Roth 401(k) vs 401(k): Which is a Better Tax Strategy?

When formulating a retirement plan for a comfortable future, choosing a 401(k) can be one way to take advantage of tax-efficient investing. Deciding between the two main types of 401(k) plans, however, can have long-ranging tax consequences.

If you’re trying to decide between a Roth 401(k) vs. 401(k), here’s what you need to know to make the best choice for your needs, ensure you have the retirement savings you need, and learn more about how to invest money wisely.

Quick comparison: Roth 401(k) vs. 401(k)

	Roth 401(k)	401(k)
Tax on contributions	Yes	No
Tax on withdrawals	No	Yes
Mandatory withdrawal age	72	72
Early withdrawal penalties	10%	10%
Loans	Depends on employer	Depends on employer
Income limits	No	No
Contribution limit (for tax year 2023)	$22,500 +$7,500 (if age 50 or over)	$22,500 +$7,500 (if age 50 or over)
Contribution limit (for tax year 2024)	$23,000 +$7,500 (if age 50 or over)	$23,000 +$7,500 (if age 50 or over)

Traditional 401(k): the basics

The traditional 401(k) allows you to receive a tax break today while your money grows tax-deferred in your retirement account until you decide to withdraw the money. In 2024, the 401(k) contribution limits allow you to add up to $23,000 to your account. If you’re at least age 50, you can make catch-up contributions of up to $7,500, bringing your total to a potential $30,500. Contribution limits can increase, however. The IRS sets contribution limits each year, taking into account cost-of-living increases.

In general, the 401(k) is offered through your employer. If your workplace offers a 401(k) plan, it’s usually possible to ask to have your contributions automatically taken from your paycheck before taxes are determined. This reduces your taxable income, effectively lowering your tax bill today.

Because your employer usually handles the transaction, it’s relatively easy to start saving for retirement. On top of that, some employers even offer what’s known as a company match and they contribute to your 401(k) as well. For example, your employer might offer a 50% match on up to 6% of your income. To get the maximum employer contribution, you’d arrange to have 6% of your income withheld from your check and deposited into your 401(k).

Let’s take a closer look at this to see what that means in real-world terms:

• Let’s say you get paid twice a month, and each paycheck is $2,500.
• You want to maximize your company match, so you ask to have 6% withheld from your check, which amounts to $150.
• Because your employer kicks in a 50% match on what you contribute, you get another $75 put into your 401(k) account.
• The total that goes into your 401(k) each paycheck is $225, which means you’re contributing $450 per month.

By taking advantage of the employer contributions, every month you get $150 in free money invested on top of the money you have withheld from your check. Over time, this could grow significantly to help create a bigger nest egg.

Withdrawing money from your 401(k)

With a regular 401(k), once you retire and begin to withdraw money, you have to pay taxes based on your current tax rate at the time of the withdrawal. In most cases, you need to wait until you reach age 59 1/2 to begin withdrawing money from your account. Although there are exceptions, if you withdraw money early, not only will you have to pay taxes on what you take out, but you will also have to pay an additional 10% penalty.

It’s also important to note that a 401(k) account comes with required minimum distributions (RMDs) when you turn 72. Once you reach that age, you’re required to begin taking money from the account based on a formula that considers the size of your nest egg and your life expectancy. You’re taxed on your RMDs, just as you would be on any withdrawal.

Finally, it’s also possible to take out a loan against your 401(k). However, loan terms and whether a loan is even possible is determined by your employer. If your employer allows 401(k) loans, though, you might be able to borrow money without paying taxes or a penalty. In general, you have five years to repay your loan. Because it’s a loan, you have to make interest payments as well as repay the principal, but some like this strategy because it’s interest you pay to yourself.

Even though it can be tempting to get a 401(k) loan and pay yourself interest, it’s important to understand that the interest you pay isn’t likely to replace what you could have earned by leaving that money in the market. There’s no real way to make up for the opportunity cost that comes with having your money out of a 401(k) investment account.

Finally, if you quit your job or are laid off while you’re still repaying a 401(k) loan, it will come due. At that point, you will have 60 days to pay the remaining balance or that money counts as an early withdrawal and you’ll be stuck paying taxes and penalties.

Roth 401(k): the basics

The Roth 401(k) is very similar to the traditional 401(k) in terms of how it works. The contribution limit is the same, and you have to wait until age 59 1/2 to access your account penalty-free. There are also RMDs with the Roth 401(k) when you reach age 72.

