your retirement savings.

If you have any questions about the traditional or Roth 401(k) plan or how they differ, please feel free to give us a call at 800.472.1043. You can also fill it out a contact form or check out our app!

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