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How to Decide Between A Traditional 401(k) and Roth 401(k)?

Nov 29 2022

Retirement Growth

We increasingly work with younger clients who are offered both a traditional 401(k) and a Roth 401(k) by their employers. They know that investing in either plan is a smart way to lay the foundation for their retirement yet they still often ask “what is the real difference between the two options?” And, unsurprisingly, they also want to know which one is the best plan for their specific income level, tax bracket, and retirement goals.

So, what we have set-out to do here is answer a few common questions about the plans and lay out a framework to help readers decide for themselves which avenue is best for their families. Ultimately, either is better than not saving anything for retirement – yet neither option is necessarily better for everyone. It is an individual choice and depends on personal circumstances, and, of equal importance, what you think your retirement will look like. If you are weighing the choice between a traditional and Roth 401(k), keep reading to learn background on the plans and some factors you may want to consider.

History of the Traditional 401(k) and Roth 401(k) Plan

The 401(k) plan has become the savings vehicle of choice for most Americans. Created in November 1978 by the US Congress, Section 401(k) of the Revenue Act was originally intended as a way to defer bonus and stock option compensation in a tax-free way. Everything changed in 1981 when the IRS issued rules allowing employee contributions, starting the 401(k) revolution.

Over the years, a number of consequential enhancements have occurred.  In 1996, the Small Jobs Protection Act (SBJPA) simplified the rules to encourage employer adoption of 401(k) plans. The Pension Protection Act (PPA) of 2006 made higher contribution levels permanent and encouraged automatic enrollment. The result has been a steady increase in the number of employers with plans as well as the number of Americans saving within a 401(k) (or, defined benefit) plan. As of 2020, more than 2-in-3 workers in private industry now have access to a 401(k):

Source: US Bureau of Labor Statistics

Starting in 2006, employers were also allowed to amend their 401(k) plan documents to allow employee after-tax contributions – which was the start of the Roth 401(k).

What Are the Differences Between a Traditional 401(k) & Roth 401(k)?

The key difference for those saving for retirement is the tax treatment of employee contributions. Traditional 401(k) savings is tax-deferred, and distributions are taxed as ordinary income. If, for example, you earn $80,000 and you defer $5,000, your taxable income will be reduced to $75,000, saving you $1,100 in taxes, given current tax brackets. However, that same $5,000 contribution made to a Roth 401(k) would be fully taxable. In both cases, the growth of the investment would be tax-deferred.

So, our basic framework for contributions, withdrawals, and growth looks like this:

Some Considerations When Weighing the Two Plans

So far, this might seem pretty straightforward. Do you want to pay taxes now or later? But, as with everything related to your personal finances, it can be a little more complicated than that. There are a number of considerations you will want to weigh in addition to the “pay now vs. pay later” question.

First, contributions to a traditional 401(k) could not only lower your income and taxes, directly, but also reveal other tax benefits that you could not obtain, otherwise. That is because a traditional 401(k) contribution lowers both your AGI and MAGI levels (adjusted and modified adjusted gross income). If you are on the cusp of being able to take the student loan interest deduction (capped at $140,000 for married filing jointly), for example, it might make sense to contribute to a traditional 401(k) to bring you under that MAGI threshold. On the other hand, since a Roth 401(k) contribution is made with post-tax dollars, this lowering of income is not an option via the 401(k).

A second major consideration is whether you think that you will be in a higher tax bracket or lower tax bracket upon retirement and using the funds. Obviously, no one knows what future tax rates will look like, but you can still use your best judgment to determine where you think you will realistically fall in retirement. Talk to a financial professional if you need some help calculating your projected income in retirement. You will also need to consider how the income will be treated. Taking some of your retirement income from a Roth 401(k), for example, can lower your gross income in the eyes of the IRS (in comparison), which may in turn lower your retirement expenses. A lower income in retirement may also reduce the taxes you pay on your Social Security benefits and the cost of your Medicare premiums that are tied to income. Traditional 401(k) income receives different tax treatment, however, in which case you might lose this potential advantage.

