Many employers offer Roth and traditional 401(k) plans to help their employees save for retirement. These individual retirement accounts (IRAs) are funded using payroll deductions. Understanding the similarities and differences between Roth and traditional 401(k) options can help you decide how best to save for your retirement.
Roth vs. Traditional 401(k): Taxes
Both Roth and traditional 401(k) plans are tax-advantaged. With a traditional 401(k) plan, you deposit pre-tax money and pay ordinary income taxes when you withdraw contributions and earnings, typically after retirement. With a Roth 401(k) plan, you deposit money after taxes are taken out and withdraw your funds tax-free.
Most people do not expect that their income tax bracket will remain the same throughout their lifetime. If you do not expect any significant changes in your income tax bracket, then it may not matter whether you deposit your savings into a Roth or a traditional 401(k). However, many people expect their income to decline in retirement and, therefore, choose a traditional 401(k) plan.
Contributions to a traditional 401(k) plan lower your taxable income for state and federal taxes the year you contribute, as long as you meet certain conditions, depending on your filing status and income.
If you expect your local, state, and federal income taxes to decrease when you retire because you plan to retire to a state with lower income tax requirements, a traditional 401(k) could be a better option. You would need to consider whether savings on state income taxes after a move would mitigate an expected increase in federal income taxes over the years.
Roth vs. Traditional 401(k): Contribution and income limits
Roth and traditional 401(k)s have the same contribution limits. In 2024, contributors
- Under the age of 50 can contribute up to $7,500
- 50 and older can contribute $8,500
In 2024, single filers must have a maximum adjusted gross income under $161,000 to contribute to a Roth 401(k), with contribution limits decreasing starting at $146,000. For married couples filing jointly, the maximum adjusted gross income is $240,000, with a phase-out range starting at $230,000.
Roth vs. Traditional 401(k): Early withdrawals
If you withdraw money from a traditional IRA before you turn 59½, you will be required to pay taxes on the amount you withdrew and a 10% early withdrawal penalty. If you use the withdrawal to pay for qualified first-time homebuyer expenses (up to $10,000), birth or adoption (up to $5,000), disaster recovery (up to $22,000), qualified higher education expenses, or other eligible expenses, you may not need to pay the penalty.
Using a Roth IRA, you can withdraw contributions equal to the amount contributed and any net earnings tax- and penalty-free, as long as the withdrawal is made by the due date of your return for that year. The withdrawals are treated as though you never made them to your Roth 401(k).
Withdrawals before age 59½ are not subject to penalties on the contribution, but there is a 10% federal penalty when you withdraw earnings.
Roth vs Traditional 401(k)s: Required Minimum Distributions
Roth IRAs do not require the account owner to take the required minimal distributions (RMDs). This feature makes them ideal for people who wish to transfer their wealth to the next generation. Beneficiaries of a Roth IRA do not have to pay taxes on withdrawals. However, they are required to take distributions on a prescribed schedule or roll the account into their own IRA.
The owner of a traditional 401(k) must begin receiving distributions from their traditional IRA by April 1 of the year following their 73rd birthday, as long as they reach age 72 after December 31, 2022. Except for the first year in which you receive a distribution, excess distributions cannot be used to reduce distribution amounts in subsequent years.
Roth vs Traditional 401(k)s: Other considerations
It is possible to convert a traditional IRA into a Roth IRA, but the opposite is not true. You can choose to contribute to a traditional IRA to lower your tax burden when you have a higher income, and then convert traditional IRAs to Roth IRAs when your taxable income is lower.
If you can make the maximum contribution to a Roth IRA of $23,000 ($30,500 if you are over age 50), a Roth IRA can make more sense than a traditional IRA. You can contribute this money, allow it to grow tax-free, and then withdraw it without paying any additional taxes.
A fee-only financial planning professional can meet with you and discuss your financial goals and objectives. They can help you weigh the benefits of traditional and Roth 401(k)s and develop a tax-saving strategy that best suits your current financial situation.
There is no one-size-fits-all guide to investment. Working with a wealth manager can ensure you make the best financial decisions for yourself and your loved ones.
