Updated: Aug 3, 2020
If you haven't already done so, you should read this post about IRAs and 401(k)s. Once you've done that, you're ready to learn about the two types that exist: Roth and Traditional. Most resources only discuss Roth/Traditional IRAs, but offering these two types of 401(k)s is becoming increasingly popular.
75% of companies that offer a 401(k) also offer the choice between Roth and Traditional, even though the Roth 401(k) only came into existence in 2006.
Both types of accounts are great. The only difference is when you pay taxes:
With a Roth account, you pay taxes on the money now (at the end of the calendar year). You can access the money later (typically in retirement) without owing anything more.
With a Traditional account, you don't have to pay any money for taxes now. Pay all the taxes when you take the money out of the account.
This table shows the differences between a Roth IRA and a Traditional IRA. The rules are similar but not exactly the same for a 401(k).
Some good things to note...
You can put money into both a Roth and Traditional IRA!!! You just can't put in more than $6,000 total.
You CANNOT take your contributions out of a Roth 401(k) penalty-free and tax-free, unlike a Roth IRA. Be careful with that!
Quick example for clarity:
Say that you contribute $4,000 to a Roth IRA and $2,000 to a Traditional IRA. Say that your investments do well, and your Roth IRA grows by $400 and your Traditional IRA grows by $200. At the end of the year, you'll owe taxes ONLY on the original $4,000. You can take out that original $4,000 (your contribution) any time with no additional taxes/penalties. However, you'll pay a 10% penalty on anything else (the $200, $400, or $2,000) you take out. After age 59.5, you can take out any of the money penalty-free, but you'll have to pay taxes then on whatever you take out of the Traditional IRA.
Can't figure out which type of IRA or 401(k) to choose? It depends if you think you'll make more money now or when you want to access the funds. By making the best choice, it'll ensure you minimize how much you pay in taxes.
Use this calculator through Fidelity to figure out your best bet for an IRA: https://www.fidelity.com/calculators-tools/ira-contribution-calculator
Use this calculator through Bankrate to decide on the best 401(k) for your situation: