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You may be wondering, is it better to contribute to a traditional 401(k) or a Roth 401(k)? Well, today, I am going to help you find the right answer for your retirement plan. In this guide, I will share everything you need to know about comparing the Roth vs. traditional 401(k), including how each type works, the tax implications, and much, much more!
So, let’s get started!
What is a 401(k)?
First, as you are probably aware, a 401(k) is a tax-advantaged retirement vehicle offered by many employers in the U.S. It allows you to set aside money for retirement in a way that will enable you to defer or eliminate some taxes (as is the case on earnings in a Roth 401(k)…more on that in a minute).
401(k)s are similar to Individual Retirement Accounts (IRAs) in that they offer tax advantages. You can either choose to pay taxes on your contributions now. Or, you can choose to contribute pre-tax money and pay taxes on withdrawals in retirement. There are merits to each of these approaches, which I will cover in detail.
Notably, 401(k) programs are only offered by employers, whereas you can set up IRAs independently. Additionally, 401(k)s only provide a defined set of investment choices, whereas IRAs allow you to invest in any publicly traded security (like individual stocks, bonds, etc.). I’ll get into more detail on this a bit later, but for now, remember that 401(k)s are only offered by your employer and carry limited investment options.
What is a Roth 401(k)?
Roth 401(k)s are an investment plan offered by your employer in which you will contribute post-tax money.
In other words, you will pay taxes on your income today.
However, once you pay tax on your contributions, you will never owe taxes again on either the contributions or the gains.
What is a Traditional 401(k)?
A traditional 401(k) is distinctly different from a Roth 401(k) because you will contribute pre-tax money.
Said differently, any money you contribute will reduce your taxable income (i.e., you’ll pay less in taxes this year), and when you withdraw money in retirement, you will pay taxes on both contributions and the gains.
What are the Similarities Between a Roth 401(k) and a Traditional 401(k)?
Before I dive into some detail on Roth and traditional 401(k)s, I want to cover some key characteristics that apply to both types of plan options.
First, as mentioned above, both of these are workplace retirement programs. That is, they are typically only available to you if you work a plain old W-2 job.
Second, the contribution limit for both Roth and Traditional 401(k)s is $20,500 plus catchup contributions for those age 50 and older as of 2022.
Finally, in each of these 401(k) plan options, you are eligible to receive an employer match on contributions if offered by your employer. However, typically the employer match is always provided on a pre-tax basis, meaning even if you have a Roth 401(k), you’ll owe tax on employer contributions at retirement.
What are the Differences Between a Roth 401(k) and a Traditional 401(k)?
Now that we’ve covered similarities let’s cover critical differences between the Roth 401(k) and traditional 401(k).
Timing of Taxes
The most notable difference between these two types of plans is the timing of tax payments.
- Roth 401(k): Contributions after-tax, meaning you will pay more taxes in the current year
- Traditional 401(k): Contributions pre-tax, meaning you will pay fewer taxes in the current year
Withdrawals (in Retirement):
- Roth 401(k): Withdrawals are not taxed in retirement (contributions & gains)
- Traditional 401(k): Contributions and gains are taxed in retirement, meaning you will pay more in taxes during retirement
While this is all very interesting, you’re here because you want to know which of these options is better. I’ll get to that in a minute, but first, I need to cover a few more fundamental differences.
Access to Funds
Because the government isn’t willing to give you something for nothing, you generally cannot access funds placed into a 401(k) account until you reach age 59.5. If you access these funds, you will usually pay penalties to the IRS (except in certain circumstances).
Note that this applies to both the Roth and traditional 401(k).
Notably, however, the Roth has an additional restriction. You must have the plan open for five years and be age 59.5 or older to take withdrawals. While for most folks, this won’t matter, if you’re in your 50s, make sure to consider this before opening a Roth 401(k).
Finally, there is one additional nuance. Both Roth and Traditional 401(k)s mandate you take required minimum distributions beginning at 70.5. However, if you have a Roth 401(k), you can roll these funds into a Roth IRA, a retirement account with no required minimum distributions, and avoid this requirement.
A Roth 401(k) May Allow You to Contribute More
As I explained early, both the Roth 401(k) and traditional 401(k) carry a contribution limit of $19,500 as of the time of this writing. However, and this is important, you can contribute more money to a Roth 401(k).
But you just said they carry the same limit of $19,500. What do you mean? If you contribute $19,500 to a Roth 401(k), you contribute $19,500 post-tax to this account. If you contribute $19,500 to a traditional 401(k), you are contributing $19,500 pre-tax.
Said another way, $19,500 in a Roth 401(k) account is worth $19,500 in retirement, but the $19,500 in a traditional 401(k) is worth less than $19,500 in retirement once taxes are paid.
So, if you can afford to contribute up to the limit, you can contribute more tax-advantaged dollars if you leverage a Roth 401(k). Therefore, even for high-income earners in above-average tax brackets, the Roth 401(k) is worth considering.
Roth vs. Traditional 401(k): Which is Better?
Now that we have covered each of these plans’ merits, I want to start talking about strategy. Let’s cover some of the pros and cons of each type of program, so you can consider which might be right for you.
Roth 401(k): Pros
- Not counted as taxable income in retirement (because you will pay all taxes today), therefore reducing taxes in retirement, including on income like social security
- If you believe your tax rate is lower today than it will be in retirement, it is advantageous to pay the tax today (when your rate is lower) than in retirement
- Allows you to invest more tax-advantaged money if you are a high-income earner (because you’re contributing $19,500 post-tax, not pre-tax)
Roth 401(k): Cons
- Increases taxes you will pay today
- If you believe your tax rate would be lower in retirement, you’re disadvantaging yourself by paying taxes at the higher rates today
- Must hold the account for 5+ years before taking withdrawals; if you have the account for less than five years and take withdrawals, you’ll pay penalties
Traditional 401(k): Pros
- Decreases your tax burden in the current tax year
- May be able to pay taxes at a lower rate if you are in a lower tax bracket/rate at retirement
- Also, it may be advantageous to convert a traditional 401(k) to Roth 401(k) if you are out of work/have a low income for a few years, such as if you go back to school, take time off work to stay home with children, etc.
