Traditional 401(k) vs. Roth 401(k): Choosing the Right Account for Your Future

What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement investment account that allows employees to save and invest a portion of their paychecks. The name “401(k)” comes from the section of the Internal Revenue Code that lays out the rules, limitations, and tax advantages for this type of account. Both an employee and employer can contribute to a 401(k), and many employers offer to match employees’ contributions up to a certain threshold as part of their total compensation. There are several types of 401(k) plans, but the two most common are the traditional and Roth versions. 

Key Differences Between Traditional and Roth 401(k)s

Tax Implications

The primary difference between traditional and Roth 401(k)s is their tax treatment. Traditional 401(k) contributions are tax-deferred. This means your contributions are made pretax, reducing your taxable income for the year. Instead of paying taxes on that portion of your income now, you defer the responsibility and instead pay taxes on your withdrawals during retirement. 

In contrast, Roth 401(k) contributions are made after taxes, meaning that your contributions don’t provide an immediate tax break, but both contributions and investment growth can be withdrawn tax-free in retirement. Note that “pretax” and “after taxes” do not indicate the date or time when contributions were made but rather how they are reported to the IRS and whether they are counted as part of your income when you file your yearly tax return.

Withdrawal Rules and Penalties

Generally, you cannot withdraw funds from a traditional 401(k) before age 59.5 without incurring a 10% penalty and income taxes on the withdrawal. At age 73, you must start taking a required minimum distribution (RMD) each year, which is the minimum amount you can withdraw based on your life expectancy and account balance. Not withdrawing the RMD can result in a substantial penalty: 50% of the amount that should have been withdrawn. 

Contributions to a Roth 401(k) can be withdrawn penalty-free anytime. However, to withdraw earnings tax-free, you must be at least 59.5 and have held the account for at least five years. Like traditional 401(k)s, Roth 401(k)s are subject to RMDs. However, you can avoid this requirement by rolling over the fund in your Roth 401(k) to a Roth individual retirement account, allowing them to continue growing tax-free for longer. This strategy is especially attractive for high-net-worth individuals who have other assets to draw upon early in retirement and want to maximize the tax benefits a Roth account provides. 

How to Decide Which 401(k) is Best for You

Not all employers offer both a traditional and Roth 401(k) option. If your employer only offers one, you will have to use the account offered or seek a non-employer-sponsored alternative. Note that it is also possible to have more than one employer-sponsored retirement account over the course of your career and diversify account types. The type of account you prefer may change as your financial circumstances or the accounts available to you change. If your employer does give you a choice between traditional or Roth, you should consider several factors when making your decision, including your current and expected retirement tax bracket, which stage of your career you are in, and how soon you plan to retire.

If you expect to be in a higher tax bracket in retirement than you currently are, a Roth 401(k) might be beneficial because you will have already paid taxes on the income at your lower rate. Conversely, if you expect to have a lower income in retirement, a traditional 401(k) could save you money in the short term and allow you to invest more than you otherwise may have been able to. High-income professionals at the peak of their earning years might prefer traditional 401(k)s to lower their taxable income now, whereas those in lower tax brackets or early on in their careers might benefit more from a Roth because their taxes are already relatively low, and they stand to gain more from the tax-free growth over time.