Roth vs. traditional 401(k) deferrals: Similarities, differences, and examples

We believe that opening and contributing to a 401(k) is almost always a good idea. Not only can a 401(k) provide tax advantages, but your employer may match your contributions. However, as you’re signing up for your account, you may notice two contribution types available: A traditional pre-tax deferral or a Roth (post-tax) deferral. 

So, what are the differences between the two? Can you choose both? And how should you decide? This article will break down the deferral types, and help you decide what’s best for you (it could be both!). First, let’s start by defining the two deferral types:

• Traditional 401(k) deferrals (pre-tax): All 401(k) plans must allow eligible employees to contribute deferrals from their paychecks on a pre-tax basis. These contributions are made to your 401(k) account before federal and state taxes are taken out. Contributions are often set at a percentage of an individual’s salary but can be a predetermined dollar or percentage if your plan allows. Pre-tax deferrals delay income tax until distribution, meaning you pay taxes on the deferral and earnings when your funds are withdrawn. 

• Roth 401(k) deferrals (post-tax): Many (but not all) 401(k) plans also allow participants to contribute Roth deferrals. Rather than paying taxes on the contribution at the point of withdrawal, contributions are made on an after-tax basis (also known as a post-tax deduction). This means the total amount you contribute is deducted after federal and state taxes have been taken out. Because you already paid taxes on your Roth deferral, it’s not subject to income taxation when withdrawn, but earnings on your Roth contributions may be subject to taxes if you do not meet certain requirements, described further below.

Three questions to ask 

Three questions can help guide if you should contribute traditional (pre-tax) or Roth (post-tax) deferrals to your 401(k) account. We’ll explore each in more depth, but here are some rough guidelines to help guide your thinking:

1. Will I be in a higher tax bracket today, or when I retire?

• Today (generally, high earners and older workers): Consider a traditional 401(k)

• When I retire (generally, low earners and younger people): Consider a Roth 401(k)

2. Is there a chance I’ll need to withdraw before age 59 ½?

• Yes: Consider a Roth 401(k)

• No: Consider a Traditional 401(k)

3. Is there a time (before retirement) when I’ll be making less than I am now?

• Yes: Consider a Traditional 401(k)

• No: Consider a Roth 401(k)

Roth (post-tax) vs. traditional (pre-tax) deferrals 

The main difference between Roth (post-tax) vs. traditional (pre-tax) deferrals is the way they’re taxed. Let’s review some additional similarities and differences.

Similarities between Roth and pre-tax deferrals

• Employers can match contributions: Some companies offer to match the funds employees put into their retirement accounts, which offers tax advantages for both employees and employers.

• They are subject to the same contribution limit: You can contribute up to $23,000 to your 401(k) in total between both Roth and pretax deferrals in 2024, or up to $30,500 if you’re 50 or older (compared to $7,000 for individual retirement accounts (IRAs)).

• You aren’t stuck with just one option: You can switch your contributions between a Roth deferral and a traditional deferral, and may even be able to contribute to both simultaneously if your employer offers both (more on this below).

• 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!). (Withdrawals are subject to plan document provisions.)

Differences between Roth and pre-tax deferrals

• You don’t pay taxes on your deferrals when funds are withdrawn during retirement—and you won’t have to pay taxes on distributions of Roth contributions during retirement. However, earnings on deferrals may or may not be taxable depending on certain requirements.

• You must qualify for tax-free Roth deferrals, meaning tax-free withdrawals on earnings only occur if you’re older than 59 ½ and after a minimum of five years since you made your first Roth contribution.

• Roth deferrals are excluded from required minimum distributions (RMDs) starting in 2024.

• Individuals who make more than $145,000 in taxable income in the prior year may only make catch-up contributions on a Roth basis. SECURE 2.0 passed on December 29, 2022, and added this significant change to catch-up contributions, which will go into effect no later than January 1, 2026.

How to decide between Roth and pre-tax deferrals

Let’s talk about the differences between accounts, which will help you shape your decision. The three key factors—tax advantages, withdrawals, and rollovers—can help determine which may be beneficial for you to choose.

1. Tax advantages: Will you be in a higher tax bracket today, or when you retire?

As we’ve reviewed, one of the most important distinguishing factors between Roth and pre-tax deferrals is when the money is taxed.

• Traditional pre-tax 401(k) contributions are made before taxes. You can deduct your contributions from your current income, and you’ll be taxed on the money you withdraw upon retirement.

• Roth post-tax 401(k) contributions are made after taxes. Your deductions won’t impact this year’s tax returns, but you’ll get to withdraw them tax-free on retirement.

You may want to consider traditional pre-tax 401(k) contributions if…

• You’re a high earner whose tax bracket is probably higher than it will be when you retire.

• You plan to be in a lower tax bracket by reducing your total taxable income through 401(k) contributions.

Example: 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) deferrals: 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) deferrals: 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 may seem obvious that paying an extra $4,000 in taxes today (Roth) is better than paying $15,000 at retirement (traditional). But keep in mind that the $4,000 you save today could grow thanks to the power of compound interest. However, it is important to note that investing is subject to risk, including risk of loss. Past performance is not indicative of future results. 