Traditional 401(k): Cons
- Taking a risk on future tax brackets and rates, creating more uncertainty about your retirement picture
- May have a higher tax rate in retirement if your income increases, placing you in a higher tax bracket
- Can contribute fewer total dollars (because they’re on a pre-tax basis)
- Higher taxable income in retirement, potentially triggering increased tax obligations on other sources of income like social security
While I can’t tell you the right answer for your situation, I am very comfortable using a Roth 401(k) even though I am in a relatively high tax bracket.
Why? Because I do not know what tax rates will be in retirement, and the consensus is that tax rates will eventually have to increase to cover current government spending levels.
Using a Roth 401(k), I know what my tax obligation is, because it’s happening today, and then I can rest easy knowing I’ll never pay tax on that money again.
Splitting Contributions between Roth and Traditional 401(k)
Given that both Roth and traditional 401(k)s come with pros and cons, you may be wondering, can I contribute to a Roth 401(k) and a traditional 401(k)?
The answer is yes! You can contribute to both types of 401(k)s up to the total cap (i.e., $20,500 total as of 2022).
Additionally, some folks consider a strategy to start their careers using a Roth 401(k) and then switch to a traditional 401(k) once their earnings and tax rates increase. This can also be an effective strategy to consider.
Roth vs. Traditional 401(k) Calculator
As I think you can now see, deciding between a Roth and traditional 401(k) plan isn’t an easy decision. There is no mathematical formula that can determine what the right answer is for you. Your decision is only as correct as your assumptions about your future income and tax policy.
However, many folks like to try to put some numbers to this decision. For that reason, I want to share my favorite Roth vs. traditional 401(k) calculator with you.
Roth vs. Traditional 401(k) FAQs
Who is Eligible for a Roth 401(k)?
While the Roth IRA carries income limits, the Roth 401(k) has no such restriction.
Anyone whose employer offers a Roth 401(k) is eligible to contribute to that plan, regardless of their income.
How Much Should I Invest in a Roth or Traditional 401(k)?
Another common question is how much you should plan to invest in your Roth or traditional 401(k).
Easy! Try to contribute up to the cap ($19,500 per year as of this writing).
While this is a sizeable goal, it can significantly impact setting you on the path to financial independence.
Should I Roll Over My Traditional 401(k) to a Roth 401(k)?
As a Roth 401(k) is a relatively new option, many wonder if they should roll over their traditional 401(k) to a Roth 401(k) if their employer is now offering that option.
While this is an option, understand that you will pay taxes in the year the conversion occurs. For example, let’s assume that you roll over $100,000 from a traditional 401(k) to a Roth 401(k) and are in the 30% tax bracket.
In other words, you would owe $30,000 in taxes at the time of the rollover.
Ensure you keep the tax obligation in mind and speak to a tax professional if this is an option you’re considering.
What’s the Difference between a Roth 401(k) vs. Roth IRA?
One question that comes up frequently is how a Roth IRA differs from a 401(k).
It is essential to understand that a Roth 401(k) is not the same as a Roth IRA. An IRA is a retirement account that you can set up on your own, independently from your employer. While it functions somewhat similar in that you contribute after-tax dollars, a Roth IRA allows you to choose any investment you wish and reduces potential friction (read: cost) on your investments.
While I won’t go into all the differences now, one key thing to note is that Roth IRAs do carry an income limit, so not everyone is eligible. A Roth 401(k), however, is available to any whose employer offers the plan.
However, in general, the principles of a Roth 401(k) and Roth IRA are very similar in that you contribute after-tax dollars on which you will not pay any future tax.
Should I Convert My 401(k) to a Roth IRA?
One common question is whether you should convert your 401(k) to a Roth IRA.
If you had a Roth 401(k) and elect to leave your employer, I would urge you to roll it over to a Roth IRA. Again, the key reasons are that you will have a more significant number of investment options, and you eliminate costs that are often associated with 401(k) plans.
However, if you’re considering rolling over a traditional 401(k) to a Roth IRA, make sure you understand the tax implications. It may make more sense to roll your 401(k) into a traditional IRA. Speak to your tax professional to understand the potential repercussions.
Can I Have a 401(k) and an IRA?
Finally, I often get asked if you can have both a 401(k) and an IRA.
The short answer to this question is yes; you can. However, the tax benefits can get a little murky (particularly with traditional IRAs), so you’ll want to speak with your tax professional to determine how a combination of the two might work for you.
Finally, I want to note that I would always advocate maxing out your IRA before your 401(k), assuming you contribute at least enough to your 401(k) to earn the company match. I am a proponent of this approach because the number of available investments and a reduction in fees in your IRA makes it preferable to a 401(k).
Roth vs. Traditional 401(k): A Summary
Deciding to go with a Roth 401(k) or a traditional 401(k) is a personal decision. However, for many folks, I suggest going with the Roth if for no other reason than the certainty it provides for tax obligations and money in retirement.
However, spend some time thinking through the pros and cons and then making the right decision for your situation. If you have questions, be sure to let me know in the post comments.
Finally, if you’re not quite sure how to make the most of your 401(k) account, check out this post: A Guide to Investing in Your 401(k): Are You Missing Out on Free Money?