The basic difference between a Roth vs Traditional 401(k) is tax treatment for contributions and withdrawals. Roth 401(k)s are appropriate for investors who want tax-free withdrawals in exchange for paying taxes on contributions. Traditional 401(k)s are preferable for investors seeking upfront benefits from tax-deductible contributions and who pay taxes on withdrawals instead.
Roth 401(k) vs Traditional 401(k) Comparison
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|Employer Matching Contribution Limit (Tax-Deductible for Employer)|
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In many respects, Roth and Traditional 401(k) accounts are very similar. Both offer the same investment options allowed within a 401(k) plan. They both allow for employer matching and profit-sharing that are discretionary for the employer, as well as tax-free growth once contributions are in an account.
The biggest difference between a Roth vs Traditional 401(k) is that contributions to Traditional 401(k)s are tax deductible, offering investors an upfront tax benefit, while Roth 401(k) contributions are taxed, but holders can withdraw their funds tax-free during retirement, delaying their tax benefit.
While Traditional 401(k) contributions are tax deductible, withdrawals are taxed as ordinary income when they’re taken. Roth 401(k) contributions are not tax deductible and withdrawals taken during retirement are not taxed as income.
“When deciding between a Roth 401(k) and a Traditional 401(k), there is no one-size-fits-all answer. Instead, the right answer for you will depend on your current tax situation and whether your tax rate is likely to be higher or lower in retirement.” – Gerri Walsh, Senior Vice President for Investor Education, FINRA
Gerri went on to say that “you won’t have to pay taxes on Roth 401(k) withdrawals, as long as you wait until you are at least 59½ years old and you meet the IRS’ five-year rule. That means the higher your tax bracket is in retirement, the more advantageous a Roth is likely to be. Strong savers—including those who contribute the maximum amount allowed by the IRS each year—are good Roth candidates because they are likely to have a bigger nest egg in retirement that can benefit from Roth’s tax-free withdrawals.
On the other hand, if you are in a low tax bracket today, you might consider a Roth now, when a lowering of your gross income will not be as significant a tax benefit as it might be later on, if you find yourself in a higher bracket.”
When to Use a Roth 401(k)
A Roth 401(k) is good for business owners, high-earners, and tax-conscious investors who want their potential income tax liability during retirement and are willing to forego benefits of tax-deductible contributions. This is because, unlike Traditional 401(k) contributions, contributions to a Roth 401(k) are not tax deductible. However, the account still grows tax-free over time.
Some cases when it’s especially beneficial to use a Roth 401(k) include:
- Investors who frequently maximize 401(k) contributions – Once you regularly maximize your 401(k) contributions, you should think about putting some of your contributions in a Roth 401(k) so that not all of your withdrawals during retirement will be taxed as income.
- 401(k) participants with outside investments – If you have balances in 401(k)s or IRAs outside of work, you can put new contributions in a Roth 401(k) to lower your tax burden during retirement.
- Trust beneficiaries – If you stand to inherit money outside retirement plans or other assets and are willing to forego the upfront benefit of tax-deductible contributions, you can reduce your long-term tax liability by using a Roth 401(k).
For more information on how Roth 401(k)s work, their contribution limits and specific rules, be sure to check out our ultimate guide to Roth 401(k)s.
When to Use a Traditional 401(k)
A Traditional 401(k) gives participants the upfront tax benefit of tax-deductible contributions. Their account then grows tax-free, but when they start making withdrawals, those distributions are taxed as income. Most participants should be making sizable contributions to a Traditional 401(k) before they consider using some of their contributions for a Roth 401(k).
Some cases when it’s particularly beneficial to use a Traditional 401(k) include:
- Younger or inexperienced investors – If you’re new to investing or are still learning about retirement plan contributions, you may benefit more from investing in a straightforward, Traditional 401(k).
- Tax refund maximizers – Although Roth 401(k)s allow for tax-free withdrawals after age 59½, Traditional 401(k)s offer tax-deductible contributions that increase your short-term tax benefit.
- Those who think tax rates will decline in the future – If you think that tax rates during retirement will be lower than they are now, you may get more benefit by deducting your contributions from taxable income today and paying taxes when you withdraw money in retirement.
To get more information on the costs and benefits of traditional 401(k) plans, check out our list of the Best 401(k) Companies.
When to Diversify with Both a Roth 401(k) vs Traditional 401(k)
Investors can diversify between a Roth 401(k) vs Traditional 401(k) by splitting their $18,500 in allowable contributions between different accounts. Using both a Traditional vs Roth 401(k), investors build savings to be withdrawn tax-free in retirement while also getting some upfront tax deductions that make it easier to maximize 401(k) contributions.
