Should my 401k be roth or traditional

When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw from your account, usually after you retire.

An increasing number of employers are offering employees a relatively new 401(k) choice—a Roth 401(k). If you participate in a Roth 401(k), the amount you defer doesn't reduce your taxable income or your current income taxes. But when you withdraw after you retire, the amounts you take out are tax-free, provided you're at least 59½ and your account has been open at least five years.

Both the traditional 401(k) and Roth 401(k) offer tax advantages when you defer a portion of your salary into an account in your employer’s retirement savings plan. Both feature tax-deferred compounding of contributions that are made to the account. Both have no income limits and require minimum distributions after you turn 72 in most cases, and both can be rolled over to an IRA when you retire or leave your job for any reason.

Here is a chart showing the different tax structures for the two 401(k) options:

Contributions and earnings taxed at your ordinary income tax rate 

Subject to a 10% tax penalty if made before you reach age 59½ 

• the account must be held for at least 5 years, and 
• the withdrawal is made either because of disability, death, or attainment of age 59½.

Employers may offer a Roth 401(k) only if they already offer a traditional 401(k)—and may give you the option of splitting your annual contribution between a traditional and Roth 401(k)—though your total contribution can’t be more than the annual limit Congress sets for a 401(k). However, once you’ve made contributions, you may not move money between the two 401(k) accounts because of their different tax structures.

What’s more, if your modified adjusted gross income is too large to allow you to qualify for a Roth IRA, a Roth 401(k) is one way to have access to tax-free withdrawals. There are no income restrictions limiting who can participate. The only requirement is being eligible to participate in your employer’s plan.

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• Roth 401(k)s and traditional 401(k)s are similar in many ways, but they differ in how your contributions and withdrawals are taxed. 
• Traditional 401(k)s offer up-front tax breaks; you pay the IRS on withdrawals when you retire. With Roth 401(k)s, you pay taxes on deposits, in exchange for tax-free withdrawals later.
• When deciding between a Roth and a traditional 401(k), your age, current tax bracket, and projected retirement income all come into play.

If you have access to an employer-sponsored 401(k) plan, you may also have access to a Roth 401(k). Since 2006, the IRS has allowed companies to offer these types of retirement accounts, which applies many of the best features of a Roth IRA to a traditional 401(k). A survey by the Plan Sponsors of America (PSCA) on the state of 401(k) plans in 2020 found that 86.3% of 401(k) plans now offer a Roth version. Yet, PSCA reported that only 23% of plan participants chose to contribute to them, suggesting that Roth 401(k) plans, while getting more accessible, are still somewhat of a mystery.

Here's a breakdown of the differences between Roth 401(k)s and traditional 401(k)s, along with a few scenarios that will help you weigh which best suits your retirement planning. 

Understanding the similarities and differences

Roth and traditional 401(k)s are similar in many ways. They're both retirement saving plans with the same annual contribution limits. Both require that you be at least 59 ½ years old to withdraw your savings (without incurring a 10% IRS penalty), and both require minimum distributions at age 72 (unless you're still working). Neither have minimum or maximum income requirements. 

The money in each account grows tax-free, and you usually have the same investment options (mutual funds, ETFs, etc.) for both — whatever the plan sponsor offers.

How Roth and traditional 401(k)s differ

The key difference between a Roth and traditional 401(k) comes down to when your savings are taxed.

Traditional 401(k)s are pre-tax accounts, meaning the money comes straight "off the top" of your paycheck. As a result, you receive a current-year tax reduction of your income. In return, you'll pay income tax when you start withdrawing money, usually after you retire.

A Roth 401(k), like a Roth IRA, is a post-tax account: Your contributions do not lower your taxable income in the year that you make them. However, on the flip side, all qualified distributions — IRS-speak for withdrawals — of your earnings are tax-free. 

Here's how a Roth 401(k) and 401(k) differ on paper:

Traditional 401(k) vs Roth 401(k)

Traditional 401(k)

Roth 401(k)

Contributions

Made with pre-tax dollars

Made with post-tax dollars

Deducted from gross income for the year

Included from gross income for the year

Withdrawals

Subject to both federal and most state income taxes

Not taxed provided: the account was held for at least five years and withdrawals are made on or after 59 ½ or on account of disability or death

Employee contribution limits

$20,500 in 2022

$20,500 in 2022

Employees age 50 or older can contribute an additional $6,500

Employees age 50 or older can contribute an additional $6,500

First RMD

Age 72 unless you're still working and don't own 5% of company

Age 72 unless you're still working and don't own 5% of company

Age 70 ½ for those who reached that age before January 1, 2020

Age 70 ½  for those who reached that age before January 1, 2020

Employer match

Yes

Yes, but funds go into traditional 401(k) account

One thing to keep in mind is if your employer matches a portion of your traditional 401(k) contributions, there's a strong chance that it may offer the same match for your Roth 401(k) contributions as well. 

However, the money that your employer contributes will still go into a traditional 401(k) even if you opt for a Roth. These contributions are classified as pre-tax dollars and will be taxable when you withdraw from them.

Roth 401(k) vs. traditional 401(k): Which plan is best for you?

