Existing and newly eligible employees face a difficult decision when managing their retirement and deciding what type of 401(k) contribution will hold their best interest. Most employers have added the ability to defer after-tax contributions (Roth) in addition to pre-tax (Traditional) contributions, to provide added flexibility so individuals can better prepare for retirement. According to the Plan Sponsor Council of America, roughly 88% of 401(k) plans allowed Roth contributions in addition to Traditional. Before making the decision, it is important to first understand the key differences and similarities so you can plan accordingly.

Traditional 401(k)

Contributions into a Traditional 401(k) are pre-tax and help lower your taxable income based on the amount you contribute within that year. For example, if you claimed an income of $100,000 in 2023, and you made $10,000 in pre-tax contributions, your taxable income would be reduced to $90,000 for that year. This provides tax savings up front, however, the entire account balance (including potential market appreciation) is taxable as income when taking distributions. If your main concern is reducing taxable income or you are on the edge of entering a new tax bracket, it could make sense to deduct taxable income now to reduce taxes in the current year.

Roth 401(k)

When utilizing a Roth 401(k), contributions are made after-tax. The money going into the account is taxed prior to being funded and invested. A key difference from a Traditional 401(k) is that both the funds you invest in the Roth account as well as any earnings while invested, are NOT subject to tax when you make a qualified distribution in retirement. Per the IRS website, a qualified distribution is a distribution that is made at least 5 years after the year of the participant’s first contribution to the Roth account and is made on or after age 59½, on account of the participant’s disability, or on or after the participant’s death. For those with a long-time horizon until retirement, this could create many years invested in the market where an individual can create a tax-free nest egg. Keep in mind, there are no guarantees when investing in the market.

In addition, some 401(k) plans allow in-plan Roth rollovers where a participant may rollover vested plan balances to a designated Roth account in the same plan. An in-plan rollover could give you the ability to shift pre-tax funds to a Roth account within your plan should it be eligible and allowed. Consult with your financial and/or tax advisor as making this shift will have tax implications.

Similarities

Whether you utilize a Roth or Traditional 401(k) plan, if you are under the age of 50, you can defer up to $22,500 per year into your account. If over the age of 50, this number increases to $30,000 per year. Keep in mind this number can change each year and is typically adjusted for inflation. If your employer offers a company match, either election whether Roth or Traditional, will help you utilize receiving that match (check with your individual plan). Typically, the employer match will be a pre-tax source within your Plan. Whether making a Roth or Traditional contribution, payments will automatically be deducted directly from your pay, helping put money away before seeing it in your personal account. For both Roth and Traditional plans, penalty free distributions can be received once the participant is 59 ½ years old.

Considerations

Now that we have discussed both types of 401(k) contributions, what do we do with this information when making a choice in our personal 401(k)? It is important to note that each of us has a different situation and different goals for retirement. The fact that you are utilizing these contributions in the first place is a particularly important step to working towards retirement. Typically, when you are in the early years of your career, you are in a smaller tax bracket compared to your later years in the workforce. If you are still in those early years, it could make sense to lean on Roth contributions and pay the taxes now, while you aren’t in a high tax bracket. Investing in the market early in your career gives you a chance to potentially increase your account balances through market growth while avoiding taxes on distributions during your retirement years.

However, if you are trying to limit taxes now or are on the border of a new tax bracket, leaning on Traditional contributions provides relief and could even be used to keep you out of a higher income tax status. While distributions during retirement may be fully taxable, if you are no longer working or working part-time, you could potentially pay those taxes at a lower tax bracket than what you would pay while working. This is not always an all or nothing decision. Many 401(k) plans allow you to utilize both Roth and Traditional contributions, should you decide to do so. This could be an effective way to create flexibility in retirement and give you diverse sources to pull from depending on your personal situation. Annual reviews of your accounts are important as well. What might have made sense five years ago may not make sense for you now. It is encouraged to consult your financial or tax advisor when making this decision.

 

Joshua VanderGraaff
Employer Retirement Plan Advisor

Disclosures:

This is provided for informational purposes only and should not be interpreted in any way as investment, tax, accounting, legal or regulatory advice. An investor must take into consideration his/her individual circumstances. 

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.  All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their wealth advisor prior to making any investment decision.

 

Sources:

Retirement topics – contributions. Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics- contributions

Roth ACCT in your retirement plan: Internal Revenue Service. Roth Acct in Your Retirement Plan | Internal Revenue Service. (n.d.-a). https://www.irs.gov/retirement-plans/roth-acct-in- your-retirement-plan

Schwab.com. (n.d.). Roth vs. traditional 401(k)-which is better?. Schwab Brokerage. https://www.schwab.com/learn/story/roth-vs-traditional-401k-which-is-better

Choosing a retirement plan: 401K plan: Internal Revenue Service. Choosing a Retirement Plan: 401k Plan | Internal Revenue Service. (n.d.). https://www.irs.gov/retirement- plans/choosing-a-retirement-plan-401k-plan

Katedore. (2023, February 13). Pre-tax vs. Roth 401(k): Deciding which to use for retirement is trickier than you think. CNBC. https://www.cnbc.com/2023/02/11/how-to-decide-between- pre-tax-and-roth-401k-contributions.html