Understanding the Basics

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 your contributions.

What Is a 401(k)?

A traditional 401(k) is a workplace retirement savings plan funded with pretax dollars. This means you pay taxes on your distributions in retirement. Many employers offer 401(k)s and may match a portion of employee contributions, providing a significant benefit.

One of the main advantages of a traditional 401(k) is the reduction of your taxable income while you contribute, deferring taxes until retirement when your income is likely lower. However, early withdrawals (before age 59½) 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. Your contributions grow tax-free, and you won’t pay taxes on withdrawals in retirement.

Similar to a traditional 401(k), early withdrawals from a Roth 401(k) before age 59½ can result in a 10% penalty. Additionally, you must own the account for at least five years to take qualified distributions. Non-qualified distributions may also be taxed on a portion of your earnings.

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

Similarities

• Both are employer-sponsored, meaning you can’t open one on your own.
• 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, reducing your current adjusted gross income. Roth 401(k) contributions are made after-tax and do not reduce your current adjusted gross income.
• Taxes on distributions: Traditional 401(k) withdrawals in retirement are taxed as income. 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 account ownership for at least five years for penalty-free withdrawals, in addition to the 10% early withdrawal penalty.
• Required minimum distributions: Starting in April 2024, Roth 401(k)s will not require 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 on your money. If you expect a lower income and tax rate in retirement, a traditional 401(k) might be beneficial. Conversely, if you anticipate a higher income and tax rate in retirement, a Roth 401(k) could offer more certainty and tax-free withdrawals.

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 types of accounts. This strategy, known as tax diversification, allows you to benefit from different tax rules and potentially lower your overall tax obligation.

The Bottom Line

When choosing between a Roth 401(k) and a traditional 401(k), consider what your employer offers and your future tax situation. If you need assistance navigating your retirement options, consider consulting a financial advisor.

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