The 401(k) is the preferred financial vehicle for building a nest egg for retirement: Not only does it offer tax advantages, but some employers match their employees’ contributions. If you’re starting a new job, opening and contributing to a 401(k) is almost always a good idea. But should you put your money into a traditional 401(k), as nearly nine in ten do, or opt for a Roth 401(k)? We’ll break down the differences between the two, and help you decide which retirement account is best for you.
The short answer
Three questions should guide whether you contribute to a Roth or traditional 401(k). We’ll explore each in more depth, but if you’re looking for a quick-and-dirty answer, here it is:
Will I be in a higher tax bracket today, or when I retire?
- Today (generally, high earners and older workers): Traditional 401(k)
- When I retire (generally, low earners and younger people): Roth 401(k)
Is there a chance I’ll need to withdraw before age 59 ½?
- Yes: Roth 401(k)
- No: Traditional 401(k)
Is there a time (before retirement) when I’ll be making less than I am now?
- Yes: Traditional 401(k)
- No: Roth 401(k)
Additionally, it’s important to note that generally, traditional 401(k)s are much more commonly used because Roth 401(k)s are less likely to be offered -- if you’re not sure which options you have through your current 401(k) provider, be sure to ask specifically whether you can contribute to a traditional or a Roth 401(k), or possibly both.
Similarities between Roth and traditional 401(k)s
First, let’s go over how Roth and traditional 401(k)s are alike.
- They’re employer-sponsored. Not every company offers a 401(k), and you can’t open one on your own - that’s what an IRA is for.
- Employers can match contributions. Some companies even offer to match the funds employees put into their retirement accounts, which offers tax advantages for both employee and employer.
- Investments grow tax-free. You’ll pay income taxes either when you contribute or withdraw, but you won’t be paying annual capital gains taxes.
- Contributions are limited. You can contribute up to $18,500 to your 401(k) a year, or up to $24,500 if you’re 50 or older. (Your 401(k) contributions won’t count towards IRA limits, though.)
- You aren’t stuck with just one option. You can switch your contributions between Roth and traditional 401(k)’s, and even contribute simultaneously. Keep in mind that the contribution limit applies to the total amount, regardless of account type.
- There are no income restrictions. Roth IRAs prohibit contributions if your taxable income is above $120,000 ($177,000 for married-filing-jointly). There are no such restrictions on either Roth or traditional 401(k)s.
- Penalty-free withdrawals start at age 59 ½ or with a qualifying event. You can start withdrawing from your 401(k) upon disability, death, hardship, or reaching age 59 1/2. It’s possible to take out a loan up to 50% of the account balance, up to $50,000 (though we recommend avoiding this if possible!).
Now, let’s talk about the differences between accounts. The three key factors - tax advantages, qualified withdrawals and rollovers - will determine which is right for you. We’ll explore each in detail.
Tax advantages: Will I be in a higher tax bracket today, or when I retire?
The most important distinguishing factor between Roth and traditional 401(k)’s is when the money is taxed. Traditional 401(k) contributions are pre-tax, meaning that you can deduct your contributions from your current income, and you’ll be taxed on the money you withdraw upon retirement. Roth 401(k) contributions are after-tax, so your deductions won’t impact this year’s tax returns, but you’ll get to withdraw them tax-free on retirement. We’ll walk through a few examples in a minute, but here’s a quick-and-dirty answer:
A traditional 401(k) is best if:
- You’re a high earner whose tax bracket is probably higher than it will be when you retire.
- Reducing your taxable income by the amount of your contribution would put you in a lower tax bracket.
A Roth 401(k) is best if:
- You’re a low earner whose tax bracket will probably be lower when you retire.
- You think that policy changes will make tax rates overall much higher when you retire - for example, you predict that the same income taxed at 20% today will be taxed at 40% when it’s time for you to retire.
Generally speaking, a Roth 401(k) is best for low-income and young people, who are likely in the lowest tax bracket of their careers. According to a 2014 Aon Hewitt survey, workers age 20-29 have the highest rates of participation in Roth 401(k)’s.
Example: high earner today
Say your annual income is $100,000, your effective tax rate is 40%, and you contribute $10,000 to your 401(k). Let’s also say that in 40 years, you retire and withdraw $60,000 from your account, putting you in a 25% tax bracket.
- Traditional 401(k): Your $10,000 contribution lowers your taxable income to $90,000, so you pay $36,000 in taxes this year. (For simplicity’s sake, we’re assuming that you’ll still be in the same tax bracket). Then, when you retire, you pay 25% in taxes on $60,000, for a total of $15,000 in taxes.
- Roth 401(k): Your $10,000 contribution is after-tax, so you pay 40% taxes on the full $100,000 for a tax bill of $40,000 this year. When you retire, you withdraw tax-free, so you don’t pay any taxes on the $60,000.
