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Both Roth 401(k)s and traditional 401(k)s are employer-sponsored retirement accounts that have their own sets of benefits for investors. The biggest difference between the two is when you pay taxes on the money you contribute to the account.
Traditional 401(k)s are tax-deferred accounts, which means you fund your account with pretax dollars and pay taxes on your distributions in retirement. Roth 401(k)s are funded with post-tax money, and you don't pay any taxes on your distributions in retirement. Here's more on what that means and how Roth 401(k)s and 401(k)s compare to one another.
What Is a 401(k)?
A traditional 401(k) is a type of workplace retirement savings plan. Many employers offer 401(k)s to their employees, and some also offer to match a portion of employee contributions.
Apart from the huge benefit of a potential employer match, a main advantage of investing through a traditional 401(k) is it reduces your taxable income while you contribute to it. That allows you to defer taxes until you withdraw money in retirement, when your income is likely significantly lower than during your working years. If you withdraw funds early (before age 59½ in most cases), however, you'll typically have to pay a 10% early distribution penalty.
What Is a Roth 401(k)?
A Roth 401(k) is a type of employer-sponsored retirement account that you fund with after-tax money. Your money grows in the account tax-free, and you won't have to pay taxes on withdrawals in retirement.
As is the case with a traditional 401(k), if you withdraw funds from your Roth 401(k) before age 59½, you could have to pay a 10% penalty. On top of that, with a Roth 401(k), you need to own the account for at least five years to take qualified distributions.
With a Roth 401(k), there's an added incentive not to withdraw your funds early: On top of the 10% penalty, taking non-qualified distributions from a Roth 401(k) can also result in being taxed on a portion of your earnings.
Roth 401(k) vs. Traditional 401(k)
To decide which type of retirement account is right for you, be sure you understand the key differences and similarities between the two.
Similarities Between Roth 401(k) and 401(k)
- Employer sponsored: Both traditional and Roth 401(k)s are employer-sponsored, which means an individual investor can't open and use one on their own. Solo 401(k)s and Roth IRAs are options for those who don't have access to either plan through work.
- No income limit to participate: Neither of these types of 401(k)s put a cap on how much you can make and still participate in the plan.
- Annual contribution limits: Contributions to both 401(k)s are the same: For 2023, you can contribute up to $22,500 (and an additional $7,500 in catch-up contributions if you're 50 or older). The limit applies to all your 401(k) contributions, meaning the total you contribute to any type of 401(k) account can't exceed it.
- Automatic saving: Both of these types of 401(k)s pull your contributions directly from your paycheck, so you won't have to worry about setting aside funds on your own. This makes saving consistently easier to achieve.
Differences Between Roth 401(k) and 401(k)
- Taxes on contributions: With a traditional 401(k), your contributions are tax-deferred and reduce your adjusted gross income during your working years. On the other hand, contributions to a Roth 401(k) are made after-tax and don't decrease your current adjusted gross income.
- Taxes on distributions: With a traditional 401(k), money you withdraw in retirement is taxed as income. With a Roth 401(k), you'll pay no taxes on your contributions or earnings when you take qualified distributions.
- Employer matches: While employers can offer to match your contributions to both types of 401(k)s, per IRS requirements, matching funds on a Roth 401(k) must go into a traditional 401(k) account and are pretax.
- Rules for penalty-free withdrawals: While the IRS assesses a 10% early withdrawal penalty for both types of accounts, Roth 401(k)s include an additional caveat: You need to own the account for at least five years to take penalty-free withdrawals. Plus, early withdrawals also incur taxes on a prorated amount of earnings in the account.
- Required minimum distributions: Required minimum distributions were eliminated for Roth 401(k)s starting in April 2024. That means that if you save in a Roth 401(k), you won't be required to begin taking money out at a specific time. In contrast, a traditional 401(k) requires you to begin taking required minimum distributions at age 73. (This was raised from age 72 in previous years).
Is It Better to Invest in a Roth 401(k) or a Traditional 401(k)?
Traditional 401(k)s and Roth 401(k)s have different benefits and downsides, and picking the right type of savings plan for you comes down to when you want to pay taxes on your money. Here are a couple things to consider.
First, investing in a 401(k) allows you to defer taxes now. If you think your income level and tax rate will be lower in retirement, that could mean paying less taxes on your savings by putting them off until you take distributions.
On the other hand, investing in a Roth 401(k) means paying taxes now, and protecting yourself from the potential of being taxed at a higher rate if you earn more throughout your career and end up with a higher taxable income level in retirement. This gives you more certainty about your retirement income, because what you have saved is what you get with a Roth 401(k).
Can I Contribute to Both a Roth 401(k) and a Traditional 401(k)?
Yes, if your employer offers both a traditional 401(k) and a Roth 401(k), you can contribute to both types of savings plans. Contributing to Roth 401(k) and traditional 401(k) can help you accomplish tax diversification, which is where you invest in retirement accounts with different tax rules to lower your overall tax obligation.
- Tax-deferred retirement accounts like 401(k)s and individual retirement accounts (IRAs) allow you to lower your taxable income now and pay taxes based on your income bracket in retirement.
- After-tax retirement accounts like Roth 401(k)s and Roth IRAs require you to contribute with after-tax funds, but your earnings grow tax-free and you don't pay taxes on distributions in retirement.
- Fully taxed retirement accounts are taxable, general investment accounts where you buy assets such as stocks, bonds, index and mutual funds through a brokerage. While they're fully taxed, you can use techniques like loss harvesting to fit these into a larger tax diversification strategy.
Each of these types of accounts can play a part in your larger retirement plan.
The Bottom Line
When it comes to choosing between a Roth 401(k) and a traditional 401(k), start with what's available to you. Not all employers offer a Roth 401(k), though many do. If you have a traditional 401(k) through work but not a Roth 401(k), you could contribute enough of your income to the 401(k) to exhaust any employer match available to you. After that, you could explore the benefits of a Roth IRA.
If you need help going over your retirement investing options, consider reaching out to a financial advisor. A financial advisor can help you create a plan for retirement based on your particular financial situation. For example, an advisor can help you weigh the benefits of a traditional 401(k) against a Roth 401(k) to make the right choice for you.