Roth vs. Traditional 401(k) Contributions – How to Choose Blog Feature
Eric Droblyen

By: Eric Droblyen on August 5th, 2020

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Roth vs. Traditional 401(k) Contributions – How to Choose

Roth 401(k) | Retirement Planning | Plan Design

The most expensive thing you’ll probably buy during your lifetime is retirement. Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you participate in a 401(k) plan – you’re saving now to buy retirement income later. When you consider that income may need to last 10, 20, even 30 years, it’s easy to understand why retirement is not cheap. However, by following a simple 3-step plan during your working years - save early and often, invest appropriatelyminimize account fees - you can reduce the out-of-pocket cost of your retirement by a lot.

You may be able to reduce your retirement's cost even further by contributing Roth deferrals to your 401(k) account instead of traditional deferrals. While traditional deferrals are contributed pre-tax and then taxed at distribution, Roth deferrals are the opposite - contributed after-tax and then tax-free at distribution. Taking the tax hit on Roth deferrals now could save you a lot in taxes in the long-run.

Not all 401(k) plans permit Roth deferrals, but if your plan does, making an informed decision about the best deferral option for your 401(k) account can be well worth your time. Not sure how to choose? Below is a comparison and factors to consider.

Roth vs Traditional 401(k) – Side-by-Side Comparison

In general, Roth and traditional deferrals are subject to similar contribution and distribution rules. Their primary difference is when they’re taxed – Roth on the front-end (at contribution), traditional on the back-end (at distribution).

 

Traditional 401(k)

Roth 401(k)

Tax treatment at contribution

Contributions are made pre-tax, which reduces your current taxable income.

Contributions are made after taxes, with no effect on current taxable income.

Contribution limits

Subject to the same IRC section 402(g) annual limit - $19,500 ($26,000 if “catch-up” eligible) for 2020.

Tax treatment at distribution

Both contribution principal and earnings are subject to Federal and most State income taxes when distributed.

Contribution principal is tax-free when distributed.

Earnings too if part of a “qualified distribution.” A qualified distribution is made at least five years after the first Roth deferrals are contributed and after: 

  • Attainment of age 59½
  • Death or disability

Distribution restrictions

Same. Neither can be distributed until one of the following events occurs:

  • Termination of employment
  • Death or disability
  • Plan termination

However, a plan may permit their in-service distribution upon:

  • Age 59 ½
  • Hardship

Premature distribution penalty

Penalty applies to both contribution principal and earnings.

Penalty applies to taxable earnings only.

Rollovers

Can be rolled to any qualified plan or IRA.

Can only be rolled to:

  • another Roth 401(k) account
  • a Roth IRA

Required Minimum Distributions (RMDs)

Distributions must begin no later than age 72 (age 70 ½ if reached age 70 ½ before January 1, 2020), unless still working and not a 5% owner.

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Roth vs. Traditional 401(k) - How to Choose

To make an educated choice between traditional and Roth deferrals, you want to consider your current tax situation and your anticipated situation in retirement. In general, you want to choose traditional deferrals if you expect your tax rate to decrease in retirement and Roth deferrals if you expect it to increase. 

Reasons to Choose Traditional 401(k)

Reasons to Choose Roth 401(k)

  • You expect to be in a lower tax bracket in retirement
  • You want maximum rollover flexibility.
  • You want to do an in-plan Roth rollover later. 
  • You expect to be in a higher tax bracket in retirement.
  • You’re young and expect your income to grow throughout your career.
  • You want to minimize your Social Security taxes and/or Medicare B premiums in retirement.

Roth vs Traditional 401(k) - Tax Examples

Below are examples that demonstrate how taxes would affect the value of Roth and traditional deferrals over a 10-year period assuming a 5% annual rate of return.

Example 1 - Tax rates are the same

 

Roth 401(k)

Traditional 401(k)

Pre-tax income

$2,000.00

$2,000.00

Taxes (20%)

20.00%

0.00%

Contribution amount

$1,600.00

$2,000.00

Balance at retirement

$2,606.23 

$3,257.79 

Taxes (20%)

0.00%

20.00%

After-tax proceeds

$2,606.23 

$2,606.23

Example 2 - Tax rate is lower in retirement

 

Roth 401(k)

Traditional 401(k)

Pre-tax income

$2,000.00

$2,000.00

Taxes (20%)

20.00%

0.00%

Contribution amount

$1,600.00

$2,000.00

Balance at retirement

$2,606.23 

$3,257.79 

Taxes (15%)

0.00%

15.00%

After-tax proceeds

$2,606.23 

$2,769.12

Example 3 - Tax rate is higher in retirement

 

Roth 401(k)

Traditional 401(k)

Pre-tax income

$2,000.00

$2,000.00

Taxes (20%)

20.00%

0.00%

Contribution amount

$1,600.00

$2,000.00

Balance at retirement

$2,606.23 

$3,257.79 

Taxes (25%)

0.00%

25.00%

After-tax proceeds

$2,606.23 

$2,443.34

Some tax planning now can pay off big-time later!

It can be tough to pass up a tax break by choosing Roth over traditional deferrals, but you need to think ahead when saving for retirement. Paying taxes now might help you save thousands – or even tens of thousands – in net taxes. That additional money that can come in handy in retirement.

That said, nobody has a crystal ball about their future earnings and tax rates. If the right choice for you is not clear, you can always split your deferrals between Roth and traditional.

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About Eric Droblyen

Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.

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