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Understanding 401(k) Plans: Traditional vs. Roth

Both Roth 401(k)s and traditional 401(k)s are employer-sponsored retirement accounts that offer unique benefits. The primary difference lies in the timing of tax payments on contributions.

What Is a 401(k)?

A traditional 401(k) is a workplace retirement savings plan funded with pretax dollars, reducing your taxable income during your working years. Taxes are paid upon withdrawal in retirement. Employers often match a portion of employee contributions, enhancing the benefit. However, early withdrawals typically incur a 10% penalty.

What Is a Roth 401(k)?

A Roth 401(k) is also an employer-sponsored retirement account, but it is funded with after-tax money. This means your contributions grow tax-free, and you won’t pay taxes on qualified withdrawals in retirement. Early withdrawals before age 59½ may incur a 10% penalty and taxes on earnings if the account is less than five years old.

Roth 401(k) vs. Traditional 401(k)

Understanding the key differences and similarities between these accounts can help you decide which is right for you.

Similarities

• Both are employer-sponsored.
• No income limit to participate.
• Annual contribution limits are the same: up to $22,500 for 2023, with an additional $7,500 for those 50 or older.
• Automatic saving through payroll deductions.

Differences

• Taxes on contributions: Traditional 401(k) contributions are tax-deferred, while Roth 401(k) contributions are made after-tax.
• Taxes on distributions: Traditional 401(k) withdrawals are taxed as income, whereas Roth 401(k) withdrawals are tax-free.
• Employer matches: Matching funds for Roth 401(k)s must go into a traditional 401(k) account and are pretax.
• Penalty-free withdrawals: Roth 401(k)s require the account to be at least five years old for penalty-free withdrawals, in addition to the 10% early withdrawal penalty.
• Required minimum distributions: Starting April 2024, Roth 401(k)s will not have required minimum distributions, unlike traditional 401(k)s, which require them starting at age 73.

Is It Better to Invest in a Roth 401(k) or a Traditional 401(k)?

The choice between a Roth 401(k) and a traditional 401(k) depends on when you prefer to pay taxes. Traditional 401(k)s allow you to defer taxes until retirement, potentially lowering your tax burden if your income is lower then. Roth 401(k)s require you to pay taxes now, providing certainty about your retirement income as withdrawals are tax-free.

Can I Contribute to Both a Roth 401(k) and a Traditional 401(k)?

Yes, if your employer offers both options, you can contribute to both. This strategy, known as tax diversification, can help you manage your overall tax obligation by spreading your investments across accounts with different tax treatments.

The Bottom Line

When choosing between a Roth 401(k) and a traditional 401(k), consider what your employer offers and your tax preferences. If you need assistance, a financial advisor can help you create a retirement plan tailored to your financial situation.

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