If you’re enrolling in your company retirement plan, your company may offer you a choice: a Roth 401(k) or a traditional 401(k).
In this article, I’ll explain why the tax implications are the biggest differences between contributing to a Roth 401(k) vs. a traditional 401(k). I’ll also outline the circumstances that may lead you to choose one over the other.
Table of Contents
- What Is a Roth 401(k)?
- Tax Differences: Roth 401(k) vs. Traditional 401(k)
- Roth vs. Traditional 401(k): Similarities
- Roth vs. Traditional 401(k): Differences
- Why You’d Choose a Roth 401(k)
- Why You’d Choose a Traditional 401(k)
- Things To Do Whether You Invest in a Roth or a Traditional 401(k)
What Is a Roth 401(k)?
A Roth 401(k) is a workplace retirement savings plan. It combines some elements of a Roth IRA with some elements of a traditional 401(k).
The majority of employers with retirement plans now offer both Roth and traditional 401(k)s.
For any retirement account, the tax implications are important to understand. Just like a Roth IRA, when you contribute to a Roth 401(k), you’re putting in money that has already been taxed. That means you can withdraw your Roth 401(k) investment gains tax-free in retirement.
If your company offers a 401(k) “match,” the dollars your employer contributes will go into a traditional 401(k) even if you’re contributing to a Roth 401(k).
Money expert Clark Howard has a clear preference for Roth 401(k)s over traditional 401(k)s due to the future tax advantages (more on that shortly).
“A Roth 401(k) is vastly superior to a traditional 401(k),” Clark says. “With a Roth 401(k), you put in money that’s already been taxed, and it’s never taxed again.”
There are a few important differences between a Roth 401(k) and a Roth IRA. With a Roth 401(k):
- There are no maximum income contribution limits, unlike a Roth IRA.
- You can withdraw your contributions at any time, just as you can with a Roth IRA.
Tax Differences: Roth 401(k) vs. Traditional 401(k)
Roth versus traditional 401(k) is a question of when you pay taxes. You pay taxes before contributing to a Roth 401(k); you don’t pay taxes until after you withdraw from a traditional 401(k).
Determining which option is better for you likely boils down to your answer to this question: Are you currently paying a lower tax rate than you expect to be in the future? If your answer is “Yes,” a Roth 401(k) is a great option.
Clark is on the record saying he expects taxes to rise in the future, so he thinks there’s a clear answer to the question of Roth versus traditional 401(k).
“Our tax rates today are unusually low because we’re running massive budget deficits. Who’s going to pay for those?” Clark says.
“At some point, those tax rates will increase. That means there’s a good chance tax rates will be higher when you go to spend your nest egg.”
Again, you contribute “post-tax” dollars to a Roth 401(k), meaning the money you put in has already been taxed. You won’t have to pay taxes on it again when you withdraw funds during your retirement.
You contribute “pre-tax” dollars to a traditional 401(k), meaning you put money into your 401(k) before it’s taxed. This reduces your taxable income. You’ll have to pay taxes on the money when you withdraw during retirement.
When you withdraw from your Roth 401(k) account once you’re retired, here’s the tax situation:
- Money you contributed: No taxes
- Money you earned through investments: No taxes
- Money you got through a 401(k) company match: Taxes owed
Roth vs. Traditional 401(k): Similarities
Even though they have different names, a Roth 401(k) and a traditional 401(k) are like cousins. They share some of the same DNA.
Roth and traditional 401(k)s both:
- Are workplace retirement plans
- Allow you to receive a company match
- Are governed by the same maximum contribution limits set by the IRS
- Offer you the same investment options within your company’s plan
- Require you to start withdrawing your money at 73 years old*
Roth vs. Traditional 401(k): Differences
|Roth 401(k)||Traditional 401(k)|
|Retirement withdrawals||Not taxed||Taxed|
|Withdrawal requirements*||Age 59½|
Account 5+ years old
|Early withdrawal penalty||Only on investment earnings||On the full amount (including contributions)|
|Taxes due for Roth IRA rollovers||No||Yes|
|Required Minimum Distribution||No||Yes (starting at age 73^)|
*You can withdraw before reaching the 59½ age limit, but you’ll need to pay a 10% early withdrawal penalty. There are IRS exceptions that allow you to withdraw before 59½ for Roth and traditional 401(k)s.
