Should i use traditional or roth 401k

When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw from your account, usually after you retire.

An increasing number of employers are offering employees a relatively new 401(k) choice—a Roth 401(k). If you participate in a Roth 401(k), the amount you defer doesn't reduce your taxable income or your current income taxes. But when you withdraw after you retire, the amounts you take out are tax-free, provided you're at least 59½ and your account has been open at least five years.

Both the traditional 401(k) and Roth 401(k) offer tax advantages when you defer a portion of your salary into an account in your employer’s retirement savings plan. Both feature tax-deferred compounding of contributions that are made to the account. Both have no income limits and require minimum distributions after you turn 72 in most cases, and both can be rolled over to an IRA when you retire or leave your job for any reason.

Here is a chart showing the different tax structures for the two 401(k) options:

Contributions and earnings taxed at your ordinary income tax rate 

Subject to a 10% tax penalty if made before you reach age 59½ 

• the account must be held for at least 5 years, and 
• the withdrawal is made either because of disability, death, or attainment of age 59½.

Employers may offer a Roth 401(k) only if they already offer a traditional 401(k)—and may give you the option of splitting your annual contribution between a traditional and Roth 401(k)—though your total contribution can’t be more than the annual limit Congress sets for a 401(k). However, once you’ve made contributions, you may not move money between the two 401(k) accounts because of their different tax structures.

What’s more, if your modified adjusted gross income is too large to allow you to qualify for a Roth IRA, a Roth 401(k) is one way to have access to tax-free withdrawals. There are no income restrictions limiting who can participate. The only requirement is being eligible to participate in your employer’s plan.

1. You are currently in a lower tax bracket, but you expect that to change. Let’s say you are a young professional who is anticipating salary increases, which will put you in a higher tax bracket down the road. Contributing to a Roth IRA or Roth 401(k) means you pay the relatively low rate on taxable income now. Once you’ve retired, you will not pay any taxes on qualified distributions from the plan.

2. You are close to retirement and are concerned about RMDs. “If you’ve been a disciplined saver and have contributed a healthy percentage of your income to Traditional accounts for many years, eventually you’ve got to pay the piper,” says Young. Beginning in the year you reach age 72,* you must begin taking required minimum distributions (RMDs) from Traditional IRAs and from 401(k)s—including Roth 401(k)s—the later of age 72* or once you’re retired. As the name suggests, these withdrawals are required, even if you don’t need the income at the time.

RMDs could bump you to a higher tax bracket. Qualified distributions from a Roth 401(k) or Roth IRA, on the other hand, would not create taxable income or increase your tax rate. Therefore, a Roth contribution may be preferable in order to limit the RMD income taxed at a higher rate.

Someone in this position may also want to consider the effect on their beneficiaries. The SECURE Act, passed in 2019, requires most non-spouse beneficiaries to withdraw all retirement account balances within 10 calendar years. This change increases the likelihood that Traditional account withdrawals will push them into a higher tax bracket, which makes Roth assets even more attractive.

3. You are a prodigious saver. Suppose you can contribute the maximum amount to a retirement plan ($20,500 for 2022 or $27,000 if you’re over age 50), even if you don’t get a tax break. In this case, the Roth account effectively enables you to save more in a tax-advantaged manner. Saving the maximum amount ultimately results in more after-tax retirement assets for the Roth account balance than a Traditional contribution that is pretax.

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