Saving for retirement can put you on the path to true financial independence. With rising concerns about the solvency of Social Security beyond 2037 and the savings burden placed on individuals, choosing to participate in an employer-sponsored 401(k) plan can have a positive impact on your future retirement preparedness. But you have another critical decision to make after choosing how much to contribute to the plan: whether to contribute to a traditional 401(k) or a Roth 401(k).
If you understand the differences between a traditional and a Roth 401(k) and identify the contribution limits, you can decide which option makes sense for you. You may even potentially reduce your total lifetime income taxes.
What's the Difference Between a Roth and Traditional 401(k)?
|Roth 401(k)||Traditional 401(k)|
|Contributions||Made with after-tax dollars||Made with pre-tax dollars|
|Withdrawals||No tax on qualified withdrawals||Taxed as ordinary income in retirement|
|Employer match||Considered pre-tax contribution||Considered pre-tax contribution|
Traditional 401(k) plans are funded with pre-tax dollars, which are dollars that have not yet been taxed.
Contributions made to a Roth 401(k) are after-tax dollars, or dollars that have already been taxed.
How much you can annually contribute to a Roth 401(k) is the same as it is for a traditional 401(k). In 2021, you can contribute up to $19,500 to a 401(k), including pre-tax and designated Roth contributions.
If you are age 50 or older, you can contribute an additional $6,500 in catch-up contributions. These figures remain unchanged from 2020.
You can contribute to both a Roth 401(k) and a traditional 401(k) as long as your combined contributions do not exceed the annual 401(k) contribution limits.
Choosing whether it makes sense for you to receive the tax savings now or later is a big part of deciding between a Roth or traditional 401(k).
Traditional 401(k) plans help lower your taxes now, because you are only taxed on the income that remains after you make your contributions. However, you will have to pay taxes on the contributions and investment earnings when you start taking money out in retirement.
With a Roth 401(k), on the other hand, the income tax breaks come later. You can make tax-free withdrawals of contributions and earnings in the account during retirement provided that the distributions are qualified. For distributions to be qualified, you must have the account for at least five years and the distributions must be made after you reach age 59 1/2 (or earlier if you have a disability).
Both a Roth 401(k) and a traditional 401(k) allow you to receive an employer match. An employer match is treated as a pre-tax contribution, whether you put it into a Roth or a traditional plan. This means that matching funds and the investment growth of these funds will be taxed as ordinary income when you begin taking distributions at retirement.
Not all employers provide matches, and some employers might provide matching contributions to a traditional 401(k), but not a Roth 401(k).
It is also important to note the similarities and differences between a Roth 401(k) and a Roth Individual Retirement Arrangement (IRA). Roth 401(k) accounts and Roth IRAs both offer tax-free withdrawals of contributions and earnings for qualified distributions. However, the Roth IRA contribution limit is significantly lower than the Roth 401(k) limit: $6,000 in 2020 and 2021, or $7,000 if you're age 50 or older.
Moreover, Roth IRAs are subject to income limitations. For example, in 2020, single individuals with a modified adjusted gross income (MAGI) of $139,000 or more are ineligible to contribute to a Roth IRA, as are couples filing jointly with a MAGI of $206,000 or more. In 2021, single filers with a MAGI of $140,000 or more are unable to contribute, as are married couples filing jointly with a MAGI of $208,000 or more.
Unlike Roth IRAs, your ability to contribute to a traditional or Roth 401(k) is not affected by your income because 401(k) plans are not subject to income limitations.
A first-time home purchase counts as a qualified distribution for a Roth IRA.
Which Is Right for You?
First, check whether your employer offers a Roth 401(k); this account only took effect in 2006 and isn’t offered by all firms. Approximately half of all plan sponsors now offer a Roth option. If you have a Roth 401(k) available, assess whether the Roth account provides similar features as the traditional 401(k), such as automatic enrollment.
Also, understand how your company's matching contributions work (if your employer offers a match). Many employers give you an incentive to participate in a 401(k) plan by matching your contributions; consider contributing at least as much as needed to maximize your 401(k) match. If you have a company-provided match, your employer is allowed to make matching contributions even if you elect to participate in a Roth 401(k).
However, the company match must be made to the designated Roth 401(k) plan.
Some employers offer an after-tax 401(k) contribution option, but this can differ significantly from a Roth 401(k) and shouldn’t be confused with a Roth 401(k).
Will Lowering Your Income Qualify You for Tax Breaks?
In many cases, the simple act of reducing your adjusted gross income (AGI) can make you eligible for tax credits and other tax breaks. For example, the Retirement Savings Contribution Credit, also known as the Saver's Credit, is not available if your AGI is above $65,000 as a married couple filing jointly in 2020 ($66,000 in 2021), $48,750 as the head of the household ($49,500 in 2021), and $32,500 for all other filers ($33,000 in 2021).
Since contributing to a traditional 401(k) lowers your taxable income, it can help you get a larger tax credit if your income is slightly above these limits. Paying attention to your adjusted gross income and lowering it when possible can also make you eligible for a Roth IRA or fully tax-deductible contributions to a traditional IRA.
Do You Want to Pay Taxes Now or Later?
Trying to navigate the complicated income tax code in the U.S. can make the Roth vs. traditional 401(k) decision-making process seem complicated. But it all comes down to whether you want to pay taxes now (Roth) or at the time you withdraw the money (traditional). Deciding on the best option for you requires a little retirement planning to determine when you think you will be in the highest marginal tax bracket.
If you are in the early stages of your career and are currently in a lower income tax bracket, the Roth option is appealing. You can lock in known income tax rates today that could be lower than your future income tax bracket during retirement when you will need your retirement savings.
However, if you are in your peak earning years and nearing retirement, it likely makes more sense to take the tax breaks today with a pre-tax traditional 401(k) contribution. As a result, you will benefit from paying income taxes at a lower tax bracket during retirement rather than during your high-income years immediately before leaving the workforce.
Is Your Income Likely to Increase?
Seriously consider your future earnings potential when making the Roth vs. traditional 401(k) decision. If you are at or near your peak earning years right now, you may want to stick with pre-tax 401(k) contributions. But if you anticipate your income increasing, you will likely see your income tax bracket increase. This could bump you into a higher tax bracket and would, therefore, make the Roth option more appealing.
Will You Work During Your Retirement?
You may not see any big changes in your income tax bracket if you plan on working into traditional retirement years. The result of this might be that you remain in the same tax bracket. Usually, if your tax bracket is the same at retirement, you will see equal benefits with a Roth 401(k) compared to a traditional 401(k). But consider keeping some money in a Roth account to avoid seeing your income taxes creep into a higher marginal tax bracket.
Similarly, most retirees in the U.S. end up with an income-replacement rate during retirement that is lower than their income while working. But if you think your income will be higher in retirement, the Roth 401(k) could make more sense because you won't owe taxes on qualified Roth 401(k) distributions.
Will Tax Rates Be Higher When You Retire?
If you're worried about higher taxes across the board as a result of the current political and economic landscape, consider going with a Roth 401(k). But keep in mind that just because income tax rates may increase, that doesn’t necessarily mean your tax rate will be significantly higher.
The Bottom Line
The Roth vs. traditional 401(k) decision is more complicated than it seems. Choosing the best account for you depends on a variety of factors, such as your expectations about future income tax rates and how much tax diversification you are seeking.
However, it doesn't always have to be an either-or. There are certain situations, such as when your pre-retirement and retirement tax brackets are the same, where it makes sense to contribute to both a traditional 401(k) and a Roth 401(k) plan.