The most expensive thing you’ll probably buy during your lifetime is retirement. Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you participate in a 401(k) plan – you’re saving now to buy retirement income later. When you consider that income may need to last 10, 20, even 30 years, it’s easy to understand why retirement is not cheap. However, by following a simple 3-step plan during your working years - save early and often, invest appropriately, minimize account fees - you can reduce the out-of-pocket cost of your retirement by a lot.
You may be able to reduce your retirement's cost even further by contributing Roth deferrals to your 401(k) account instead of traditional deferrals. While traditional deferrals are contributed pre-tax and then taxed at distribution, Roth deferrals are the opposite - contributed after-tax and then tax-free at distribution. Taking the tax hit on Roth deferrals now could save you a lot in taxes in the long-run.
Not all 401(k) plans permit Roth deferrals, but if your plan does, making an informed decision about the best deferral option for your 401(k) account can be well worth your time. Not sure how to choose? Below is a comparison and factors to consider.
In general, Roth and traditional deferrals are subject to similar contribution and distribution rules. Their primary difference is when they’re taxed – Roth on the front-end (at contribution), traditional on the back-end (at distribution).
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Traditional 401(k) |
Roth 401(k) |
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Tax treatment at contribution |
Contributions are made pre-tax, which reduces your current taxable income. |
Contributions are made after taxes, with no effect on current taxable income. |
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Contribution limits |
Subject to the same IRC section 402(g) annual limit - $23,000 ($30,500 if “catch-up” eligible) for 2024. |
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Tax treatment at distribution |
Both contribution principal and earnings are subject to Federal and most State income taxes when distributed. |
Contribution principal is tax-free when distributed. Earnings too if part of a “qualified distribution.” A qualified distribution is made at least five years after the first Roth deferrals are contributed and after:
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Distribution restrictions |
Same. Neither can be distributed until one of the following events occurs:
However, a plan may permit their in-service distribution upon:
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Penalty applies to both contribution principal and earnings. |
Penalty applies to taxable earnings only. |
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Can be rolled to any qualified plan or IRA. |
Can only be rolled to:
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Distributions must begin no later than age 72 (age 70 ½ if reached age 70 ½ before January 1, 2020), unless still working and not a 5% owner. |
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To make an educated choice between traditional and Roth deferrals, you want to consider your current tax situation and your anticipated situation in retirement. In general, you want to choose traditional deferrals if you expect your tax rate to decrease in retirement and Roth deferrals if you expect it to increase.
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Reasons to Choose Traditional 401(k) |
Reasons to Choose Roth 401(k) |
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Below are examples that demonstrate how taxes would affect the value of Roth and traditional deferrals over a 10-year period assuming a 5% annual rate of return.
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Example 1 - Tax rates are the same |
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Roth 401(k) |
Traditional 401(k) |
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Pre-tax income |
$2,000.00 |
$2,000.00 |
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Taxes (20%) |
20.00% |
0.00% |
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Contribution amount |
$1,600.00 |
$2,000.00 |
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Balance at retirement |
$2,606.23 |
$3,257.79 |
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Taxes (20%) |
0.00% |
20.00% |
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After-tax proceeds |
$2,606.23 |
$2,606.23 |
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Example 2 - Tax rate is lower in retirement |
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Roth 401(k) |
Traditional 401(k) |
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Pre-tax income |
$2,000.00 |
$2,000.00 |
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Taxes (20%) |
20.00% |
0.00% |
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Contribution amount |
$1,600.00 |
$2,000.00 |
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Balance at retirement |
$2,606.23 |
$3,257.79 |
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Taxes (15%) |
0.00% |
15.00% |
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After-tax proceeds |
$2,606.23 |
$2,769.12 |
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Example 3 - Tax rate is higher in retirement |
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Roth 401(k) |
Traditional 401(k) |
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Pre-tax income |
$2,000.00 |
$2,000.00 |
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Taxes (20%) |
20.00% |
0.00% |
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Contribution amount |
$1,600.00 |
$2,000.00 |
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Balance at retirement |
$2,606.23 |
$3,257.79 |
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Taxes (25%) |
0.00% |
25.00% |
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After-tax proceeds |
$2,606.23 |
$2,443.34 |
It can be tough to pass up a tax break by choosing Roth over traditional deferrals, but you need to think ahead when saving for retirement. Paying taxes now might help you save thousands – or even tens of thousands – in net taxes. That additional money that can come in handy in retirement.
That said, nobody has a crystal ball about their future earnings and tax rates. If the right choice for you is not clear, you can always split your deferrals between Roth and traditional.