Investing in a Traditional 401(k) vs a Roth 401(k)

By Jane Young, CFP, EA

Many investors are faced with the decision on investing their retirement contributions into a traditional 401(k) or a Roth 401(k).  Although most large employers currently offer a Roth 401(k), only about 14% of the participants select this option.  The best decision depends on your unique situation and financial circumstances.

The biggest difference between the two options depends on when you pay taxes.  With a traditional 401(k), your contribution is made with pre-tax dollars, so your contribution is deducted from your taxable income.  However, you must pay regular income tax upon distribution in retirement.  A contribution to a Roth 401(k) is made with after tax money and your distributions are tax free.  With a traditional plan you can start taking taxable distributions at age 59 ½ without a penalty.  With a Roth plan you can take tax free distributions of contributions and gains without penalty once you reach age 59 ½ and have participated in the plan for five years.

The limit on annual 401(k) contributions in 2023 is $22,500 plus a catch-up provision of $7,500, if you are age 50 or older.  Your contributions can be comprised of a traditional plan, a Roth plan, or a combination of the two.  There is no income limit on contributions to a Roth 401(k) as there are with a Roth IRA.   Additionally, you must take a required minimum distribution on a traditional 401(k) but beginning in January 2024, you are no longer required to take a required minimum distribution on a Roth 401(k).

The decision to invest in a traditional or a Roth plan would be easy if you had an accurate picture of tax rates and your financial circumstances in the future.  Generally, investing in a traditional plan is better if you are currently in a high-income tax bracket and anticipate lower taxable income in retirement. A traditional plan also gives you more flexibility to wait and convert some of your retirement plan to a Roth in low-income years right after retirement.  

A Roth 401(k) may be a better option if you are currently in a low tax bracket and expect to be in a higher bracket in retirement.  This is generally true for those early in their careers.  A Roth is also advantageous for younger investors because their money has more time to grow tax free.  Additionally, a Roth may be a good choice if you expect tax rates to increase.  This is very likely because current rates are historically low and are due to automatically increase in 2025, if congress does not extend the rate cuts put in place by the Tax Cuts and Job’s Act (TCJA).

There is no right answer, the best solution may be a mix of traditional and Roth plans.   A mix will give you some diversification between taxable and non-taxable accounts.  This will provide you with flexibility to manage your tax bracket during retirement.