Do you have a 401(k) with both a Roth and traditional option? Do you ever wonder which you should choose to contribute to and why? How do you even know if you’re allowed to choose both? In this blog, we are going to cover Roth 401(k) vs traditional 401(k). We will explain both the similarities and differences between Roth and traditional 401(k) and when you might want to choose each option.
What is a 401(k)?
A 401(k) is a type of retirement plan that is offered through an employer. It allows for employee deferrals, meaning money comes out of the employee paycheck and goes straight into the 401(k) account. Many 401(k)s also offer matching contributions in which an employer matches, up to a certain limit, the amount of money the employee puts in. This match is often in the form of a percentage of salary.
For example, if your employer offers a 401(k) with a 100% match up to 3% of salary, this means if you put 3% of your salary into your 401(k), your employer will add that same amount out of their pocket into your 401(k). If your employer offers a 50% match up to 7%, this means you need to put in a full 7% of your salary to receive the full match of 3.5% from the employer (50% of 7).
Some employers do flat contributions, in which they add a set amount to the account and the employee doesn’t need to add money to receive it. However your employer does their contributions, it is important to ensure you are getting the maximum amount of “free” money offered to you by contributing at least the amount needed to receive the match.
Roth 401(k) vs Traditional 401(k)
Now that you have the 401(k) basics down, let’s get into Roth 401(k) vs traditional 401(k). Your employer may offer both options for you, and you can decide how to save your money. The biggest difference between a traditional 401(k) and a Roth 401(k) is how the money that you contribute is taxed. Let’s go through a couple of examples.
What is a traditional 401(k)?
A traditional 401(k) is a retirement account that grows tax-deferred. This means the money is taken from your paycheck before income taxes are withheld, so when it is added to the account, no taxes have been paid on it yet. The money will grow in that account tax-deferred, and you will pay taxes on both the growth and contributions at the time of withdrawal. This lowers your taxable income currently but creates taxable money in retirement.
For example, If your salary is $100,000 and you contribute 10% of your salary to a traditional 401(k), then you get a $10,000 tax deduction. So in your W-2, instead of your total wages appearing as $100,000, they will appear as $90,000 since you contributed $10,000 to your traditional 401(k). This means that your taxable income will be lower and your taxes will be lower. However, when you retire and withdraw that money, every dollar that you withdraw from that traditional 401(k), you have to pay federal taxes (and maybe state taxes).
What is a Roth 401(k)?
A Roth 401(k) is a retirement account that grows tax-free. By choosing Roth, you are choosing to pay income tax on the Roth 401(k) contributions now. Your money then grows in that account until retirement, and the growth comes out completely tax-free when you make qualified withdrawals. This keeps your tax bill today the same but lowers your tax bill in retirement.
With the Roth 401(k), you don’t get any tax deductions upfront. However, when you retire and withdraw all of that money that you’ve accumulated, you pay $0 in taxes. Let me illustrate to you the potential power of a Roth 401(k). Let’s say you contribute $10,000 each year to a Roth 401(k) for a total of 30 years and you made an average of 7% return per year. At the end of 30 years, you’ve accumulated close to $1,000,000 and all of that is tax-free.
One thing to keep in mind is that regardless of which type of contribution you decide to make, employer contributions to your retirement account will always be traditional. This is because no taxes have been paid on that money when it gets added.
Who is eligible for a Roth 401(k)?
This is where Roth 401(k)s can be a great tool to have in your financial toolbox. Anyone can contribute to a Roth 401(k), regardless of income, if the employer offers Roth as an option. There are no income restrictions to be eligible to contribute to a Roth 401(k).
Can you do both a Roth 401(k) and a Traditional 401(k)?
You can contribute to both a Roth 401(k) and a traditional 401(k) at the same time. There are limits to these accounts though, and those limits are aggregate. You can’t max out both a Roth 401(k) and a traditional 401(k). The yearly maximum limit is combined between both accounts.
Roth 401(k) and Traditional 401(k) Contribution Limits 2023
The contribution limit for Roth 401(k) and traditional 401(k) for 2023 is the same. You can defer $22,500 out of your paycheck into a traditional 401(k) if you are under age 50, and $30,000 per year if you are 50 or older. Alternatively, you can contribute $22,500 to your Roth account if you are under 50, and $30,000 if you are 50 or older.
Remember though, you can’t max out both. The combined contribution limit for both accounts for 2023 is $22,500. As long as the total amount of contributions between these two types of accounts does not exceed $22,500 (or $30,000), you are able to have both types. For example, if you are under 50 and you contribute $15,000 into your Roth account, this leaves $7,500 that you can contribute to your traditional 401(k).
Note: Employer matching or flat contributions do not count against these limits. The limits above are for employee contributions only.
Make sure you don’t make these 401(k) mistakes!
Roth vs Traditional 401(k): Early Withdrawals
The IRS allows favorable tax treatment in retirement accounts to incentivize people to save for retirement. The IRS also imposes rules on when you can access this money without penalty to dissuade people from using their retirement savings before retirement. The age the IRS allows withdrawals from most retirement accounts is 59.5. Prior to that, without specific circumstances, the IRS imposes certain penalties and taxes on early withdrawals.
Early withdrawal rules of traditional 401(k)s differ slightly from early withdrawals of Roth 401(k)s. None of the money in a traditional account has ever been taxed, so when it comes out, regular income taxes must be paid. In addition to the regular income taxes, an early withdrawal penalty generally applies, this penalty is 10% of the unqualified withdrawal. That’s a large chunk to hand over to the IRS before even seeing your money!
