An employer-sponsored 401(k) plan offers a tax-advantaged way to grow retirement savings, along with the potential for matching contributions. These plans come in two flavors: The traditional, tax-deferred kind, which lets you contribute pre-tax dollars, or a Roth 401(k), which is funded with after-tax dollars but lets you realize tax free growth and retirement income. So if you have both options available to you, which should you choose? Both choices can offer tax advantages, but before you invest, it’s important to learn how they compare and how they serve your financial plan and tax situation.
Do you need help planning for retirement? Consider speaking with a financial advisor who serves your area today.
How Traditional 401(k) Plans Work
A traditional 401(k) is what you may think of when you think of workplace retirement plans. With this type of retirement account, you make elective salary deferrals into the plan. These deferrals come out before income tax is applied to the money; this lowers your taxable income, effectively acting as an instant tax deduction. The money that’s in your traditional 401(k) grows on a tax-deferred basis. At age 59 1/2, you can begin taking qualified distributions from your plan. Those distributions are subject to ordinary income tax but not the 10% early withdrawal tax penalty.
Your employer can also make matching contributions into the plan. If a match is available, you may have to contribute a certain percentage of your income to get the full match.
For 2024, employees can contribute up to $23,000 to a traditional 401(k). A catch-up contribution of $7,500 is allowed for workers aged 50 and older. The total amount of contributions allowed, including your contributions and employer matching contributions, is $66,000.
The investments offered through a traditional 401(k) plan are determined by the plan administrator. Typically, investment options include mutual funds, target-date funds, index funds and exchange-traded funds. Each investment in the plan may have an associated management fee and you may pay administrative fees to the plan as well.
Some 401(k) plans allow employees to take loans and/or hardship withdrawals. Loans must be repaid with interest and if you separate from your employer before the loan is paid in full, the entire amount becomes a taxable distribution. Hardship withdrawals from a traditional 401(k) are taxable and you may also owe the 10% early withdrawal penalty.
How a Roth 401(k) Works
A Roth 401(k) is similar to a traditional 401(k) in several ways. These plans can be offered by employers alongside or in place of traditional 401(k) plans.
You make contributions to the plan, which your employer can match. The biggest difference, however, is that you’re putting after-tax dollars into a Roth 401(k), versus pre-tax dollars with a traditional 401(k).
What that means for you from a tax perspective is that once you begin taking qualified distributions from your Roth account, those withdrawals (including any returns your contributions earned over the years) would be 100% tax-free. So while you don’t get to reduce your taxable income in the year you make the contribution, you get to enjoy tax-free growth and withdrawals in retirement. That’s particularly beneficial to you if you anticipate being in a higher tax bracket at retirement and want to minimize your tax liability on your retirement income.
Employer contributions made on your behalf would still be directed into a pre-tax (tax-deferred) account.
What About RMDs?
Required minimum distributions, or RMDs, kick in for certain types of qualified retirement accounts once you reach age 73 (up from 72, as of 2023). The amount of money you’re required to withdraw is based on your life expectancy and the value of your account. If you fail to take your RMD on schedule, the IRS can impose a tax penalty of 50% of the amount you were required to withdraw.
Traditional 401(k) plans (as well as traditional IRAs) are subject to RMD rules. You also have to follow the RMD guidelines for Roth 401(k)s. However, the IRS doesn’t impose this rule for Roth IRAs (at least, while the account owner is alive).
Your RMDs from a traditional 401(k) would be taxed at your ordinary income tax rate. Your Roth 401(k) RMDs would not be taxed as long as they’re qualified distributions. But, the disadvantage is that you’d have to take money from the plan to avoid a tax penalty.
Which Type of 401(k) Is Better for Retirement Savings?
There’s no right or wrong answer to this question. It largely depends on your current income and tax bracket, your estimated income and tax bracket in retirement and your long-term financial goals.
Gregory Kasten, founder and CEO of Unified Trust Company in Lexington, Kentucky, says most investors choose the traditional 401(k) but notes that a Roth 401(k) can be a good choice for someone who otherwise wouldn’t be able to save in a Roth IRA due to their income.
Eligibility to contribute to a Roth IRA, which also allows for tax-free distributions in retirement with no required minimum distributions, phases out once your modified adjusted gross income reaches a certain threshold. These limits are set by the IRS each year and correspond to your filing status. For 2024, the phase-out limit for single filers, heads of household and married couples filing separately who live apart is $161,000. For married couples filing separately who live together, the limit is $10,000. The limit is $240,000 for married couples who file a joint return.
Your age can also play a part in determining whether a traditional or Roth 401(k) makes sense.
“The Roth 401(k) is particularly suited for young people who are in a lower tax bracket and have a lot of working years left ahead of them,” Kasten says. “A Roth 401(k) can then grow tax-free and compound over many years.”
However, if this relatively low income means that your budget is tight, then you might not be able to afford a retirement contribution that doesn’t also reduce your tax hit in the present. In this case, a traditional 401(k) contribution might be the more practical option.
Bottom Line
Contributing to a traditional 401(k) could help reduce your tax liability during your highest earning years, since your contributions are tax-deductible. But a Roth 401(k) could shrink your tax bill in retirement once you’re ready to start living off your savings. It also has the benefit of letting you realize tax-free investment growth, which could be a big benefit if you start early and see a lot of success in the market in your working years.
Tips for Managing Your 401(k)
- Once you’ve had a chance to review the investment options offered through your 401(k) plan, you may want to consult a financial advisor to build a financial plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Take advantage of SmartAsset’s 401(k) calculator to estimate how much you can save in your plan and how that money will grow over time. Consider increasing your contributions to your plan annually, or at the very least, make sure you’re contributing enough to your plan to get the full employer matching contribution, since failing to do so essentially means leaving free money on the table.
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