Traditional 401(k) Vs. Roth 401(k) – Which is Better for Me?

Written by Michael Bird, CIMA® , AIF® | Client Advisor | Bend, Oregon

If your employer sponsors a 401(k) plan, then it is more likely than not that you can contribute on either a Traditional (pre-tax) basis or on a Roth (after-tax) basis. This begs the question, “Which is better for me?” To answer that question, we must make the distinction between the two contribution types.

For the most part, the difference is in when you receive the tax benefit; either when you make the contribution or when you take the distribution. Traditional contributions are taken out of your paycheck and put into the 401(k) plan without being taxed, but the contributions and earnings are taxed upon qualified distribution (in retirement after age 59½). Roth contributions are the opposite – taxed as they enter the 401(k) plan, but both contributions and earnings are untaxed when pulled out as qualified distributions.

Which Is Better For Me?

It’s All About the Taxes

A 401(k) plan is an effective tool for saving for retirement because it includes tax incentives for saving. When determining which method is better for your situation, the primary factor that really matters is the tax rate now vs. the tax rate when you take distributions from the account.

If you expect your tax rate to be higher in retirement than it is now, choose the Roth option.

If you expect your tax rate to be lower in retirement than it is now, choose the Traditional option.

Of course, the problem is that there is no way to accurately predict whether tax rates will increase or decrease in the future. This is what makes this question a guessing game and impossible to answer.

Avoid the Guessing Game

Not sure what to do? No problem! Because there is no way to perfectly predict which option will be better for you, you could simply pick whichever option you like better or even choose to contribute to both Traditional and Roth accounts, effectively splitting the difference between the two contribution methods.

Focus on What’s Important

I want to stress the importance of not getting caught up on the topic of Traditional vs. Roth. While selecting the best form of contribution may matter, it will have a very limited impact on your retirement account balance compared to deciding how much to contribute to your 401(k) plan or how to invest within the plan. Be sure to contribute at least to the maximum that your employer matches and work towards contributing the annual maximum limit. By doing this, you are investing in yourself. Give until it hurts!

Other Nuanced Considerations

While the future tax rate is the factor that differentiates the winning choice between Roth & Traditional and is the most important factor that most people should consider, there are a few other minor considerations that may have an impact on your decision.

Tax Diversification – One additional reason to use the Roth option or a mix of both Roth and Traditional is tax diversification. In retirement, having both Roth and Traditional funds will allow you the flexibility to adjust your taxable income year-to-year by choosing how you draw from the two different account types. Keep in mind that all employer contributions, such as a match, are contributed on the Traditional basis.
Eliminate Required Minimum Distributions (RMDs) – 401(k) account types require you to take distributions, known as RMDs, starting at age 72 (assuming you are retired at this age). However, rolling a Roth 401(k) account into a Roth IRA is easy once you reach retirement. Roth IRAs are not subject to RMDs; therefore, this would eliminate RMDs so you could pass more of this money on to heirs.
Roth Five Year Rule – You cannot take any distributions from a Roth 401(k) until the account is five years old – an important distinction if you are considering this option close to retirement.

Roth Income Limits – Roth IRAs have income limits, meaning some high-income earners may be ineligible to participate in a Roth IRA. However, Roth 401(k) accounts do not have this restriction, making it the only path to a Roth account for some savers.

Emotion – If you’re a think-with-your-heart kind of person, this point is for you: emotions play a big role in how we invest. Some people like to use the Traditional 401(k) approach because of the immediate gratification of the tax break. If it gets you to save more for retirement, go for it! Others prefer to pay the taxes in small chucks on each contribution rather than see their $1 Million nest egg reduced to under $800,000 because they still owe taxes on it.

The Traditional vs. Roth question has been asked by thousands, if not millions, of people. Don’t overthink it. Devote your focus to saving as much as possible for your retirement and to not making investment mistakes. May the tax rates be ever in your favor!

Disclaimer: Investing in securities involves risk and is no guarantee against loss. This article is for informational purposes only and is not intended to be a solicitation, offering, or recommendation by ASI Wealth Management of any product, transaction, or services, including investment management or advisory services. The opinions expressed in this article should not be considered investment, tax, or legal advice and should not be relied on in making any investment or other decision. For more information, please see:
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