Most employers’ 401(k) plans give you the option of making contributions on a pre-tax (traditional) or after-tax (Roth) basis. So, how do you decide which is right for you? The answer depends on several factors, including your current and expected future tax circumstances and your estate planning goals.
What’s the difference?
The difference between a traditional and Roth 401(k) is essentially the same as the difference between traditional and Roth IRAs: It comes down to the way they’re taxed. Contributions to traditional 401(k) plans are made with pre-tax dollars — that is, they’re deductible. Funds grow on a tax-deferred basis and both contributions and earnings are taxable when they’re withdrawn. Contributions to a Roth 401(k) plan are made with after-tax dollars — that is, they’re nondeductible. But qualified withdrawals of both contributions and earnings are tax-free.
Unlike a Roth IRA, however, you can participate in a Roth 401(k) plan regardless of your income. You’re ineligible to contribute to a Roth IRA if your modified adjusted gross income exceeds certain thresholds (in 2023, $153,000 for single filers and $228,000 for joint filers).
Salary deferral limits for traditional and Roth 401(k) plans are the same: currently, $22,500 plus an additional $7,500 in catch-up contributions if you’ll be 50 or older by the end of the year. The limits on combined employee and employer contributions are $66,000 and $73,500, respectively (up to 100% of compensation).
Distribution rules for traditional and Roth 401(k) plans are also similar. Penalty-free withdrawals (tax- and penalty-free withdrawals for Roth plans) are available when you reach age 59 1⁄2, die or become disabled (with limited exceptions). In addition, for a Roth 401(k), the account must be at least five years old.
Another important difference between the two types of plans is that traditional 401(k) accounts are subject to required minimum distribution (RMD) rules when you reach a certain age. Specifically, age 73 for those who turn 72 this year or after, increasing to age 75 for those who reach that milestone after 2032. Currently, Roth 401(k) accounts must make RMDs, but under the SECURE 2.0 Act, that requirement will be eliminated starting in 2024. SECURE 2.0 also allows plans to offer matching contributions as Roth contributions.
Which to use?
The main differences between traditional and Roth 401(k)s are the timing of income taxes and, starting next year, the ability to keep funds in a Roth account indefinitely. From a tax perspective, with a Roth 401(k) you pay tax at the time of your contributions, while traditional 401(k) funds are taxed when you withdraw them. Mathematically speaking, that means the best choice depends on whether you’ll be in a higher or lower tax bracket after you retire.
If you’re a high earner and expect to be in a lower bracket when you retire, you’re better off with the upfront tax break offered by a traditional 401(k). If you expect to be in a higher tax bracket in retirement (for example, if you’re early in your career and expect your income to grow substantially in the future, or you believe Congress will raise taxes down the road), then consider a Roth plan and pay the tax now.
Taxes aren’t the only factor, however. It’s also important to consider the estate planning implications. The elimination of RMDs for Roth 401(k)s make them a powerful estate planning tool. So long as you don’t need the funds for living expenses, you can leave them in the account, growing on a tax-free basis, for life. So long as the account is at least five years old, your heirs will be able to withdraw the funds tax-free.
With a traditional 401(k), the RMD rules will force you to draw down the account, regardless of whether you need the funds, leaving less for your heirs. Plus, withdrawals by your heirs will be taxable and, under current rules, nonspousal beneficiaries generally must withdraw the funds within 10 years.
Weigh your options
If your employer offers a choice between a traditional and Roth 401(k) plan, weigh your options carefully based on your tax circumstances and estate planning goals. If you’re uncertain about which to choose, consider splitting your contributions between the two options.
Disclaimer: The THK Legal Blog is for informational purposes only and should not be relied upon as legal advice. In no case does the published material constitute an exhaustive legal study, and applicability to a particular situation depends upon an investigation of specific facts. You should consult an attorney for advice regarding your individual situation. All THK blogs are considered advertising material by the Indiana Bar Association.