One of the most important questions in retirement saving is also among the least understood.
Whether a retirement saver should use a Roth or traditional source, or both, “is the number one question we get,” says Cary Carbonaro, a CFP Board ambassador and senior vice president and director of women and wealth with ACM Wealth.
A traditional 401(k), often just called a 401(k) or a regular 401(k), involves saving money into a pre-tax account,which means the amount saved is deducted from one’s taxable income for that year. To set the stage, we take this example:
- If a participant is saving 10% into a traditional account with a $50,000 annual salary, that person would only owe taxes on the $45,000, with the last $5,000 put into the 401(k). This money then grows tax-free and is taxed as income when it is withdrawn in retirement. Both the initial $5,000 plus the resulting growth over the years would be taxed for the year it is withdrawn.
A Roth 401(k), sometimes just called a Roth or Roth account, is taxed at the time of saving. To use the same example of a worker who earns $50,000 and saves 10%:
- The participant will end up with $5,000 saved in their Roth 401(k). However, they are still taxed on $50,000 income even though the $5,000 is not available to them: There is no upfront deduction.
In summary, a traditional account is tax deferred with an upfront benefit, whereas Roth is a tax break with a long-term benefit.
Choosing between the two or splitting between them depends on all sorts of factors, Carbonaro says, but can hinge on variables such as a participant’s age, existing savings distribution, and income and ability to save.
Who Should Go All-in on Traditional?
At the moment, despite the benefits of Roth, many more people use traditional accounts, Carbonaro says.
This is the right strategy for many people who are looking to save on their taxes in the near term, she says. This group can include those who are struggling to save at all, and those in higher tax brackets that are not in need of additional Roth savings.
In the end, the upfront tax break can make the difference between not saving and saving at all and “the most important thing is that they are doing it,” Carbonaro says.
With savings rates in the U.S. well below retirement needs, the ease and prevalence of traditional 401(k)s is where many participants will land in the near term.
Who Should Split Roth and Traditional
That said, there are many advantages to Roth 401(k) saving, and the option is gaining traction in the marketplace.
Carbonaro advises most of her clients to split their savings between Roth and traditional accounts, advising that they “do half in regular and half in a Roth, because you’re allowed to split.”
She says that splitting can help savers take advantage of the benefits of both tax scenarios and gives them greater flexibility in both their working and retirement years.
Carbonaro notes that it is more expensive upfront to save in Roth, and a traditional 401(k) can lighten this burden. But putting all savings in a traditional account can be a bad idea as well, because in retirement “you will have a tax bomb due,” says Carbonaro.
If a saver has a matching contribution, or other employer contributions, it will usually be made on a traditional basis, because the savings are not taxed on that match until the participant takes it out. Those seeking a balanced approach should consider this. If they have a 6% match and they contribute 3% each into traditional and Roth, that results in 9% savings in traditional with the company match and 3% in Roth of their own savings.
Starting in 2023, the SECURE 2.0 Act of 2022 permits plans to offer a Roth match. This means that if a participant earns $50,000 and their employer contributes $2,000, their savings would be taxed as if they had earned $52,000 in order to save more on a Roth basis. Not all qualified retirement plans allow this, and plan sponsors are not required to offer it under law, but they may choose to.
Who Should Do All-in on Roth?
The two categories of savers that should really consider doubling down on Roth saving are those who are very young, say 20s and 30s, and those who are higher earners, says Carbonaro.
A Roth 401(k) can be “incredibly attractive for a high net worth individual,” Carbonaro says.
A primary reason for this is that individuals earning over $146,000 or couples earning over $230,000 are not allowed to have a Roth individual retirement account. This means that if a higher earning person wants to have Roth savings, their 401(k) will likely be their only avenue to do so, Carbonaro says. They can always save into a traditional IRA later to seek a more balanced approach.
If a participant does not need the tax deduction, Roth can also be highly beneficial for younger savers because “they have time on their side,” she notes.
As the principal benefit of a Roth is that the growth over time is not taxed on the backend in retirement, the more time a saver has, the more a Roth will benefit them.
There is a common misconception in retirement saving that Carbonaro pushes back against.
Many people think that they should save in a traditional 401(k) while they are working and earning in a higher tax bracket, and then pay taxes on it once retired and in a lower bracket. In practice, especially for young savers, it is extremely rare for one’s working and retirement tax brackets to be so lopsided that the long-term benefit of untaxed growth in Roth is offset by this strategy, Carbonaro says.
“I am not seeing that with my clients at all,” she says.
Withdrawal and Inheritance Planning
For those savers who can sock away some money in Roth, they can see some benefits both in continued growth and in passing on savings to heirs.
Carbonaro says, when it comes to withdrawing funds, “take the Roth money last,” as Roth will continue to grow tax-free in your retired years.
If a participant is able to live off traditional savings and other income for a while before taking the Roth money, it is usually smart to do so.
Carbonaro also adds that a Roth “is the best asset to pass on to your kids,” and “If I am an heir, I want a Roth.”
Legal requirements mandate that an inherited Roth must be withdrawn within 10 years. However, that 10-year clock does not start until that heir turns 21. So, if the money is left to a young child, they will receive additional years for that Roth money to grow and can withdraw with no tax liability.