With a Roth 401(k), the money you have put in has already been taxed, so that amount won’t be taxed again. Early withdrawals from a Roth 401(k) are pro-rated though. A portion of your early withdrawal will be a tax-free return of contributions, and the other portion will be an early withdrawal of the growth, which will incur regular income tax with an unqualified withdrawal. Early withdrawals from a Roth 401(k) may also be subject to the 10% tax penalty unless there are specified circumstances.
Click here to see the IRS penalty exceptions.
Roth 401(k) vs 401(k): Access
For a traditional 401(k), you can start receiving distributions at age 59 ½. There are no other rules for receiving your money. For a Roth 401(k), you can start withdrawing money without penalty at 59 ½ as long as you’ve had the account for at least five years. This won’t make a difference for people who are a while away from retirement, but if you are approaching 59 ½ then it’s important to be aware of this rule.
401(k) vs Roth 401(k): Required Minimum Distributions (RMDs)
At the moment, Roth 401(k)s and traditional 401(k) are subject to the required minimum distribution (RMD). Therefore, the account owner must start taking RMDs from her Roth 401(k) for the year in which she reaches age 70½ and continue for every year thereafter.
However, starting in 2024, RMDs will no longer be required for Roth 401(k) accounts. This change is part of the SECURE 2.0 Act of 2022. No RMDs for Roth 401(k)s means that you can leave the money in the account and let it grow tax-free.
What are the similarities between a Roth 401(k) and a traditional 401(k)?
- Automatic contributions: Your contributions are automatically taken from your paycheck.
- Company match: Both plans usually include a company match which basically means free money from your employer.
- Contribution limits. Both types of 401(k)s have the same contribution limits. In 2023, you can save up to $22,500 per year (or $30,000 if you’re over 50) in your account. This is a huge benefit of 401(k)s compared to IRAs which have a contribution limit of $6,500 per year.
How do I choose between a Roth 401(k) or a traditional 401(k)?
Regardless of what your tax bracket is now, it may be a good idea to have both Roth 401(k) and traditional 401(k) in your retirement portfolio for tax diversification reasons. This will allow you to strategically withdraw traditional 401(k) money in retirement to allow you to pay taxes in the lower brackets and then supplement your income with the tax-free Roth 401(k) money. If your employer matches your contributions, you already have traditional retirement money in your account. You may want to consider adding at least some Roth 401(k) funds so you have options in retirement.
My friend Lee messaged me the other day and asked for some advice about deciding between a Roth 401(k) or a traditional 401(k). She said that her colleagues were telling her to do a pre-tax 401(k) while her friend Alan was telling her she should do a Roth 401(k). If you’re struggling with the same question, you’re not alone.
The general rule of thumb is if you think you will be in a higher tax bracket in retirement than you are today, choose Roth 401(k). By choosing Roth, you are paying taxes at your current tax rate, and avoiding them at your higher retirement tax rate. If you think you are currently in a higher tax bracket than you will be in retirement, traditional 401(k) may be the way to go. This way, you get a tax deduction now while you are in a high bracket, and pay taxes later while in a lower one.
It’s not always easy to figure out which tax bracket you’ll be in once you retire. Tax rates can change in the future and we have no way of knowing how they will change. One thing to keep in mind is that the Tax Cuts and Jobs Act is going to expire in 2025. This means that starting from 2026 onward, our tax brackets are going to increase.
We also can’t see into the future to know exactly what our retirement income needs will be and we can only estimate based on the information we have today. You may want to think about the lifestyle that you would like when you retire. Do you want to travel a lot? If yes, then you will probably withdraw a lot of money and this may end up putting you in a higher tax bracket. Or, do you want to buy a vacation home and just hang out there? If yes, then you may be in a lower tax bracket. These are all things for you to consider.
If I open a Roth 401(k), do I still get employer matching?
Yes, if your employer does employer matching then you will still get employer matching. However, it doesn’t go to your Roth 401(k), it goes to your traditional 401(k).
Can I have a Roth 401(k) or traditional 401(k) if I am self-employed?
If you’re self-employed, you can create your own Roth solo 401k. If you want to know more, check out the solo 401(k) versus SEP IRA blog and another on tax-free investing for YouTubers.
Should you split contributions between traditional and Roth 401(k)s?
Splitting contributions between a traditional and Roth 401(k) may make sense for some people. It would mean that some of your money in retirement would be tax-free and some you would need to pay taxes on. It may make more sense to contribute to a Roth 401(k) if you’re currently in a low-tax bracket, and a traditional 401(k) if you’re in a high-tax bracket. It’s important to consult a financial advisor to help you decide if split contributions would be beneficial for your situation.
Should I roll over my traditional 401(k) to a Roth 401(k)?
It’s best to consult a financial advisor as it really depends on your unique situation. It’s important to keep in mind that if you do roll over your traditional 401(k) to a Roth 401(k), then you will need to pay taxes on it now. If you are converting a large amount of money, then it could bump you into a higher tax bracket which means a bigger tax bill.
Is Roth 401(k) better than a traditional 401(k)?
There are many decisions to be made when it comes to retirement savings and planning. How you invest your money, choosing Roth 401(k) or traditional 401(k), and how much to save, are the most important decisions to be made to have a successful retirement. Having a fee-only financial planner who can assist you in making these decisions can help you rest assured knowing you’re on the right track. If you are interested in having a comprehensive financial plan, schedule a free discovery call with one of our fee-only financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.
