A traditional 401(k) and a Roth 401(k) are tax-advantaged retirement plans that can help you save for retirement. While both types of accounts follow similar rules — they have the same contribution limits, for example — the impact of a Roth vs. traditional 401(k) on your tax situation, now and in the future, may be quite different.
In brief: The contributions you make to a traditional 401(k) are deducted from your gross income, and thus may help lower your tax bill. But you’ll owe taxes on the money you withdraw later for retirement.
Conversely, you contribute after-tax funds to a Roth 401(k) and can withdraw the money tax free in retirement — but you don’t get a tax break now.
To help choose between a Roth 401(k) vs. a traditional 401(k) — or whether it might make sense to invest in both, if your employer offers that option — it helps to know what these accounts are all about.
Traditional 401(k) vs Roth 401(k): 5 Key Differences
Before deciding on a Roth or traditional 401(k), it’s important to understand the similarities and differences between each account, and to consider the tax benefits of each in light of your own financial plan. The timing of the tax advantages of each type of account is also important to weigh.
|Traditional 401(k)||Roth 401(k)|
|Funded with pre-tax dollars.||Funded with after-tax dollars.|
|Contributions are deducted from gross income and may lower your tax bill.||Contributions are not deductible.|
|All withdrawals taxed as income.||Withdrawals of contributions + earnings are tax free after 59 ½, if you’ve had the account for at least 5 years. (Employer match + earnings are taxed as income, however.)|
|Early withdrawals before age 59 ½ are taxed as income and are typically subject to a 10% penalty, with some exceptions.||Early withdrawals of contributions are not taxed, but earnings may be taxed and subject to a 10% penalty.|
|Account subject to RMD rules starting at age 72.||Also subject to RMD rules starting at 72, but it’s possible to rollover Roth 401(k) funds to a Roth IRA, to avoid RMDs.|
1. How Each Account is Funded
• A traditional 401(k) allows individuals to make pre-tax contributions only. These contributions are typically made through elective salary deferrals that come directly from an employee’s paycheck and are deducted from their gross income.
• Employees contribute to a Roth 401(k) also via elective salary deferrals, but they are saving after-tax dollars. So the money the employee contributes to a Roth 401(k) cannot be deducted from their current income.
2. Tax Treatment of Contributions
• The contributions to a traditional 401(k) are tax-deductible, which means they can reduce your taxable income now, and they grow tax-deferred (but you’ll owe taxes later).
• By contrast, since you’ve already paid taxes on the money you contribute to a Roth 401(k), the money you contribute isn’t deductible from your gross income, and withdrawals are generally tax free (some exceptions below).
3. Withdrawal Rules
• You can begin taking qualified withdrawals from a traditional 401(k) starting at age 59 ½, and the money you withdraw is taxed at ordinary income rates.
• To withdraw contributions + earnings tax free from a Roth 401(k) you must be 59 ½ and have held the account for at least five years (often called the 5-year rule). If you open a Roth 401(k) when you’re 57, you cannot take tax-free withdrawals at 59 ½, as you would with a traditional 401(k). You’d have to wait until five years had passed, and start tax-free withdrawals at age 62.
4. Early Withdrawal rules
• Early withdrawals from a 401(k) before age 59 ½ are subject to tax and a 10% penalty in most cases, but there are some exceptions where early withdrawals are not penalized, including certain medical expenses; a down payment on a first home; qualified education expenses.
You may also be able to take a hardship withdrawal penalty-free, but you need to meet the criteria, and you would still owe taxes on the money you withdrew.
• Early withdrawals from a Roth 401(k) are more complicated. You can withdraw your contributions at any time, but you’ll owe tax proportional to your earnings, which are taxable when you withdraw before age 59 ½.
For example: If you have $100,000 in a Roth 401(k), including $90,000 in contributions and $10,000 in taxable gains, the gains represent a 10% of the account. Therefore, if you took a $20,000 early withdrawal, you’d owe taxes on 10% to account for the gains, or $2,000.
Bear in mind that a traditional 401(k) and Roth 401(k) also share many features in common:
• The annual contribution limits are the same for a 401(k) and a Roth 401(k). For 2022, the total amount you can contribute to these employer-sponsored accounts is $20,500; if you’re 50 and older you can save an additional $6,500 for a total of $27,000. This is an increase of $1,000 over the 2021 limit, which was capped at $19,500.