With the Roth option of a 401(k), the main difference is how the contributions and withdrawals are taxed. When you put money into a Roth 401(k), you do so with post-tax dollars. So, you’ll pay income tax before your Roth contribution is taken out of your paycheck.

Although there’s no tax benefit today, you can reap some tax savings later. Because you already paid taxes on your contributions, a Roth allows you to take your distributions tax-free, so you don’t have to worry about paying taxes on your money down the road, no matter how much you take out of your Roth account. For people who believe they will be in a higher tax bracket in the future, the Roth can be a good tax-saving strategy. The main caveat is that your Roth 401(k) must be established for at least five years before you start taking distributions.

With a Roth 401(k), you still have to take RMDs and there are limitations on 401(k) loans, but you get to manage your tax bill in the future. It’s also important to note that if your employer offers a 401(k) match, and you have a Roth account, the employer match won’t be put into your Roth. Instead, you’ll have a separate traditional 401(k) and the employer’s portion will go into that. You’ll still have to pay taxes on the withdrawals from that money in the future.

Avoiding RMDs with a Roth 401(k)

It’s actually possible to avoid taking RMDs when you have a Roth 401(k) — but you have to take an extra step and open a Roth individual retirement account. Because a Roth IRA doesn’t come with RMDs, you can get around the requirement by rolling your Roth 401(k) into a Roth IRA.

Additionally, with the money in a Roth IRA, there are some other flexibilities in the way you can access the money. Consider consulting with a financial professional about whether rolling your Roth 401(k) into a Roth IRA makes sense for your financial situation and goals.

How to pick between a Roth 401(k) vs. 401(k)

For the most part, choosing between a Roth 401(k) vs. 401(k) is about deciding when you want your tax advantage and what makes the most sense for your personal finances.

In general, if you think you’re likely to be in a lower tax bracket in the future, a traditional 401(k) can make sense. You’ll save money by paying taxes on your withdrawals at a lower income tax rate in retirement.

On the other hand, if you think your future tax rates will be higher, a Roth 401(k) can make sense. You’ll pay taxes today, but your invested money will grow tax-free over time and when you withdraw from your account you won’t have to pay taxes. Many people who are younger and just starting out often choose Roth accounts because their taxes are low right now, so they can sock away money and avoid paying a higher tax on that money later in life.

As your income increases during your working years, it might make sense to shift some of your contributions to a traditional 401(k) in order to take advantage of the bigger tax savings you stand to achieve.

It’s worth noting that you aren’t limited to one account type. Your combined annual contributions to your 401(k) accounts are limited to a total of $23,000 (with an additional catch-up of $7,500 if you’re 50 or older) for 2024, but you can divide those contributions between accounts according to your preference. Consider consulting with a financial advisor who can help you figure out how to make contributions that make the most sense for your situation and that can maximize your potential tax savings.

A note about rollovers and conversions

It’s possible that you have an old 401(k) account after leaving a job or that you want to make a change to your retirement plan. In that case, you may want to roll over your 401(k) to an IRA. Doing this can provide you with the ability to gain more control over your investment options as well as potentially save money in fees. Before you roll your 401(k) into an IRA, it’s important to pay attention to the type of account you have.

In most cases, experts recommend that your rollovers match in terms of tax treatment. So if you have a traditional 401(k), you’re usually better off rolling it into a traditional 401(k). When you have a Roth 401(k), then you can roll over that account to a Roth IRA without concerns about the tax treatment. Just remember that if you have a Roth 401(k) and your employer has been making matching contributions, the money your employer contributed is considered traditional, and will need to be rolled into a traditional IRA in order to avoid tax issues.

You can still decide to convert your traditional 401(k) into a Roth IRA, but be aware that there are usually tax consequences. Because your traditional 401(k) contributions were made with pre-tax money, you need to pay taxes when you convert to a Roth IRA. Consider talking to a tax professional before you move forward with this approach. You don’t want to be stuck with an unexpected and high tax bill. It’s possible for a professional to help you work out a plan to convert your traditional 401(k) to a Roth IRA in stages, so you aren’t doing it all at once, and the tax bill is easier to handle.

FAQs

Bottom line

Understanding the difference between the Roth 401(k) vs 401(k) is important for both retirement planning and tax planning. Both of these accounts can be great for building wealth for the future and making the most of your money. However, they have different uses and different places in your planning.

Consider speaking with a financial professional before moving forward. If you’re closer to retirement, a specialist can help you figure out how to coordinate your traditional and Roth accounts when you start taking Social Security benefits.

Retirement planning requires some thought and long-term planning, so keep that in mind as you make contributions to your 401(k) accounts.