With access to a Roth 401(k) becoming more and more common, I wanted to break down the differences between a Traditional vs Roth 401(k). Including the advantages of each and how to decide which 401(k) plan to choose.
I’m currently considering a Roth 401(k) myself and was surprised by how much nuance there is in making the decision between the common two 401(k) options.
Yes, a lot of things are the same (such as contribution limits). Though, there are some major differences (like when your money is taxed) and minor ones as well (for example, the withdrawal rules).
We’ll get into all of that below to help you easily make an informed decision on which 401(k) type is right for you.
Before diving in, I also wanted to introduce you to Blooom, a 401(k) robo-advisor. They offer a free “check-up” for you 401(k) and help to proactively identify problems and find optimizations. You can check them out here if interested in learning more.
Give Blooom’s free analysis a shot right now:
Traditionally, a 401(k) allowed workers to contribute pre-tax dollars to an investment account, watching their money compound and grow prior to having to pay taxes.
However, with the introduction of the Roth 401(k) in 2006, you can now contribute post-tax dollars and withdraw them without paying taxes when retirement time rolls around – similar to a Roth IRA.
Traditional vs Roth 401(k)
Having options is always a good thing, right?
I usually agree there, but more options typically result in more confusion. As is the case with 401(k)s.
At the end of the day, investing in any 401(k) is an amazing start – Roth or not. Though, if you want to make sure you’re maximizing your 401(k) and investing in the right type, you’ll find all the info you need to know below.
What’s the Same: Traditional vs Roth 401(k)
Let’s start with what the two accounts have in common – there are a lot of similarities:
Retirement accounts: As mentioned above, both are retirement savings accounts designed by the IRS to encourage people to invest and build their retirement savings.
Company Match: Both accounts could offer a company match. This does not mean they do, but neither one is restricted there. The only difference is that a company match for a Roth 401(k) still goes into a pre-tax account, or traditional 401(k).
Contribution Limit: The 401(k) contribution limit for both accounts in 2021 is $19,500 (same as 2020). If you are 50 or older, you can also add a catch-up contribution of $6,500 (making the total amount $26,000).
Withdrawal Age: Both accounts have a minimum withdrawal age of 59.5. You can get your money sooner (at least some of it), but there will be early withdrawal penalties and taxes to pay.
Required Minimum Distributions (RMD): Whether you invest in a traditional or Roth 401(k), you will be required to start withdrawing money at age 72 (if you were born after June 30, 1949).
What’s Different: Traditional vs Roth 401(k)
Here’s where things get interesting. Obviously these accounts are not created equal, and what’s different between them is what will help you decide which one is right for you.
The main difference, as you’ll see, is how the accounts are taxed (and not taxed).
Tax Treatment on Contributions
Traditional 401(k): Money is contributed pre-tax (before you pay your normal income taxes).
Roth 401(k): Money is contributed post-tax (after you pay your normal income taxes).
Tax Treatment on Withdrawals
Traditional 401(k): All of your money is taxed upon withdrawal (it is treated as regular income).
Roth 401(k): None of your money is taxed upon withdrawal, including your capital gains.
Income Taxes Today
Traditional 401(k): Contributing to a traditional 401(k) lowers your current taxable income, which could send you into a lower tax bracket and have other benefits (lowering your MAGI – more on this later).
Roth 401(k): Contributing to a Roth account does not lower your current taxable income (you still pay income taxes as usual), but it does lower your income in retirement, which could have tax benefits down the road (while keeping income in a higher tax bracket today).
Traditional 401(k): You cannot withdraw money before age 59.5 without paying penalties and taxes.
Roth 401(k): You also cannot withdraw money before age 59.5 without paying penalties and taxes. However, the slight difference with a Roth 401(k) is that you also need to have the account open for at least five years to avoid any fees. So, if you open an account at age 58, you cannot freely start withdrawing money at age 59.5 without consequences.
How to Choose Between a Traditional vs Roth 401(k)
If you know what your tax situation will be when you retire, then the answer is easy. Choose a Traditional 401(k) if your taxes will be lower in retirement, and a Roth 401(k) if your taxes will be higher in retirement.
The problem is… none of us really know what our tax situation will be in retirement (to be honest, most of us probably barely know our current tax situation). Even if we did, Uncle Sam could choose to change the tax laws in 20 years (or 1 year), which could change your financial situation.