You will also want to consider your age and timeframe for making withdrawals as well as how much flexibility you seek in making withdrawals in retirement. This includes whether or not you envision yourself potentially retiring early. That is because unlike the IRA version of the Roth, you cannot withdraw contributions from a Roth 401(k) any time you like. The Roth 401(k) has a five-year rule for distributions; you must hold the account for five years before distributions are considered qualified and can be taken tax-free. That rule applies even if you have reached 59½, the age at which retirement distributions are typically allowed.

What About A Roth IRA?... And Some Final Thoughts

That final point about withdrawal periods is definitely something to consider if you are getting a late start on retirement planning and want to access that money soon. In that case, a Roth IRA may be a better choice, since it does not have the same restrictions.

Then there is the reverse scenario: You would rather not access that money at all. Like traditional 401(k)s and traditional IRAs, Roth 401(k)s require you to begin taking distributions at 72. These are called required minimum distributions. But the Roth 401(k) has an easy way out: You can roll its balance directly into a Roth IRA without a tax burden. And since there is no income limit for Roth 401(k) contributions like there is on Roth IRAs, this is a great way for high earners to accumulate a lot of funds in their Roth IRA, indirectly. Then, since the Roth IRA does not require minimum distributions, you are better positioned to potentially preserve that money and pass the account to your heirs or charities.

So, which one is right for you? Generally, a Roth 401(k) can be the better option than a traditional 401k for:

  • Highest wage earners (to maximize retirement savings)
  • Lower wage earners (those already under other MAGI tax benefit caps)
  • Big savers
  • Younger employees 

Keep in mind: which plan is right for you today could be very different for you in the future as your personal situation changes. There is also nothing wrong with contributing to both to hedge your retirement planning. And do not forget: any employer contributions — whether they be employer match or profit-sharing plans — are always made with pre-tax (traditional) contributions.

For More Information About Our Approach To Wealth Planning for Retirement, Contact Our Team Of Financial Advisors Today!

Sources:

https://www.ebri.org/docs/default-source/fast-facts/ff-318-k-40year-5nov18.pdf

https://www.bls.gov/opub/ted/2021/67-percent-of-private-industry-workers-had-access-to-retirement-plans-in-2020.htm

https://www.nerdwallet.com/article/investing/roth-401k-vs-401k

https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/traditional-and-roth-401ks

https://www.nerdwallet.com/article/investing/what-is-a-roth-ira

https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans

https://www.nerdwallet.com/best/investing/roth-ira-accounts

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

 In 2022 the maximum contribution is $20,500 for workers younger than 50 years old, with an additional $6,500 catch-up contribution available for those 50 or older

Wells Fargo Advisors Financial Network and its financial advisors provide non-fiduciary services only. They do not provide investment advice [as defined under the Employee Retirement Income Security Act of 1974 as amended (“ERISA”), have any discretionary authority with respect to the plan, make any investment or other decisions on behalf of the plan, or otherwise take any action that would make them fiduciaries to the plan under “ERISA”.

Wells Fargo Advisors Financial Network and its affiliates do not provide legal or tax advice. Transactions requiring tax consideration should be reviewed carefully with your accountant or tax advisor. Any estate plan should be reviewed by an attorney who specializes in estate planning and is licensed to practice law in your state.

Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), member SPIC. Magellan Financial Heirloom Wealth Management is a separate entity from WFAFN.

Summary
How to Decide Between A Traditional 401(k) and Roth 401(k)?
Article Name
How to Decide Between A Traditional 401(k) and Roth 401(k)?
Description
If you are weighing the choice between a traditional and Roth 401(k), keep reading to learn background on the plans and some factors you may want to consider.
Author
Jon Soden
Publisher Name
Magellan Financial
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Magellan Financial

Categorized: Investing
Tagged: 401(k), 401k Retirement Plan, Early Retirement, Roth 401(k)

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