You may want to consider Roth post-tax 401(k) contributions if…

• You’re a moderate to low-income earner or just starting your career and are most likely in the lowest tax bracket of your working years. According to Fidelity data from 2022, a Roth 401(k) option is most popular among participants aged 20 to 34, and those who make between $75,000 and $199,000.

Example: Now, say that your income today is $30,000 for a 10% tax rate, and assume the same contribution and withdrawal conditions.*

• Traditional 401(k) deferrals: 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) deferrals: 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 could grow thanks to the power of compound interest. However, it is important to note that investing is subject to risk, including risk of loss. Past performance is not indicative of future results. In this case, you may be 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) may be more attractive.*

Note: In both these examples, earnings may be taxable if withdrawals occur before a minimum of five years since your first Roth contribution and you are under age 59 ½.

2. Is there a chance you’ll need to withdraw before age 59 ½ and five years of deposits?

Qualified withdrawals are tax-free with Roth options. To be considered qualified, the Roth withdrawals must occur after a minimum of five years since you made your first Roth contribution and you are over age 59 1/2. If you make an unqualified withdrawal—a withdrawal before age 59½ and/or before five years have passed since your first contribution—you must pay income tax on earnings. 

Note: Pre-tax withdrawals are taxed on the full amount when distributed regardless of age and length of contribution deposit.

In addition to your withdrawal being subject to income taxes, you may also be hit with a 10% early withdrawal penalty based on the total distribution. To discourage you from prematurely pulling out money from your 401(k), the IRS assesses this tax penalty for withdrawing funds before age 59 ½, but there are circumstances you can withdraw penalty-free before this age.

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 withdrawal before age 59 ½.

• Traditional pre-tax deferrals: Since you pay income taxes on the full amount, the entire $4,000 withdrawal is subject to income tax and a$400 penalty.

• Roth post-tax deferrals: The $4,000 distribution is made up of a $1,000 contribution and $3,000 in earnings. In this case, the distribution is unqualified; therefore you would only pay income tax on the earnings of  $3,000, though you would still pay $400 in penalties.

How do Roth deferrals work with employer match?

Regardless of whether you choose pre-tax or post-tax deferrals, employer contributions made pre-tax (employer match and profit sharing) are taxed when you withdraw. If you make pre-tax deferrals, both your own and your employer’s contributions will go into your 401(k) account, pre-tax, and those funds will be taxed when you withdraw. 

Even if you choose Roth post-tax deferrals, employer contributions are most likely still made as pre-tax contributions. When you make a withdrawal, your Roth post-tax deferrals won’t be taxed, but any employer match funds made as pre-tax contributions account will.

3. Rollovers: Is there a time (before retirement) when you’ll be making less than you are now?

After separating from your employer, you can roll over your 401(k) account to another qualified retirement plan, be it a new employer-sponsored savings plan or IRA, as long as the new plan accepts the funds.

If you roll over pre-tax 401(k) funds to a Roth 401(k) or Roth IRA, you’ll pay income taxes on the amount you transfer, but you may not pay taxes on withdrawals once you retire (if it's a qualified withdrawal). With a traditional 401(k), you have the flexibility to decide when you’ll pay taxes on the money. (Note: If you roll over to a Roth IRA, it won’t be subject to required minimum distributions, which are required from 401(k) plans and traditional IRAs starting at age 73.)

There are no income restrictions on 401(k) deferrals. One of the advantages of a Roth 401(k) (vs. a Roth IRA) is there are no income restrictions. Roth IRAs prohibit contributions if your modified adjusted gross income (MAGI) is above $153,000 or $228,000 for married filing jointly. There are no such restrictions on 401(k) deferrals.

Moving pre-tax funds to Roth

If you’re a holder of a pretax 401(k) account and believe you would benefit from switching pre-tax to post-tax Roth funds, your plan may offer the option of converting your assets. The Small Business Jobs Act of September 2010 enabled savers to convert non-Roth balances in tax-qualified retirement plans into Roth balances, as long as their employers offered the option. Prior to this Act, the only option for retirement savers was to take a distribution and put those funds into a Roth IRA. 

Consult your plan administrator to determine if you have the option to convert to a Roth account and learn about the applicable costs. Remember that there are costs to convert to Roth, so time your conversion with a tax year chock full of deductions to offset those costs.

Roth accounts can be more restrictive

You can roll over your account only into another Roth account, including 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, taking time out of the workforce while parenting, 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 foresee leaving the workforce before retirement, even if it’s temporary, you may want to contribute to a 401(k) account with the intent of rolling over when you aren’t drawing a salary.

Can you make pre-tax and post-tax contributions to a 401(k)? 

• Yes, you can make pre-tax and post-tax contributions to a 401(k) if your employer offers both and allows both deductions simultaneously. 

• If you make both contribution types, the annual contribution limit for both types of deferrals combined is still $23,000 in 2024 (and $30,500 if you’re age 50+).

Generally, traditional pre-tax deferrals are more common, as post-tax deferrals are less likely to be offered. However, making both may allow you to adjust to the changes in your future tax obligations. Ask your employer if they offer a Roth deferral option or for more information to help you decide.