Roth 401(k) vs. Traditional 401(k): Understanding the Differences

Saving for retirement is a crucial aspect of financial planning, and employer-sponsored retirement plans, such as the 401(k), offer a valuable opportunity to build a nest egg for your future. When participating in a 401(k) plan, a major decision, if your employer offers it, is whether to contribute to a Roth 401(k) or a Traditional 401(k).

The key difference has to do with taxes. A Roth 401(k) is a post-tax retirement savings account. That means your contributions have already been taxed before they go into your Roth account. In retirement, distributions from the Roth 401(k) are largely tax free. On the other hand, a Traditional 401(k) is a pretax savings account, meaning your contributions go in before they’re taxed making your taxable income lower. However, in retirement distributions from the Traditional 401(k) are taxable as ordinary income. Once you consider when you want your investments to be taxed, you can decide which option is right for you and your retirement savings strategy.

Roth 401(k) Basics

The Roth 401(k) was introduced in 2006 and combines features from the traditional 401(k) and a Roth IRA. If your employer offers a Roth 401(k), you can make after-tax contributions that grow to be tax free if withdrawn after age 59 ½, upon disability, or because of the owner’s death. Prior to 2023, the employer match or profit-sharing contributions are funded into the traditional 401(k) and subject to tax at distribution. However, the SECURE 2.0 Act allows employees to elect Roth treatment of the employer contributions starting in 2023. This causes those employer dollars to be taxable immediately to the employee but those amounts, and all growth can be withdrawn tax free in retirement. Key features of the Roth 401(K) include:

1. Tax Treatment:
   • Contributions: Roth 401(k) contributions are made after taxes have been taken, meaning you don’t get an immediate tax deduction for your contributions.
   • Withdrawals: Qualified withdrawals, including both contributions and earnings, are tax-free in retirement. You will, however, pay federal (and possibly state) income tax on withdrawals of company contributions that were made on a pre-tax basis and the associated growth of those funds.
2. Income Limits:
   • Unlike Roth IRAs, Roth 401(k)s do not have income limitations. This makes them accessible to high-income earners who might be restricted from contributing to a Roth IRA.
3. Required Minimum Distributions (RMDs):
   • Beginning in 2024, the SECURE 2.0 Act has removed mandatory distributions from designated Roth accounts, such as the Roth 401(k) during the account owner’s lifetime. This provides more flexibility in managing retirement income.

Traditional 401(k) Basics

The Traditional 401(k) has been a staple retirement savings vehicle for many years. Key features of the Traditional 401(k) include:

1. Tax Treatment:
   • Contributions: Traditional 401(k) contributions are made with pre-tax dollars, which reduces your taxable income for the year in which you make the contribution.
   • Withdrawals: Withdrawals in retirement are subject to ordinary income tax. Most state income taxes apply too.
2. Income Limits:
   • There are no income restrictions for participating in a Traditional 401(k). This makes a Traditional 401(k) accessible to individuals across all income levels.
3. Required Minimum Distributions (RMDs):
   • Traditional 401(k) account holders are required to take RMDs starting at age 73 (as of 2024). These distributions are subject to income tax.

When deciding between a Roth 401(k) and a Traditional 401(k), several factors should be considered to find which better aligns with your goals for retirement.

1. Current and Future Tax Situation:
   • If you anticipate being in a higher tax bracket in retirement, a Roth 401(k) might be more advantageous. Conversely, if you expect to be in a lower tax bracket during retirement, a Traditional 401(k) may provide more tax savings.
2. Immediate Tax Benefits:
   • If you need an immediate reduction in your taxable income, a Traditional 401(k) can provide that benefit through pre-tax contributions. Roth 401(k) contributions do not offer an upfront tax deduction.
   • This can be especially valuable if the 401(k) deduction pushes your taxable income low enough to preserve another deduction or credit that you are phased out of receiving.
3. Long-Term Growth and Withdrawal Strategy:
   • Consider your investment horizon and whether you prefer tax-free withdrawals in retirement (Roth) or the upfront tax benefits with taxable withdrawals (Traditional).
4. Flexibility and RMDs:
   • Roth 401(k)s offer more flexibility with no mandatory RMDs, allowing for strategic withdrawals in retirement. Traditional 401(k)s, on the other hand, have RMDs that must be taken starting at a certain age.

Choosing between a Roth 401(k) and a Traditional 401(k) involves weighing the current and future tax implications, considering your retirement income needs, and understanding the nuances of each option. It’s often beneficial to diversify your retirement savings by utilizing both types of accounts if your employer provides the option. Ultimately, consulting with a financial advisor can help you tailor a retirement savings strategy that aligns with your unique financial goals and circumstances. Contact one of our advisors to learn more.