Financial Solutions

Financial Solutions

Financial Solutions

Financial Solutions

Dec 05, 2020

Traditional 401(k) versus Roth 401(k)

How do they differ and which one is right for you?

Setting up a 401(k) can seem like a daunting task. Luckily, more plan sponsors are getting the message and making the plans more user-friendly.

According to research from Willis Towers Watson, around 40% of sponsors reduced the number of investment options they offer over the past three years, and another 41% plan to do so by 2020. Around a quarter of employers increased their contribution, either by raising the match they offer to participating employees or through other means. Lastly, 70% of respondents now offer Roth features within their 401(k) plans, an increase from 54% in 2014 and 46% in 2012.

The benefits of a streamlined investment menu and a more generous match are obvious. But what about the choice between a traditional and Roth 401(k) option? How do they differ, and which should you choose?


Traditional 401(k)
Chances are if you work for a big company, your employer offers a traditional 401(k). According to a report by the Society for Human Resource Management, as many as 90% of employers offer some sort of traditional 401(k) or similar plan.

Your money goes into a traditional 401(k) account pretax—before it even hits your paycheck. By scooping it out before it becomes taxable income, it provides you with a tax benefit today. Suppose you make $50,000 per year, but save $5,000 in a traditional 401(k). Your taxable income is lowered to $45,000, so you would pay less in taxes now.

The government is going to come looking for its tax money at some point, though. You can start withdrawing money from your traditional 401(k)s without incurring a 10% penalty at age 59 1/2 (or 55, if you are already retired). You will be taxed ordinary income tax rates on the money withdrawn from the account.

Contribution limits
The contribution limit for 2021 is $19,500, or $26,000 if you are 50 or older. (This does not include employer match.)

Employer match
If you have a traditional 401(k) and your employer offers a match, invest at least up to the match amount. For example, if your employer’s matching policy is $0.75 of every dollar up to 5%, invest at least 5%. If you make $50,000, that is $1,875 per year that your employer is offering to give you; you are effectively turning it down if you do not make the full contribution.

Most likely to benefit
If you have a good reason to believe your tax bracket will be lower or the same as it is now when you are in retirement, a traditional 401(k) can be a good way to go.

Also, if you are on the cusp of qualifying for certain tax credits and deductions, lowering your taxable income through traditional 401(k) contributions could benefit your situation.


Roth 401(k)
Your company may offer a Roth 401(k) in addition to a traditional 401(k) option.

The main difference between the Roth 401(k) and the traditional is when the money is taxed. Roth 401(k) contributions are made with after-tax dollars, so you do not receive a tax break today. However, the balance of your Roth contributions and earnings are not taxed when you take a qualified distribution when you retire.

Contribution limits
The contribution limit for 2021 is $19,500, or $26,000 if you are 50 or older. (This does not include employer match.)

Employer match
Like with the traditional, invest at least enough to take advantage of your full company match. The company match works a little differently with Roth 401(k)s, though. According to the IRS, your employer can only allocate your designated Roth contributions to your designated Roth account. Any employer contributions to match designated Roth contributions must be directed into a pretax account, just like matching contributions on traditional, pretax 401(k) contributions.

Most likely to benefit
If you believe your tax bracket will be higher in retirement than it is now in the early days of your career, a Roth 401(k) can be a great option.

Additionally, if you plan to roll over to a Roth IRA, rolling over a Roth 401(k) is simpler than rolling over a traditional 401(k) because you would not owe taxes on the conversion. (More on that below.)


After-tax 401(k)
Do not confuse a Roth 401(k) with an after-tax 401(k). Traditional and Roth 401(k) savers will always come out ahead of after-tax 401(k) savers, and most investors probably do not need this account type. (See the example below.)


Which One Is Better?
If you are like many people, you might not know whether your marginal tax rate will be lower in retirement than it is now. If you did, you would know with certainty which account type is the better choice.

Even though it seems like the Roth saver would come out ahead because all the investment earnings come out tax-free, that is not necessarily the case.

Here is a simplified example if you follow $10,000 invested in a traditional 401(k) for 10 years, where the tax is applied at end of holding period. Suppose that that initial contribution earns a 5% return every year. When we take the money out, it is taxed at a 25% rate.

($10,000*1.05^10)*0.75 = $12,216.71

Now we will put the same amount into a Roth 401(k), where the tax rate is applied to the contribution amount (funding the account with after-tax contributions).

(0.75*$10,000)*1.05^10 = $12,216.71

The variable that would cause the outcome to differ is if you are in a different tax bracket. In the previous example, if you started your career in the 22% tax bracket but ended it in the 32%, you would have come out ahead with the Roth, as your traditional 401(k) balance would shrink to $10,913.59 after factoring in your higher tax rate in retirement. (But obviously, tax brackets could change over a multi-decade span.)

By contrast, the after-tax 401(k) is funded with after-tax dollars and the earnings are also taxed. This is why the after-tax 401(k) option does not have a chance of outperforming the Roth or traditional 401(k) options; they really only make sense for investors who have already maxed out contributions to tax-advantaged account types such as traditional or Roth 401(k)s.

[(0.75*$10,000)*1.05^10] = $12,216.71

Then you subtract the contribution amount, which you already paid taxes on. $12,216.71-$7,500 = $4,716.71. The $4,716.71 difference is the earnings, which would be taxed at ordinary income rates, assuming you are in the 25% tax bracket: ($4,716.71*0.75 = $3,537.53). To figure out your after-tax balance, you would then add your post-tax earnings back to your after-tax contribution amount.

$7,500+$3,537.53 = $11,037.53


Why Not Choose Both?
If you have both types of plans available, another option would be to invest in both the traditional and Roth 401(k). Bear in mind, you can only invest up to $19,500 in total across the two plans; $26,000 if you are 50 or older. The benefit of investing in both plan types is tax diversification. Like asset-class diversification, diversifying your portfolio among account types with different tax treatments ensures that at least some of your assets will be well-positioned whatever may come; you are not casting your lot with a single outcome.

At some point (age 70 1/2 currently) investors will need to take required minimum distributions from their 401(k) accounts. If you come into retirement with a few different account types, you can exert more control over how much you pay in taxes in any given year by choosing how much to withdraw from each account type each year.

Roth IRAs do not require minimum distributions; you decide exactly how much to withdraw, and when. If that appeals to you, it is simpler to roll a Roth 401(k) into a Roth IRA because you would not owe taxes on the money rolled over. Rolling a traditional 401(k) account into a Roth IRA does require that you pay tax on the rollover amount at your ordinary income tax rate.

© Morningstar 2018. All Rights Reserved. Used with permission.

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