How to Decide: Traditional 401(k) or Roth 401(k)?
Many employer-sponsored retirement plans now offer a Roth 401(k) in addition to a Traditional 401(k). Use our calculator to find out which is a better fit for you.
Understand the differences between a Traditional and Roth 401(k) so that you can save on taxes either now or later.
Contributions to a Traditional 401(k) are made on a pre-tax basis, so you’ll pay taxes when you start to withdraw in retirement.
Roth 401(k) contributions are made with after-tax dollars, which means you won’t have to pay more taxes on this money later in life.
You may have previously associated Roth accounts only in the context of IRAs (Individual Retirement Accounts), but with more employers offering a Roth option as part of a 401(k) plan, it’s important to understand the differences between a Traditional 401(k) and Roth 401(k).
Participating in your employer’s 401(k) plan is already a big step toward achieving your retirement goals. Now, the question to ask is whether you should contribute to a Traditional 401(k) or a Roth 401(k).
Which type of 401(k) should you choose? The answer depends on your personal situation and your retirement goals. We developed a calculator to help you decide. Get started below.
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Traditional and Roth 401(k)s: What’s the Difference?
In an effort to encourage us to save for retirement, the government created 401(k) accounts, as well as 403(b), 457, and Thrift Savings Plan (TSP) accounts for government and non-profit employees.
When you contribute part of your income to these accounts, you benefit from special tax advantages that you wouldn’t receive from investing in just a taxable account. These employer plans include features such as allowing employers to match your contributions up to a certain amount, and giving employees the ability to make either pre-tax (Traditional) or after-tax (Roth) contributions. The distinction between a Traditional and Roth 401(k) is similar to that of Traditional and Roth IRAs. Here are the key differences:
- Traditional 401(k): Contributions made with pre-tax dollars are deductible contributions. They are not counted as income, and they will lower your tax bill come April. When you contribute pre-tax dollars, you are allowing your assets to grow tax-deferred, meaning you will not have to pay taxes on the investment activity in the account, but you will be responsible for the taxes when you withdraw. By the time you retire and begin to pull money out of your account, every dollar withdrawn (including the growth) is taxable as ordinary income.
- Roth 401(k): Roth contributions are the opposite of pre-tax contributions. Contributions are made with after-tax dollars. While this option may not have been widely available in the past, many retirement plans now offer it. Unlike a Roth IRA, a Roth 401(k) does not have any income limits, so all employees can choose this account type regardless of their income level. When you contribute to these accounts, you won’t receive a tax break, but all growth and qualified future withdrawals are tax-free. Because you already paid taxes on your contributions, you won’t be taxed on this money again when you withdraw it in the future.
Should I Pay Taxes Now or Later?
The answer depends on many variables, including your current tax bracket and which tax bracket you expect to be in during retirement.
For example, if you foresee your income and earnings climbing in the future, either due to job promotions, higher income as a result of an advanced degree, or a more financially rewarding career ahead, then you may fall into a higher tax bracket later. If this is the case, we would recommend making after-tax contributions into a Roth account.
If you foresee your income decreasing, for example if you are planning on retiring, taking some time off, or leaving the workforce, then you will likely fall into a lower tax bracket in the future. If this is the case, you may be better suited to make pre-tax contributions into a Traditional account.
As a general rule:
- If your current tax bracket is higher than your expected tax bracket in retirement, then consider contributing pre-tax dollars into a Traditional account.
- If your current tax bracket is the same or lower than your expected tax bracket in retirement, then consider contributing after-tax dollars into a Roth account.
The calculator above can help you estimate and choose the option that is more favorable for your personal situation, depending on when and how you wish to pay taxes on your 401(k) contributions. This strategy is called tax arbitrage. By picking the most beneficial type of retirement contributions, you can have more control over your tax situation.
What Else Should I Consider?
Taxes are not the only factor you should consider when deciding between Traditional and Roth 401(k)s, or between funding an IRA and a 401(k). Many other factors can affect the overall growth of your retirement accounts, such as employer matches, fees, and contribution limits.
For example, let’s say you have both a Traditional 401(k) and Roth 401(k) option at your job. If taxes were your only concern, you may choose a Traditional 401(k). But, if your 401(k) has high fees and no employer match, you may have been better off opening and contributing to a Roth IRA instead.
Many employers offer to match your contributions up to a percentage of your salary. This means that your company will add additional money to your account as a way of encouraging you to contribute to your plan. In most cases, you won’t want to pass up the opportunity to receive free money.
Fees can be a huge drag on your retirement savings. If your 401(k) has particularly high fees, this can reduce or even eliminate the savings you would get from the tax benefits.
Contribution limits can vary between account type and age, and these limits periodically get adjusted for inflation. For 2019, employees can contribute up to $19,000 in their 401(k). Employees over 50 can contribute an additional $6,000 of catch up contributions, bringing their 401(k) contribution limit to $25,000.
IRAs are another option for retirement savings, and can be used instead of—or even in conjunction with—your 401(k). Using both in an efficient way can help ensure you are optimizing every dollar you save towards retirement. Tax rules for IRAs vary depending on your income level, but our calculator will take that into account for you.
We hope this calculator provides a starting point for your decision on which type of 401(k) you should be funding. Within a Betterment account, we can provide additional advice regarding which accounts you should consider funding and in what order. You can even sync up your 401(k)s and other accounts to see an overall picture of your finances. Get started or log in to complete your retirement plan and see personalized savings advice.
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