Cases where it’s best to diversify using a Roth 401(k) vs Traditional 401(k) include:
- You’re unsure of your future tax rate – If you’re not sure whether your tax rate during retirement will be higher or lower than it is today, you can hedge your bets by splitting contributions in both a Traditional and Roth 401(k).
- You want some tax deduction now and some tax-free withdrawals – Using both Traditional and Roth 401(k)s, you can get some tax deduction today but also allow yourself to build an account that you can withdraw money from tax-free in retirement.
- You’re accumulating a large Traditional 401(k) balance but still want some tax deductions – If you’re starting to build a large balance in a tax-deferred Traditional 401(k) and want to start shifting contributions to a Roth 401(k), you can keep using some of your contributions in a Traditional account to continue getting some upfront tax benefit.
“If you know you’re going to be in a higher tax bracket when you retire (i.e., someone younger or a low earner right now), then it could make sense to participate in the Roth 401(k) today. If you’re a high earner today, a Traditional 401(k) may make the most sense, as you won’t get taxed on it now while in a high tax bracket.” – Nick Ferdon, Sales Manager, Human Interest
How a Traditional 401(k) Works
A Traditional 401(k) is a typical 401(k) plan in which participants can make contributions that are tax deductible. Their account then grows tax-free, but distributions taken during retirement are taxed as income. If you withdraw money from a 401(k) before age 59½, you’ll be assessed early withdrawal penalties in addition to income taxes.
In both a Roth and Traditional 401(k) plan, employers can match employee contributions with contributions that are tax deductible to the employer. Employers may also provide pre-tax profit-sharing contributions in good years, but these contributions are discretionary for employers.
Once participants in Traditional 401(k) plans have made contributions, they have a list of potential investment options they can select online or through their plan-approved advisor. Typical 401(k) investment options usually include mutual funds and ETFs, although they may also include stocks or bonds if the plan offers a brokerage option.
How a Roth 401(k) Works
A Roth 401(k) works just like a Traditional 401(k) except that a Roth 401(k) allows plan participants to put some or all of their contributions in an after-tax account that doesn’t offer an upfront tax-deduction. Instead, using a Roth 401(k), they can grow their account and withdraw funds tax-free during retirement.
Whatever investment options are available in a Traditional 401(k) will also be available to those participants who elect to use a Roth 401(k) account for some or all of their contributions. Employers who provide matching or profit-sharing contributions can also do so for those employees who use a Roth 401(k) instead of, or in addition to, a Traditional 401(k).
Participants in 401(k) plans that have a Roth 401(k) can use some or all of their contributions for a Roth account rather than traditional tax-deferred savings. Lastly, like Traditional 401(k)s, Roth 401(k) account holders must also meet required minimum distributions (RMDs) starting at age 70½—unless they aren’t still working or a 5 percent owner of the company.
Roth 401(k) vs Traditional 401(k) Contributions
401(k) plan participants can contribute up to $18,500 between Traditional and Roth 401(k)s (plus $6,000 in catch-up contributions if they’re over 50). If your plan includes a Roth 401(k), it’s your decision how to divide contributions between tax-deductible Traditional 401(k) contributions vs Roth 401(k) contributions that aren’t tax deductible.
Dividing Roth vs Traditional 401(k) Contributions
Roth 401(k) Example
If a 401(k) participant contributes $100,000 to a Roth 401(k) over the course of 20 years from the time they’re 30 until the time they’re 50, they would have paid taxes on all $100,000 of those contributions at their ordinary income tax rate as they invested—probably $17,000 to $40,000.
Over the 20 years that employee was making contributions and afterwards, their account would fluctuate in value without any tax consequences. Hopefully by the time they retire, their account would be worth several hundred thousand dollars—let’s say $300,000, and they would not have owed any taxes on those gains.
After age 59½, but definitely starting at 70½ if they haven’t already, the employee would start taking distributions from their Roth 401(k). However, at no point would any taxes be owed on their $300,000 in distributions—that is unless they withdraw money before age 59½, in which case a 10 percent early withdrawal penalty would be assessed.
Traditional 401(k) Example
Using the same example of a 401(k) participant who contributes $100,000, this time to a Traditional 401(k), that participant would have gotten to deduct that $100,000 from their taxable income over the 20 years they were contributing to a Traditional 401(k), meaning they wouldn’t have paid taxes on that $100,000.
