Traditional vs. Roth 401(k): Which is Better for You?

When enrolling in your 401(k) plan, one of the first decisions you will face is whether to make traditional pre-tax or Roth contributions to your account. Traditional 401(k)s allow you to delay paying income taxes on the dollars you save until you take them out at retirement. With Roth 401(k)s, you contribute after-tax dollars, meaning you pay the taxes up front and then you can withdraw them tax-free in retirement.

The decision between traditional and Roth savings doesn’t need to be intimidating. Essentially, the difference between the two options boils down to a preference of when you want to pay the taxes on the income you contribute: now or in retirement.

While both are great options, one may be better suited to you than the other. Understanding these differences can help you make the best choice for your savings.

Pre-Tax Traditional 401(k): Save Now, Pay Taxes Later 

With a pre-tax traditional 401(k), your deferrals reduce your taxable income when they are contributed, providing an immediate tax break. For instance, if you contribute $10,000 and are in the 22% tax bracket, you save $2,200 in taxes this year. However, both your contributions and earnings are taxed as ordinary income when you withdraw them in retirement.

Pros of a Pre-Tax 401(k):

1. Immediate tax savings: Lowering your taxable income now can be helpful, especially if you’re in a higher tax bracket.

2. Potential for higher end balance: Contributing more upfront (since you're saving on taxes) can lead to higher growth of your retirement savings.

3. Possibly lower taxes in retirement: If you expect to be in a lower tax bracket in retirement, this could reduce your tax burden when you withdraw funds.

Cons of a Pre-Tax 401(k)

1. Uncertainty around future taxes: You cannot predict your future tax rate with 100% certainty.

2. Bigger tax bills in retirement: Every dollar withdrawn is taxed as income, which can lead to higher tax liabilities.

Roth 401(k): Pay Taxes Now, Withdraw Tax-Free Later

With a Roth 401(k), contributions are made with after-tax dollars, meaning you don’t get an immediate tax break. However, both contributions and investment earnings can be withdrawn tax-free in retirement.

Pros of a Roth 401(k):

1. Tax-free growth and withdrawals: In retirement, withdrawals are tax-free, which can be valuable if you expect higher future tax rates.

2. More flexibility in retirement: Having a source of tax-free income provides flexibility when managing your retirement income.

Cons of a Roth 401(k)

1. No immediate tax saving: Since contributions are taxed upfront, you miss out on immediate tax benefits.

2. Higher contributions can feel costly: Since contributions are taxed upfront, contributing the same amount as a pre-tax 401(k) might feel more expensive, especially for those managing a tight budget.

Key Factors to Consider

1. Current vs. Future Tax Bracket: If you're in a high tax bracket now and expect to be in a lower one in retirement, a pre-tax 401(k) might save you more. On the other hand, if you believe your tax rate will rise, the Roth 401(k)’s tax-free withdrawals could be a better option. A general rule of thumb is that Roth is preferable if you are more than 15 years from retirement.  

2. Combining Both: Many people benefit from contributing to both types of accounts to diversify their tax exposure, allowing flexibility in retirement.

Making the Right 401(k) Choice: Traditional vs. Roth

The decision between a pre-tax and Roth retirement plan can be intimidating, but it doesn’t need to be. Don’t think of it as a “right/wrong” decision, instead think of it as a “good/great” decision. They both offer great tax benefits, and most importantly, they both help you prepare for retirement. So don’t stress too much about which one is right for you, because they are both great options!

If you would like help deciding which one may be a better option for you, please don’t hesitate to schedule a meeting with one of our RetireAdvisers℠ consultants.

The concepts expressed herein represent the views and opinions of Pension Consultants, Inc., and are not intended as legal, tax, or investment advice for any specific individual, account, or plan.