Roth 401(k) Versus Traditional 401(k)

More and more employers are offering a choice between a Roth 401(k) and a Traditional 401(k). What is the best choice? We’ll explore the differences between the two retirement accounts.

 

What is a Roth 401(k)?

A Roth 401(k)is an employer-sponsored retirement account funded with post-tax money. Employers can typically choose from a selection of investment funds containing stocks, bonds, and other assets.

Employers can offer matching contributions. The contributions are automatically made via payroll deductions. The 2023 contribution limit is $22,500, with an additional $7,500 catch-up contribution limit for those aged 50 and older. Withdrawals are tax-free in retirement after age 59 1/2 as long as the account has been open for at least five years. Apart from certain circumstances, there is a 10% penalty for early withdrawal.

What is a Traditonal 401(k)?

Many of us are more familiar with Traditional 401(k)s. A Traditional 401(k) is an employer-sponsored retirement account funded with pre-tax money. Employers can typically choose from a selection of investment funds containing stocks, bonds, and other assets.

Employers can typically choose from a selection of investment funds containing stocks, bonds, and other assets.

Employers can offer matching contributions. The contributions are automatically made via payroll deductions. The 2023 contribution limit is $22,500, with an additional $7,500 catch-up contribution limit for those aged 50 and older. Withdrawals are tax-free in retirement after age 59 1/2. Apart from certain circumstances, there is a 10% penalty for early withdrawal.

Differences Between Roth 401(k) and Traditional 401(k)

Roth 401(k)s and Traditional 401(k)s have many similarities, but they have key differences too. The biggest difference is when the money is taxed.

Roth 401(k)s are post-tax retirement accounts; contributions are taxed before going into the account. Traditional 401(k)s are pre-tax retirement accounts; contributions are made before they’re taxed, which lowers taxable income.

Your contributions and the growth in a Roth 401(k) are not taxed, but any employer match is taxed at the time of withdrawal. All withdrawals from a Traditional 401(k) are taxed as ordinary income, and state taxes apply where applicable. Traditional 401(k)s do not have the five-year rule for penalty-free withdrawals after age 591/2 that Roth 401(k)s are subject to.

RMDs are required minimum distributions that must be taken from certain retirement accounts, including Roth and Traditional 401(k)s. The recently signed SECURE Act 2.0 raised the RMD age to 73 beginning in 2023 and 75 starting in 2033. And beginning in 2024, Roth 401(k)s will no longer be subject to RMDs.

Which is Right for You?

The good news is that you don’t necessarily have to choose. If your employer offers both, you can decide each year which is more beneficial for you to contribute to. If you have a significant taxable event one year, you might choose to contribute to the Traditional IRA to lower your taxable income.

If your employer allows it, you can choose to split your contribution between both types of accounts. The overall contribution limits still apply; you can only contribute the max total, whether it’s to a single account or split between two. This can be a good strategy if you’re looking for a bit of tax diversification. You get a tax deduction now and tax-free withdrawals later. And the tax deduction may lower your AGI, allowing you to contribute to a Roth IRA.

If you are close to the Roth IRA Modified Adjusted Gross Income (MAGI) limit, which for 2023 is $153,000 for single filers and $228,000 for those who are married and filing jointly, you might consider choosing the Roth 401(k) as there are no income limits.

You can use this calculator to play with the numbers and find the right strategy for you.

Can You Roll A Roth 401(k) Into a Roth IRA?

You can roll a Roth 401(k) into a Roth IRA, and it’s not very different from rolling over a Traditional 401(k) into an IRA. Contact the 401(k) provider, request the rollover, and tell them to make the funds transfer payable to the company that holds the Roth IRA.

This is known as a direct rollover and allows you to avoid tax penalties that may apply if you were to have the funds sent directly to yourself.

The five-year rule does come into play. If you have an existing Roth IRA that is at least five years old, you can roll over the Roth 401(k) and take a distribution as long as you’re at least 591/2. But if you’ve opened a Roth IRA for the first time in order to do the rollover, you’ll have to wait five years to take penalty-free distributions.

If you have questions about Roth or Traditional 401(k)s or any other aspect of financial planning, we’re here to help.