Also note that if your Roth 401(k) is less than five years old, you’ll incur a 10% early withdrawal penalty even if you’re at least 59½ years old.
^There are two ways around this rule. 1) If you’re still working for the company that oversees your traditional 401(k) plan, you can avoid Required Minimum Withdrawals (RMDs). 2) The IRS doesn’t require RMDs for Roth 401(k) accounts or Roth IRAs. So you can work around the RMD rules by rolling your traditional 401(k) into a Roth IRA.
Why You’d Choose a Roth 401(k)
Keep in mind that if your company offers a Roth 401(k) and a traditional 401(k), you’re allowed to split your contribution between both accounts.
So you can hedge your bets by using both. However, contributions to both accounts count toward your maximum contribution limit.
A Roth 401(k) makes more sense if you’re:
- Expecting a higher federal tax rate in the future (as Clark predicts)
- Maxing out your 401(k) contributions
- Hoping to leave it all for your heirs, as you no longer face RMDs for Roth 401(k) accounts in your lifetime
- Wanting to lower your taxable income during retirement (traditional 401(k) withdrawals count as taxable income; Roth 401(k) withdrawals do not)
- Aiming to make your retirement nest egg last longer (by avoiding withdrawal taxes)
Read this article for a longer explanation of why Clark is obsessed with Roth over traditional.
Why You’d Choose a Traditional 401(k)
Clark says that Roth 401(k)s currently are better than traditional 401(k)s for virtually everyone.
If you make too much money to be eligible to contribute to a Roth IRA but your employer offers a Roth 401(k), take it, Clark says.
Even if you’re in a relatively high tax bracket, he thinks your tax rate is still likely to be higher in the future than it is right now.
A traditional 401(k) may make more sense if you’re:
- In a high-income tax bracket now (at least 32% in 2022, Clark says) and you expect your tax bracket to be lower in the future
- Wanting to lower your taxable income for the current tax year to avoid a large bump in your federal income tax bracket
Things To Do Whether You Invest in a Roth or a Traditional 401(k)
You’ll face some important choices whether you put your money into a Roth 401(k), a traditional 401(k) or you split your money between the two.
1. Contribute to Your Retirement Account Each Paycheck
Workplace retirement plans make this easy. If you enroll, your contribution will go to your 401(k) before your paycheck hits your bank account.
Clark prefers a 401(k) to an IRA for many people because it removes the choice of whether or not to contribute each paycheck or each month.
2. Increase the Amount You Contribute to Your 401(k) Over Time
If you’ve saved an emergency fund, Clark strongly advocates contributing to your company’s 401(k) plan, even if it’s a small amount.
Get started. Then work toward contributing more.
“Every six months, I want you to increase your contributions by one cent for every dollar you earn,” Clark says. “You’re not going to miss that one additional cent, but you’ll steadily increase the amount of money you’re putting aside for your future.”
3. Invest Your Contributions in a Target Date Fund
Most 401(k) plans offer a limited investment menu. Typically, your options are restricted to more aggressive or less aggressive mutual funds.
The simplest thing to do is to put all your money in a target date fund. Pick the year that’s closest to when you expect to retire. The fund will automatically diversify into less risky investments the closer you get to retirement.
Clark says the biggest mistake people make with their 401(k)s is asking for and following investment advice from a co-worker, which Clark says can be “tragic” for your finances.
If a target date retirement fund isn’t available in your plan, Clark recommends investing in a broad market index fund instead. And for more sophistication, he says it’s OK to mix in an international index fund.
But he says you can’t go wrong with putting 100% of your 401(k) dollars into a target date fund.
“If you don’t know how to allocate, just pick the target retirement fund,” Clark says.
“What’s the expression? Perfect is the enemy of good? That’s why I think the ‘simple button’ is best until somebody chooses to ramp up their knowledge.”
Contributing to any retirement account is a wonderful step toward securing your financial future. If you’re getting what amounts to free money via a company match, even better!
Choosing to contribute to a Roth vs. a traditional 401(k) can make a difference, especially in terms of taxes. But you’re winning either way.
If you’re still not sure which choice is best for you, you can always consult with a financial advisor or with a tax professional.