• For both accounts, employers may contribute matching funds up to a certain percentage of an employee’s salary. And for both accounts matching funds are tax-deferred until retirement when they are taxed as income.
• In 2022, total contributions from employer and employee cannot exceed the lesser of a) the employee’s salary or b) $61,000 ($67,500 for those 50 and up).
• Employees may take out a loan from either type of account, subject to IRS restrictions and plan rules.
Because there are certain overlaps between the two accounts, as well as many points of contrast, it’s wise to consult with a professional when making a tax-related plan.
💡 Recommended: Different Types of Retirement Plans, Explained
How to Choose Between a Roth and a Traditional 401(k)
In some cases it might make sense to contribute to both types of accounts (more on that below), but in other cases you may want to choose either a traditional 401(k) or a Roth 401(k) to maximize the specific advantages of one account over another. Here are some considerations.
When to Pay Taxes
Traditional 401(k)s withdrawals are taxed at an individual’s ordinary income tax rate, typically in retirement. As a result these plans can be most tax efficient for those who will have a lower marginal rate after they retire than they did while they were working.
In other words, a traditional 401(k) may help you save on taxes now, if you’re in a higher tax bracket — and then pay lower taxes in retirement, when you’re ideally in a lower tax bracket.
On the other hand, an investor might look into the Roth 401(k) option if they feel that they pay lower taxes now than they will in retirement. In that case, you’d potentially pay lower taxes on your contributions now, and none on your withdrawals in retirement.
Often, younger taxpayers may be in a lower tax bracket. If that’s the case, contributing to a Roth 401(k) may make more sense for the same reason above: because you’ll pay a lower rate on your contributions now, but then they’re completely tax free in retirement.
If you’re older, perhaps mid-career, and in a higher tax bracket, a traditional 401(k) might help lower your tax burden now (and if your tax rate is lower when you retire, even better, as you’d pay taxes on withdrawals but at a lower rate).
Where You Live
The tax rates where you live, or where you plan to live when you retire, are also a big factor to consider. Of course your location some years from now, or decades from now, can be difficult to predict (to say the least). But if you expect that you might be living in an area with lower taxes than you are now, e.g. a state with no state taxes, it might make sense to contribute to a traditional 401(k) and take the tax break now, since your withdrawals may be taxed at a lower rate.
The Benefits of Investing in Both a Roth 401(k) and Traditional 401(k)
If an employer offers both a traditional and Roth 401(k) options, employees might have the option of contributing to both, thus taking advantage of the pros of each type of account. In many respects, this could be a wise choice.
Divvying up contributions between both types of accounts allows for greater flexibility in tax planning down the road. Upon retirement, an individual can choose whether to withdraw money from their tax-free 401(k) account or the traditional, taxable 401(k) account each year, to help manage their taxable income.
It is important to note that the $20,500 contribution limit ($27,000 for those 50 and older) is a total limit on both accounts.
So, for instance, you might choose to save $12,000 in a traditional 401(k) and $8,500 in a Roth 401(k) for the year. You are not permitted to save $20,500 in each (or $27,000 if you’re over 50).
Employer-sponsored Roth and traditional 401(k) plans offer investors many options when it comes to their financial goals. Because a traditional 401(k) can help lower your tax bill now, and a Roth 401(k) offers a tax-free income stream later — it’s important for investors to consider the tax advantages of both, the timing of those tax benefits, and whether these accounts have to be mutually exclusive.
When it comes to retirement plans, investors don’t necessarily have to decide between a Roth or traditional 401(k). Some might choose one of these investment accounts, while others might find a combination of plans suits their goals. After all, it can be difficult to predict your financial circumstances with complete accuracy — especially when it comes to tax planning — so it may be best to hedge your bets and contribute to both types of accounts, if your employer offers that option.
Another step to consider is a 401(k) rollover, where you move funds from an old 401(k) into an IRA. When you do a 401(k) rollover it can help you manage your retirement funds.
SoFi makes the rollover process seamless. You don’t have to worry about transferring funds yourself, or potentially incurring a penalty, and there are no rollover fees or taxes.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.