Roth or Traditional 401(k): Which Should I Choose?

Saving for retirement can put you on the path to true financial independence. 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. Should you contribute to a traditional 401(k) or a Roth 401(k)?

You can decide which option makes more sense for you if you understand the differences between a traditional and a Roth 401(k) and identify the contribution limits. You may even be able to reduce your total lifetime income taxes.

What's the Difference Between a Roth and Traditional 401(k)?

Contributions

Traditional 401(k) plans are funded with pre-tax dollars. This money hasn't yet been taxed.

Contributions made to a Roth 401(k) are made with after-tax dollars, or dollars that have already been taxed.

The maximum that you can annually contribute to a Roth 401(k) is the same as it is for a traditional 401(k). You can contribute up to $20,500 to a 401(k) for 2022, including pre-tax and designated Roth contributions, if you are age 49 or younger. The limit is $22,500 for 2023.

You can contribute an additional $7,500 in catch-up contributions in 2023 if you're age 50 or older. This is up from $6,500 in 2022.

Withdrawals

A big part of choosing between a Roth or traditional 401(k) involves deciding whether it makes sense for you to receive the tax savings now or later.

Saving to a traditional 401(k) plan helps to reduce your taxable income now because you're only taxed on the income that remains after you make your contributions. But you'll have to pay taxes on the contributions and investment earnings when you start taking money out in retirement.

The income tax breaks come later with a Roth 401(k). You can make tax-free withdrawals of contributions and earnings during retirement, provided that the distributions are qualified. You must have held the account for at least five years and the distributions must be made after you reach age 59½ (or earlier if you have a disability) for the distributions to be considered qualified.

Employer Match

Both a Roth 401(k) and a traditional 401(k) allow you to receive employer matches. An employer match is treated the same as a pre-tax contribution whether you put it into a Roth or a traditional plan. Matching funds and the investment growth of these funds will be taxed as ordinary income when you begin taking distributions at retirement.

Special Considerations

It's 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, but the Roth IRA contribution limit is significantly lower than that of the Roth 401(k). It's $6,500 for 2023. You can contribute an additional $1,000 in either year if you're age 50 or older.

Roth IRAs are additionally subject to income limitations. Single individuals with modified adjusted gross incomes (MAGIs) of $153,000 or more are ineligible to contribute to a Roth IRA in 2023, as are couples filing jointly with a MAGI of $228,000 or more.

Unlike with a Roth IRA, 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.

Which Is Right for You?

First check whether your employer offers a Roth 401(k) because this account only took effect in 2006 and it isn’t offered by all firms. But approximately half of all plan sponsors do offer a Roth option. Assess whether the Roth account provides similar features as the traditional 401(k), such as automatic enrollment, if you have a Roth 401(k) available.

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, so consider contributing at least as much as necessary to maximize your 401(k) match. Your employer is allowed to make matching contributions even if you elect to participate in a Roth 401(k), but the company match must be made to the designated Roth 401(k) plan.

Will Lowering Your Income Qualify You for Tax Breaks?

The simple act of reducing your adjusted gross income (AGI) can make you eligible for tax credits and other tax breaks in some cases.

For example, the Retirement Savings Contribution Credit, also known as the Saver's Credit, isn't available if your AGI is above $73,000 as a married couple filing jointly in 2023. It's $54,750 if you qualify for the head of household filing status, and $36,500 for all other filers. These thresholds are up from $68,000, $51,000 and $34,000 respectively in 2022.

Contributing to a traditional 401(k) reduces your taxable income, so 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 versus traditional 401(k) decision-making process seem complicated. But it all comes down to whether you want to pay taxes now by contributing to a Roth or when you withdraw the money because you've contributed to a traditional 401(k). Deciding on the better option for you requires a little retirement planning to determine when you think you'll be in a higher marginal tax bracket.

The Roth option is appealing if you're in the early stages of your career and are currently in a lower income tax bracket. You can lock in known income tax rates today that could be lower than your future income tax bracket during retirement at a time when you'll need your savings.

But it likely makes more sense to take the tax breaks today with a pre-tax traditional 401(k) contribution if you're in your peak earning years and nearing retirement. You might find yourself in a lower tax bracket during retirement than immediately before leaving the workforce, depending on whether you have other assets or income sources and how much taxable income they provide.

Is Your Income Likely To Increase?

Seriously consider your future earnings potential when making the Roth vs. traditional 401(k) decision. You may want to stick with pre-tax 401(k) contributions if you're at or near your peak earning years right now. But you may see your income tax bracket increase if you anticipate your income increasing. That could bump you into a higher tax bracket and would make the Roth option more appealing.

Will You Work During Your Retirement?

You might not see any big changes in your income tax bracket if you plan on working into traditional retirement years. The result might be that you remain in the same tax bracket. You'll usually see equal benefits with a Roth 401(k) compared to a traditional 401(k) if your tax bracket is the same at retirement. But consider keeping some money in a Roth account to avoid having your income creep into a higher marginal tax bracket.

Most retirees in the U.S. end up with an income replacement rate during retirement that's lower than their income while working. But the Roth 401(k) could make more sense if you think your income will be higher in retirement because you won't owe taxes on qualified Roth 401(k) distributions.

Will Tax Rates Be Higher When You Retire?

Consider going with a Roth 401(k) if you're worried about higher taxes across the board as a result of the political and economic landscape, But keep in mind that it doesn’t necessarily mean your tax rate will be significantly higher just because income tax rates may increase.

The Bottom Line

The Roth vs. traditional 401(k) decision is more complicated than it seems on the surface. Choosing the better account type for you depends on a variety of factors, such as your expectations about future income tax rates and how much tax diversification you seek.

And it doesn't always have to be an either/or decision. There are certain situations when it would make sense to contribute to both a traditional 401(k) and a Roth 401(k) plan, such as when your pre-retirement and retirement tax brackets are the same.

Frequently Asked Questions (FAQs)