The most important question to ask yourself when comparing Roth and traditional 401(k) plans is "Do I expect my tax bracket to be higher or lower after I retire?"

If the answer is "lower," then a traditional 401(k) would make more sense. But if you expect to have a higher tax rate in retirement, a Roth 401(k) could be the better choice.

Two main factors could affect your tax rate after you've stopped working. The first is your target annual retirement income. If this figure is significantly less than your income during your earning years, that could strengthen the case for the traditional 401(k). But the opposite would be true if you think you might actually be enjoying a greater income in retirement.

The second factor to consider is future changes in income tax rates. Of course, that's out of your control, and in the hands of the IRS and the political powers-that-be. But, as Rob Williams, managing director of the Schwab Center for Financial Research says, current "tax rates are close to historical lows." Some economists and financial analysts predict that they are destined to rise in ensuing years. 

So it might be better to invest via a Roth 401(k) and take the tax hit now — especially if your retirement days are decades away. By going the Roth route, you know exactly what your tax liability will be now instead of hoping they stay low in the years to come.

Reasons to choose a traditional 401(k)

Here are three scenarios in which a retirement saver may want to choose the traditional 401(k) over the Roth option.

You're currently in your peak earning years.

If you expect your income to drop significantly in retirement, you'll probably want to stick to funding your traditional 401(k). "This is likely the case if you are in the peak of your career," with the capacity to earn and contribute the most, says Brandon Renfro, CFP® and retirement specialist.

By choosing a traditional 401(k) during these high-earning years, you get a tax deduction right now, when it'll benefit you the most. Then when you retire and you're in a lower tax bracket, you'll also owe the IRS less on your withdrawals.

You need to make withdrawals within 5 years of opening your 401(k)

Unlike a Roth IRA, a Roth 401(k) is actually less flexible when it comes to the timing of withdrawals than its traditional 401(k) counterpart.

You can begin making withdrawals from a traditional 401(k) penalty-free at age 59 ½. However, with a Roth 401(k), you'll need to wait at least five years from opening your account, regardless of how old you are, to avoid taxes and penalties (on earnings; you can withdraw your contribution amounts at any time). So if you open the account at age 58, you won't be able to make tax-free withdrawals until you reach age 63.

For twenty- and thirty-something workers, this won't be a concern. But if you're getting a late start on retirement savings or you've started working for a new employer near age 59½, you may want to stick with a traditional 401(k) to avoid this 5-year rule.

You can switch to a Roth 401(k)

Finally, "another advantage of a traditional 401(k) is that you can convert it into a Roth," says R.J Weiss, CFP® professional and founder of The Ways to Wealth.

This is an important benefit that is unique to traditional 401(k) contributions. You can't make a Roth contribution this year and then decide five years down the road to convert the contributions back to a pre-tax traditional 401(k).

But you can convert traditional 401(k) contributions to a Roth 401(k) at any time down the road, providing that you can pay the income taxes that will be due at the time. 

It's something to keep in mind if you think your tax strategy and financial situation might change. With this flexibility, you could wait to pay taxes on your 401(k) contributions until a below-average income year or after completing a move from a high income-tax state to one with lower tax rates.

Reasons to choose a Roth 401(k) 

Let's look at a few situations when you might be better off choosing a Roth 401(k).

Years of investing can overcome a higher tax bracket

When choosing between 401(k)s, Natalie Pine, CFP® professional at Briaud Financial Advisors, says, "We typically recommend that younger clients use Roth instead of traditional because their money grows tax-free for such a long time."

This is her recommendation even for a younger person who is currently in a high tax bracket. Why? "Because," she explains, "the tax-free growth usually overcomes the higher tax bracket over a long enough period of time."

You're looking to maximize other retirement benefits

Lowering your income taxes isn't the only way that a Roth 401(k) can save you money in retirement. 

For example, under current tax law, Roth distributions aren't included in the calculation for determining taxability of your Social Security benefits. And they also don't count as income in Medicare premium calculations.

You want to pass along tax-free money to your heirs

A Roth 401(k) can play a valuable role in your estate plan. With a traditional 401(k), your heirs will need to pay taxes on distributions just as you would. And, depending on your asset balance, this could generate a significant tax bill.

By choosing a Roth, you remove this tax burden for the loved ones who will inherit your 401(k). Plus, if you don't plan to use the funds yourself, you can roll a Roth 401(k) into a Roth IRA to get around the age 72 minimum distribution requirement.

The bottom line

When deciding between a Roth 401(k) and a traditional 401(k), many people look at it as an "either/or" decision. But, actually, "you can hedge your bets by doing both," Rob Williams says. "Most employers will allow you to choose which percentage goes into the Roth and which will go into the traditional."

If you'd rather not try to guess what your annual income or income tax rates will look like in the future, contributing to both types of 401(k)s in this way is the safest strategy. 

Otherwise, the younger you are, the more likely you are to benefit from contributing post-tax dollars to a Roth 401(k), regardless of your current tax bracket. But the pre-tax benefits of a traditional 401(k) could become more attractive as you age and your earning power increases.