Also like a Roth 401(k), a Traditional 401(k) account would fluctuate over the time they were contributing and afterwards. Again, any gains in their account would also be tax deferred—meaning they would not need to pay taxes on gains as they go.
After age 59½, an employee would begin withdrawing from their Traditional 401(k) account. Unlike a Roth 401(k), Traditional 401(k) withdrawals would be taxable as ordinary income at the account holder’s tax rate at the time. An investor would likely pay between $45,000 and $75,000 in taxes on $300,000 in Traditional 401(k) withdrawals over the course of their retirement.
Diversified 401(k) Example
Let’s continue with our example of a plan participant who contributes $100,000 over 20 years, but this time assume that they split their contributions 50/50 in a Roth 401(k) vs Traditional 401(k). This investor would probably pay between $8,000 and $20,000 in taxes on the Roth portion of their contributions upfront.
However, this investor would also have gotten to deduct $50,000 from their taxable income over the course of those 20 years. In both their Roth vs Traditional 401(k) accounts, contributions would have grown tax-free until they start taking withdrawals.
Then, when they got to retirement, they would have a balance (again, let’s say $300,000) spread between Roth and Traditional 401(k) accounts. Assuming that half of their $300,000 was in a Traditional 401(k) and half was in a Roth, they’d likely pay about $22,000 to $38,000 in taxes during their retirement.
Traditional vs Roth 401(k) Alternatives for Small Business
While 401(k) plans offer flexibility for plan participants, they can also be costly. Whether or not a 401(k) plan includes a Roth 401(k), plans have administration costs and other fees that make them expensive for businesses with fewer than a dozen employees. In many cases, one of several alternatives may work better.
Some Roth vs Traditional 401(k) alternatives include:
- SIMPLE IRA – A SIMPLE IRA is very similar to a Traditional 401(k), with almost none of the administration costs. However, SIMPLE IRAs also have minimum requirements for employer-matching.
- Traditional IRA – A Traditional IRA is a simple, cost-effective retirement account that can be set up by anyone—it’s not tied to an employer. Using a Traditional IRA, you can contribute up to $5,500 per year (plus $1,000 catch-up contribution if you’re over 50).
- Roth IRA – A Roth 401(k) is like a Traditional IRA except that you must meet Roth IRA income limits to contribute. Contributions also aren’t tax deductible, but grow tax-free and withdrawals are tax-free during retirement.
- SEP IRA – A SEP IRA is ideal for small business owners who have few or no employees. SEPs have the same high contribution limits as 401(k)s and contributions are tax deductible. However, in order to use a SEP, an employer must fund contributions for every employee proportional to contributions the employer puts in their own account based on annual compensation
Roth vs Traditional 401(k) Frequently Asked Questions (FAQs)
If you still have questions about a Roth 401(k) vs Traditional 401(k) after reading this article, here are some frequently asked questions. If you don’t see an answer to your question, feel free to join the discussion in the comments below or visit the Fit Small Business Forum and post your question there.
Do Roth 401(k)s Have Income Limits?
Unlike Roth IRAs, Roth 401(k) accounts do not have income limits. While Roth IRA income limits can restrict your ability to contribute to a Roth IRA, anyone can contribute to a Roth 401(k) if they’re eligible for a 401(k) plan with a Roth feature.
Is It Better to Invest in a Roth IRA or Roth 401(k)?
If you’re eligible for a Roth 401(k) through your work, it’s much better to contribute to a Roth 401(k) vs Roth IRA. Roth 401(k) contribution limits are much higher than Roth IRAs, and Roth 401(k) eligibility is must less restrictive than Roth IRAs.
Can You Have a Roth IRA and Roth 401(k) at the Same Time?
Yes. If you meet Roth IRA income limits, it is possible to have a Roth 401(k) and Roth IRA at the same time. If you’re eligible for a Roth 401(k) at work and also meet Roth IRA eligibility requirements, you may still be able to contribute to a Roth IRA outside of your employer-sponsored plan.
Are Roth 401(k)s Subject to a 5-Year Rule to Withdraw Contributions?
Roth 401(k)s are subject to the 5-year rule for Roth IRAs, requiring a person to own their account for at least five years before taking qualified distributions. Not all contributions must be in the account for five years, but account holders can’t take qualified distributions within five years of opening a Roth 401(k).
Deciding on a Traditional vs Roth 401(k) boils down to long-term tax planning. While many investors contribute to Traditional 401(k)s for the upfront tax deduction, withdrawals are taxed as income during retirement. To lower your tax burden during retirement, consider using a Roth 401(k) for at least some of your contributions.