Roth 401(k) vs. Traditional 401(k): Which is better for you?

If you are unaware of whether or not you have the option to choose between a Traditional 401(k) and a Roth 401(k) within your existing 401(k) plan, you are not alone..

Surprisingly, while 80% of plans offer a Roth option, only about 17% of participants contribute to them as of 2022.

Why?

After working with thousands of investing students, anecdotal data suggests to me that many people don’t even realize that they have the option to choose.

Navigating retirement options can be tricky, especially when it comes to making decisions around your hard earned money.

It’s even trickier when we are lacking critical information.

Deciding between a Roth or Traditional 401(k) is one of those decisions that I find people obsessing over once they realize they have the option.

Both Traditional and Roth 401(k) plans offer unique benefits, and the right choice depends heavily on your current financial situation and future expectations.

Here’s a breakdown to help demystify these options:

Traditional 401(k): Save on Taxes Now

If you don’t know what type of 401(k) you’re investing in right now, it’s probably a traditional 401(k) that will give you:

• Immediate Tax Benefits: Contributions to a Traditional 401(k) reduce your taxable income, lowering your tax obligation for the year. You’ll pay less in taxes because part of you can reduce your taxable income by the amount of your contribute to your 401(k).

• Tax-Deferred Growth: Investments grow tax-deferred, meaning you won’t pay taxes on gains until you withdraw funds in retirement. In retirement, you’ll pay taxes when you withdraw.

Roth 401(k): Future Tax Savings

Typically you can choose to make Roth contributions and many times you can split your contributions between Roth and Traditional. When it comes to Roth you get:

• Tax-Free Growth: Contributions are made after-tax, but the money grows tax-free, and you won’t pay taxes on withdrawals in retirement.

• No Tax Worries Later: Ideal if you expect to be in a higher tax bracket in retirement as it allows you to lock in your current tax rate.

Pros and Cons

Deciding between a Traditional and Roth 401(k) can seem daunting.

Here are some considerations for each:

• Traditional 401(k)

  • This could be a good choice if you expect to have less income than you have now when you start to withdraw the money near retirement. This will allow you to pay less in taxes as you make withdrawals (you’ll be making less so your marginal tax rate will be lower.)

  • You could also potentially receive a tax refund (or a larger refund) because you will be able to deduct your 401(k) contributions from your taxable income. If you want to grow your money even faster, putting that refund to work for you by investing it could be a huge win.

• Roth 401(k)

  • This could be a good choice if you anticipate being in a higher tax bracket when you go to withdraw the money in retirement.

  • If you want to get paying taxes out of the way so you know that whatever you have in that account is yours, then this is also a good option for the psychological safety of knowing you have tax-free retirement funds.

You’ve got options.

If uncertainty makes you uneasy, remember that many plans allow you to split your contributions between both Traditional and Roth 401(k)s, giving you the benefits of both worlds.

Your total 401(k) contributions for 2024 however, must not exceed $23,000 .

The decision between a Roth and Traditional 401(k) is personal and depends on your financial goals, tax situation, and retirement plans.

Regardless of the choice, you're making a smart move by investing in your future.

If you’re still unsure about the best path, consider splitting your contributions until you have more information.

Ready to optimize your retirement savings?

Don’t miss my next free beginner investing workshop that will help you learn how to grow your money without more work. Check it out here.