Roth 401(k) and 403(b) accounts first hit the retirement plan market in 2006, but have only recently been more widely adopted by employers as an offering to their employees. While potentially another great option for you to save more for retirement, choosing between a Traditional and a Roth 401(k) adds yet another decision for you to make in your financial life. So together, let’s decide which is right for you.
What’s the difference between Traditional and Roth accounts?
The main difference: taxation timing.
With a Traditional 401(k), you make contributions with pre-tax money and pay taxes when you make distributions. Roth 401(k)s, like Roth IRAs, are the opposite. You pay tax on the contributions you make, but all qualified distributions come out tax-free.
While you are required to take required minimum distributions (RMDs) after age 70 ½ from both types of 401(k)s, you can rollover a Roth 401(k) into a Roth IRA and never be forced to distribute money from that account. You cannot avoid the RMD rules with a Traditional 401(k).
What’s the same between the account types?
Other than the tax treatment, these accounts are quite similar.
There are no income limitations to participate in either a Traditional or a Roth 401(k), unlike with Roth IRAs and determining whether or not you can deduct your Traditional IRA contributions. They do have contribution limits, though. Both types cap out employee contributions at $18,000. You can also make an additional $6,000 catch-up contribution if you are 50 or older.
Investments grow tax-deferred in both types of accounts. Taxes normally get collected as income from investments is received or you sell an investment at a capital gain. However, with both types of these accounts, just like with IRAs, there is no tax due when those activities happen within the account.
Both can allow for loans and in-service withdrawals. Whether or not it’s a good idea to actually take a loan from your 401(k) is a different story. And finally, when you do take money out from your 401(k), be sure to follow the distribution rules, which are the same for both types. In general, this means you need to wait until you’re 59 ½ to begin pulling money out to avoid unnecessary penalties.
Which one should you choose?
Now that you know a little bit more about the two different types of accounts, the real question becomes, “which one is right for you?” Because the main difference between the two is about timing of taxation, you need to think about whether you believe you will be in a higher tax bracket now vs. later as well as how long you have until you will actually be using the money.
You likely have a pretty good handle on what your income is and what your deductions are likely to be, so taking a look at your current tax rates is probably going to be pretty easy for you. Making assumptions about where your tax rates will be in the future so you can make an educated comparison, though, can be more difficult. You will want to pay attention to what other sources of income you will have in retirement, and when those will start compared to when you plan to take money from the 401(k). Also important to know are your state of residence during retirement and what the IRS decides future tax rates are going to be. Unfortunately, there is no crystal ball to tell us what those rates will be, so the best we can do is make decisions based on the information we have right now.
When you have compared tax brackets now with your estimated future brackets, if your tax rate is likely to be higher in retirement than it is now, choose the Roth 401(k). Otherwise, choose the Traditional.
Timing of distributions is important for a couple of reasons. First, if you wouldn’t want to take money until after you are 70 ½, the Roth allows you to continue to defer income by avoiding required distributions, assuming you roll it over to a Roth IRA as described above. Second, a longer time horizon gives the account a longer time to grow. Typically, the same amount goes into a Roth 401(k) and a Traditional 401(k) because taxes for the Roth contribution get paid with money that is outside the 401(k). If you never have to pay taxes on the growth, then all of that growth is yours, unlike a Traditional 401(k), where a part of that growth (as well as a part of your contributions) belongs to Uncle Sam.
Generally, if you have 20 or more years until you expect to use the money, the Roth is far more likely to be the better option.
Between 10-20 years, a Roth is probably a better option, but a more detailed analysis would be warranted.
If you plan on using the money within the next 10 years, then you really need to pay attention to where your tax rates are, both now and in the future.
Other things to think about…
A Roth is far better to inherit than a Traditional 401(k). Distributions will become mandatory for your beneficiaries, and those distributions will be taxed exactly like they would have been to you. That means, with a Roth, your beneficiaries won’t need to pay tax on the money, just like you wouldn’t. But with a Traditional 401(k), they would. Consider this scenario: you have a taxable estate where all of your liquid money is in a Traditional 401(k), and you die. You
Diversifying Tax Treatment of Accounts
Most of you already have some form of Traditional tax-deferred account, whether it is an old employer’s 401(k), an IRA, or your employer’s contributions to your 401(k) – they aren’t allowed to go into the 401(k) as Roth contributions. With that in mind, I’m a fan of diversifying the types of accounts you have by the way they are taxed:
- Tax-deferred – Traditional 401(k)/403(b)/IRA
- Tax-free – Roth 401(k)/403(b)/IRA
- Taxable – Individual, Joint, Trust, etc.
By having all those types of accounts, you are giving yourself the most flexibility to determine where you can take money based on the tax treatment that best suits your needs at the time that you need the money. So if you only have tax-deferred accounts, I would highly encourage you to start saving in tax-free (Roth) or taxable accounts as well.
Investing the Tax Bill Savings Now
There are some people who suggest taking your current tax savings you on Traditional 401(k) contributions and investing that money now so you have it to pay the tax burden when you do take the money out sometime in the future. This is definitely a better strategy than what people do now, which is to go spend their tax savings, but the success of this strategy hinges on your ability to stay disciplined with the money you saved for taxes. Behaviorally, do you really think you could hold onto a chunk of money, invest it, and pay the expenses of investing, all the while knowing you were going to use it to pay taxes on money you took out of your 401(k) down the road? Even though I personally hate paying taxes, I would rather pay the tax bill now so I wouldn’t have to go through that hassle and enjoy the tax free money later.
At the end of the day, the fact that you are saving for your retirement at all gives you a huge step up on most everyone else, so don’t let the decision between a Roth vs. a Traditional 401(k) keep you up at night. Do whatever feels the best to you in your current situation and move forward knowing you are doing something good for your future self.