If your employer offers a 401(k) plan, as most do, you may be faced with a big question. Which version do you want: traditional or Roth?
This question is mostly about whether you will contribute to your retirement with pre-tax money (with a traditional account) or with post-tax money (with a Roth account). In some cases, saving pre-tax money in a traditional plan is the right choice, because it benefits you more now, during your working years, but in other cases, saving post-tax money in a Roth is the right choice, because it benefits you more during retirement.
Below are the factors that should go into your decision.
Key Takeaways
- Whereas a traditional 401(k) uses pretax dollars, a Roth 401(k) uses after-tax dollars.
- Whereas a traditional 401(k) gives you a tax break now, a Roth 401(k) doesn't.
- Whereas a traditional 401(k) requires you to pay income taxes on withdrawals, a Roth 401(k) doesn't.
- If you expect to be in a lower tax bracket during retirement, the traditional 401(k) may suit you.
- If you expect to be in a higher tax bracket during retirement, the Roth 401(k) may suit you.
- If you don't know what to expect, or can't decide, consider splitting your savings between the two types of accounts.
Lower Taxes Now or Tax-Free Income Later?
The Traditional Account
When you opt for a traditional 401(k) plan, your employer deducts the amount you choose to contribute before it even shows up in your paycheck. On paper (and the paper is the Internal Revenue Service (IRS) income tax form), that means your gross income has been reduced by the amount you pay. And that also means the taxes you owe from week to week go down a bit too, softening the blow of your pay being reduced by your 401(k) contributions.
After you retire and begin withdrawing money from your traditional 401(k), you'll pay ordinary income tax on the amount you withdraw. The taxes are owed on both the original contributions and your investment earnings.
The Roth Account
If you choose a Roth 401(k) plan, your employer deducts the amount you choose from your net, after-tax income. That means no deduction and no reduction in your taxable income. For example, if you choose to contribute 3% of your salary to a Roth 401(k), that 3% is removed from your take-home pay after it's already had income tax taken out of it.
Now for the good part. Once you retire, you'll owe no income tax on the money you withdraw from the account. Because the contributions were taxed years ago, they and any investment earnings they generated over the years are tax-free.
In general, you can withdraw your earnings from a Roth 401(k) without owing taxes or penalties if:
- You're at least 59 ½ years old.
- It's been at least five years since you first contributed to any Roth IRA (the "5-year rule").
The 5-year rule applies regardless of your agewhen you opened the account. If you are 58 years old when you make your first contribution, for example, you still have to wait until age 63 to avoid taxes.
The clock starts ticking on Jan. 1 of the year you made your first contribution to any Roth. Because you have until the tax filing deadline of the following tax year to make a contribution, your five years might not be a full five calendar years.
For example, if you contribute to your Roth IRA in early April 2020—but designated it for the 2019 tax year—you'll only have to wait until Jan. 1, 2024, to withdraw your Roth IRA earnings tax- and penalty-free, assuming you’re at least 59½ years old.
Roth 401(k)s and Estate Planning
Let's say you have no intention of retiring at an early age or at any age at all. You want to keep the money in your 401(k) for the distant future when you really need it. Or maybe you know that you'll have plenty of other sources of income in retirement, and you want your 401(k) funds earmarked for your surviving family and loved ones.
Roth 401(k)s offer two distinct advantages in estate planning:
- Heirs will benefit from the Roth 401(k)'s tax-free treatment just as the original owner would have.
- As of 2024, you don't need to take required minimum distributions (RMDs) from your Roth 401(k).
Splitting Between Both Accounts
This doesn't have to be an either/or decision. You can split your savings between a traditional 401(k) and a Roth 401(k).
You can also roll over your traditional 401(k) into a Roth—though you'll owe the taxes on your contributions upfront.
You might want to do this to hedge your investments, experts say. This may be a good idea because the future is unknown: you can't say with certainty whether your tax rate will be higher or lower when you retire. Splitting your assets between these two accounts guarantees you'll have some tax-free and some taxable income.
Is It Better to Contribute to a 401(k) or a Roth 401(k)?
Both have their advantages. It depends on when you want to pay taxes. With a traditional 401(k), your contributions are deducted from your pre-tax earnings and you pay taxes on those contributions and any investment earningsyears later, typically when you retire and begin making withdrawals.
With a Roth 401(k), your deductions are made from your net,after-tax income, meaning you pay the taxes upfront. When you retire, your withdrawals will incur no income tax, since the contributions were already taxed years earlier.
Does a Roth 401(k) Make Sense for High-Income Earners?
Yes, a Roth 401(k) can be a good fit for high earners who would like to invest in a Roth IRA, but can't because of the income limits. A Roth 401(k) has no income limits.
What Are Roth 401(K) Contribution Limits for 2024?
For 2024, the 401(k) contribution limits are $23,000 and $30,500 (which includes a $7,500 catch-up contribution for those age 50or older). For 2023, those limits were $22,500 and $30,000, respectively. The combined contribution limit for an employer and employee in 2024 is $69,000, or $76,500 for those age 50 or older. For 2023, those limits were $66,000 and $73,500, respectively.
The Bottom Line
So, which plan works better for you? There's a lot to consider. For example, can your budget handle the strain of a smaller take-home paycheck? If it can, the Roth 401(k) may be the better choice. If not, opt for the traditional type. And finally, do you expect to be in a lower tax bracket after you retire? Many people are. If so, the tax hit you'll owe on your withdrawals isn't as big of an issue, so the traditional 401(k) may be better for you. If the opposite is true, then the Roth version has its advantages. And if you can't decide—or can't fully predict the future—then you may want to split your assets between these two types of accounts. It doesn't have to be an all-or-nothing decision.