That is why the most common advice out there is to invest in both. Hedge your bets, so to speak.
That way, you’re not overexposing yourself to one of the tax benefits. You’re building tax diversification and no matter which way your taxes swing as you near retirement, you’ll be balanced.
You can invest in both 401(k) accounts pretty easily in a number of ways, including:
- Switching off every year between investing in a Roth 401(k) vs Traditional 401(k)
- Switch off investing halfway through the year
- Switch off investing every month
A Quick Example
To help bring the Traditional vs Roth 401(k) decision to life, below is a quick example with the following assumptions:
- Time Horizon: 30 Years
- Annual Income: $80,000
- Annual Spending/Expenses: $30,000
- 401(k) Contributions: $19,500
- Total Income Tax Rate (Federal, State, etc.): 30%
- *Income tax bracket and amount remains unchanged over the time horizon
- Market Return: 7%
- Capital Gains Tax Rate: 15%
The image below shows how the total investment portfolio would grow over time. The “other” investment column in both scenarios is the leftover money after all spending and contributions (assuming this goes into a regular brokerage account).
There are a couple of notable conclusions:
- The Roth 401(k) scenario edges out the Traditional 401(k) scenario by about $50,000 or 2%
- Even though you have less leftover money every year to invest in a personal account with the Roth 401(k) example, you still net out ahead because you can withdraw all of your Roth money tax-free
Yes, this is a very simple example with a lot of things held constant for 30 years (which is notably unrealistic). In addition, you most likely wouldn’t withdraw your money in one lump sum when retirement comes. Though, it does help illustrate the differences between these two 401(k) accounts.
You can also easily see how if your taxes were lower in retirement, say 20%, then the traditional 401(k) scenario would be better. You’d be paying only $368,000 in ordinary income taxes, rather than $552,000.
Other Things to Consider:
MAGI and IRA Eligibility Today: Investing in a traditional 401(k) lowers your modified adjusted gross income (MAGI), which is the metric used to determine if you are eligible to contribute to individual retirement accounts (IRAs). For high earners bumping up against IRA income limits, this could be a determining factor.
Tax Implications Tomorrow: As mentioned, no one knows what the tax code will look like in the future. Though, having some estimation of your future situation could help swing your decision.
Availability: If your company isn’t offering a Roth 401(k) option, then obviously the decision is made for you.
Company Match: Most companies will offer an employer match in both types of accounts (assuming they offer a match). However, if the employer offers a match only in one, then it’s likely wise to choose that account so that you can maximize the company match.
Fund Availability: Hopefully the fund availability is the same in both accounts, but it’s worth checking to make sure you have low-cost funds available in both accounts.
IRA Strategy: If you take a split approach, you should also consider what other tax-advantaged accounts you are investing in. Both a Traditional IRA and Roth IRA are other investment accounts that have similar differences to a Traditional 401(k) vs a Roth 401(k).
401(k) Strategy: How Much Should I Invest, and in What?
Now that you have decided between a Traditional vs Roth 401(k) and which to put money in, it’s time to actually start investing in them!
How Much to Invest in Your 401(k)
The max contribution limit for your 401(k) in 2021 is $19,500. This guide can help you determine if you should be maxing out your 401(k), or potentially investing less:
What to Invest in Within Your 401(k)
Within your 401(k), you’ll like have the option to invest in a variety of investment vehicles, including:
- Equity Index Funds and Mutual Funds
- Bond Index Funds and Mutual Funds
- International Index Funds and Mutual Funds
- Company Stock
- Target Date Funds
One of the most important things to remember is to check the fees of any investment. The lower, the better.
Plus, you could also utilize Blooom, a 401(k) robo-advisor, to help invest within your 401(k).
To start, they offer a free “check-up” for you 401(k) and help to proactively identify problems and propose optimizations. You can check them out here if interested in learning more about their free check-up and ongoing 401(k) management.
Give Blooom’s free analysis a shot right now:
Summary: Traditional vs Roth 401(k)
At the end of the day, having a retirement plan and investing in either type of 401(k) is a great first step to preparing for the future. There is no need to stress out about which one is better for you, but choosing the right account could earn you some extra money down the line.
Just remember, at a high level, a Roth 401(k) rewards you later (with no taxes on eligible withdrawals) and a Traditional 401(k) rewards you now (with no taxes on contributions).