Should You Contribute to a Pre-Tax 401(k) or Roth 401(k)?
Traditional 401(k)s offer pre-tax contributions — it lowers your tax bill now, but you’ll pay taxes when you withdraw in retirement. Roth 401(k)s are becoming more common and can give you tax-free withdrawals in retirement (but you won’t get any tax benefits now).
When considering a traditional vs Roth 401(k), which is right for you? Keep reading to discover when you should contribute to a Roth vs traditional 401(k).
What is a pre-tax 401(k)?
A pre-tax 401(k) is the original version of the plan. According to the Investment Company Institute, it’s one of the most popular retirement plans — around 60 million Americans had a 401(k) plan as of 2020.
You make contributions with pre-tax dollars, and most employers allow you to deposit money from your paycheck directly into your plan. Because the contributions are pre-tax, you don’t pay taxes on the money you contribute. It lowers your taxable income, so you get a tax break now.
You also don’t pay taxes on investment gains. You essentially avoid taxes on contributions and earnings (like capital gains and dividends) until you withdraw the funds in retirement.
What is a Roth 401(k)?
A Roth 401(k) works just like a traditional 401(k) with one big difference — contributions are made with after-tax dollars.
They were introduced in 2001, making Roth 401(k)s a relatively new option for retirement savings. It combines the best features of a 401(k) and a Roth IRA: High contribution limits with no income restrictions on who can contribute. And, like a traditional 401(k), you can borrow money from your Roth 401(k).
Because you fund a Roth 401(k) with after-tax dollars, you take a tax hit now but can enjoy tax-free withdrawals in retirement.
Who’s eligible for a Roth 401(k)?
There’s really no restriction on who’s eligible for a Roth 401(k). If your employer offers it, you’re eligible.
Unlike a Roth IRA, a Roth 401(k) doesn’t have income limits. For example, according to the IRS, you’re not eligible to contribute to a Roth IRA if you earn more than $140,000 as a single filer ($208,000 for married filing jointly).
But you can contribute to a Roth 401(k) no matter how much you earn. Both the traditional and Roth 401(k) contribution limits for 2021 allow you to contribute up to $19,500. Account-holders age 50 or older can contribute an additional $6,500 as a “catch-up contribution.”
Pretax 401(k) vs Roth 401(k): Which is right for you?
Choosing between a Roth 401(k) and a pre-tax 401(k) is a balancing act. You need to decide what to do with your cash, but you don’t want to pay more taxes than necessary. 401(k) accounts can help you minimize taxes as long as possible.
A pre-tax 401(k) allows you to defer taxes. It lowers your adjusted gross income (AGI), so you pay less in taxes now when making contributions. Instead, your taxes are deferred — you pay income tax when you withdraw the funds in retirement.
But there’s such a thing as being “too efficient” with your tax strategies. Roth 401(k)s and traditional 401(k)s have required minimum distribution (RMD) rules. Account owners must start taking RMDs when reaching the age of 72, and distributions continue every year after that.
Here’s the danger: If you defer too much of your income, you could be forced into a higher tax bracket when RMDs kick in during retirement.
In the end, it comes down to whether it is better to pay your taxes now or later — and that depends primarily on your timeframe and what you think future tax rates might be.
When the Roth 401(k) is better
Generally, the Roth 401(k) is a popular retirement plan for people who want to enjoy tax-free growth and withdrawals. You’ll likely be better off choosing a Roth 401(k) if:
You’re young and in a low tax bracket
You expect tax rates across the country to go up in the future
You already have a traditional 401(k)
You anticipate your employment income to increase significantly in the future vs. what you make today
You make too much money to contribute to a Roth IRA directly
When to Choose the traditional 401(k)
The traditional 401(k) is an attractive option for people who can benefit from the tax break now. A traditional 401(k) is probably the better option if:
You’re in a high tax bracket
You expect your income need to be less in retirement than your income need today
Talk with a financial pro about your 401(k) options
The Roth 401(k) is an attractive option for people in a low tax bracket and who expect to be in a higher one when they retire. It can be tough to calculate just how much of your income you should defer for future taxes and how much you can afford to pay right now.
Still not sure which is right for you? You’re not alone. Many people don't know when to contribute to a 401(k) vs a Roth 401(k). If you contribute to the wrong type, you could end up overpaying in taxes. Wouldn’t you rather keep that money in your pocket?
When you choose a financial planner, you’ll get professional expertise to help determine which type of 401(k) is best suited for you. We’re here to help you make the most of your retirement dollars.