It seems obvious that paying an extra $4,000 in taxes today (Roth) is much better than paying $15,000 at retirement (traditional). But keep in mind that the $4,000 you save today would grow to nearly $60,000 in 40 years, assuming a 7% annual return. That’s well worth paying $15,000 in taxes. In this case, a traditional 401(k) is the better option.
Example: low earner today
Now, say that your income today is $30,000 for a 10% tax rate. Assuming the same contribution and withdrawal conditions:
- Traditional 401(k): Your contribution lowers your taxable income to $20,000, for a $2,000 tax bill today. When you retire, your tax bill is still $15,000.
- Roth 401(k): Your $30,000 taxable income means you pay $3,000 in taxes this year, and your withdrawal is tax-free.
If you invest the $1,000 you save with a traditional 401(k), that money would grow to $14,970 once you retire - less than you’d pay in taxes. In this case, you’re better off with a Roth 401(k). Plus, this example assumes that you’d invest all of your tax savings from a traditional 401(k), which isn’t an option for many lower-income earners. If you spend that money instead, a Roth 401(k) looks even more attractive.
Qualified withdrawals: Is there a chance I’ll need to withdraw before age 59 ½?
The government wants to discourage you from prematurely pulling out money from your 401(k), and therefore levies some tax penalties to people who withdraw before they're actually of retirement age. There are some circumstances when you can withdraw penalty-free before you turn 59 ½:
- Higher education expenses
- First-time homebuyers
- Certain medical expenses
- Other exceptions
As we mentioned above, qualified withdrawals are tax-free with Roth accounts, and subject to ordinary income taxes with traditional accounts. (Quick note: Roth withdrawals are only tax-free as long as five years have passed since you made your first contribution.)
It’s possible to make an unqualified withdrawal, that is, a withdrawal before age 59 ½ that’s not on the list of exceptions. No matter whether you have a traditional or Roth 401(k), you have to pay income tax on the withdrawal, plus a 10% early distribution penalty. However, traditional withdrawals are taxed on the full amount, whereas Roth withdrawals only tax the earnings.
That’s a bit abstract, so here’s an example. Let’s say you contribute $1,000 to your 401(k) account, which grows to $4,000 over time. You then make a $4,000 unqualified withdrawal.
- Traditional 401(k): Since you pay income taxes on the full amount, the entire $4,000 withdrawal is subject to income tax in addition to the $400 penalty.
- Roth 401(k): The $4,000 distribution is made up of a $1,000 contribution and $3,000 in earnings. In this case, you pay income tax on only $3,000, though you still pay $400 in penalties.
Hopefully, you will never have to make an early, unqualified withdrawal from your 401(k) and you can let the money grow in your account until you retire. However, life happens and if you want the flexibility of being able to withdraw without as steep a tax penalty, a Roth 401(k) may be a better fit for you.
How does Roth vs. traditional work with employer matches?
Regardless of whether you choose a Roth or traditional 401(k), employer contributions, which are typically given through matches, are taxed when you withdraw. If you have a traditional 401(k), both your own and your employer’s contributions will go into the same account, pre-tax, and all of those funds will be taxed when you withdraw. If you have a Roth 401(k), employer contributions will go into a separate traditional 401(k), whereas your own contributions will be in the post-tax Roth account. When you withdraw, the funds in the Roth 401(k) account won’t be taxed, but the funds in the traditional 401(k) account will.
Rollovers: Is there a time (before retirement) when I’ll be making less than I am now?
After separating from your employer, you can roll over a traditional 401(k) to another qualified retirement plan, another traditional 401(k), Roth 401(k), IRA, or Roth IRA, as long as the new plan accepts the funds. If you roll over a traditional 401(k) to a Roth 401(k) or Roth IRA, you’ll pay income taxes on the amount you transfer, though you won’t pay taxes on withdrawals once you retire. Essentially, with a traditional 401(k), you have the flexibility to decide when you’ll pay taxes on the money.
Roth 401(k)’s are more restrictive: You can roll over your account only into another Roth account - a Roth 401(k), Roth 403(b), or Roth IRA. A Roth locks you into paying taxes only when you contribute.
Why is this important? There are many scenarios when you might be in a lower tax bracket than you are today, even before your retirement - for example, getting a graduate degree, becoming a homemaker, or taking an unpaid sabbatical. If you roll over all or part of your traditional 401(k) during that time, you’ll pay income tax on the rollover amount plus your wages for that year. If you time your rollover right, you may pay very little or even escape taxes altogether.
If you foresee leaving the workforce before retirement, even if it’s temporary, you may want to open a traditional 401(k) with the intent of rolling over when you aren’t drawing a salary.
In sum, Roth and traditional 401(k) accounts have similarities and differences. Depending on your current and future tax bracket, need for early distributions, and desire to roll over accounts, one type of retirement account may be more beneficial than the other. Still, contributing to both a Roth and traditional 401(k) may allow you to adjust to the changes in your future tax obligations.