401k vs. Roth 401k: Which One Is Better?

A 401k is a great vehicle for long-term savings. Recently, I’ve seen posts on X where financial commentators debate the utility of a 401k, a few even calling them a scam. I’m not sure where that comes from. I advocate utilizing your 401k as much as possible with certain caveats. Contributing pre-tax money has been the traditional contribution method, whereas today, more and more 401k plans offer a Roth contribution option. In fact, about half of employers now offer a Roth option. Maybe you saw that option and wondered if you should choose it but had trouble pulling the trigger. I aim to explain the difference between your traditional contribution option and the Roth option before giving you some parameters for deciding the best fit for your circumstances.

The 401k Difference

Both 401k contribution types offer a $23,000 contribution limit for 2024 (which rises to $30k if you are 50 or older) and tax advantages (either now or later). The traditional 401k involves tax-deferred contributions, meaning you won’t pay any federal and state income taxes on the dollars you contribute now, but you’ll pay those taxes when you withdraw later, including on the growth and employer contributions. (Remember, though, that Social Security and Medicare taxes still apply to the contributions) The Roth 401k is a retirement savings option that taxes your contributions now, but your withdrawals in retirement are tax-free, including all your growth. Regardless of which contribution style you choose, employer contributions will be tax-deferred, meaning you’ll always have some money in your 401k that will be taxed later. 

One fact about all retirement accounts funded with pre-tax money is that at a certain age, you’re required to start withdrawing funds, called a Required Minimum Distribution or RMD. With recent law changes, all Roth-type accounts have no RMD requirements.

How to Decide

Before investing too much into any 401k account, ask yourself: Do I have any consumer debt? Do I have an emergency fund of 3 – 6 months of expenses? If not, focus on those goals before you start investing. It can be unnerving to wait, but if you have these financial goals in front of you, it can be difficult to save as much as I’m going to recommend if you’re trying to reach all of these goals simultaneously. This is where the mental part of finance comes into play. If you focus on one important goal at a time, you’ll progress more quickly, feel good about your accomplishment, and ultimately stay with the process.

Once you’re ready to invest, make contributing 15% of your gross income your savings goal. This will give you room in your budget for other goals like saving for college or paying off your mortgage and put you on a trajectory to having plenty of funds when you decide you want to stop working your day job. 

What Are Your Options?

One of the caveats to loading up your workplace 401k is the investment options available. Out of curiosity, I was reviewing the 401k plan where my 18-year-old son works and saw that they have mostly target-dated funds and only three US stock funds, none of which are low-fee. In this case, where he has such limited and poor options, he’s better off using other investment vehicles (like a Roth IRA) that provide him with a wider array of investment choices. This employer was offering a 5% match, so he’d be wise to contribute to that match in his 401k and then move over to an account like a Roth IRA to finish his investing goal.

Playing the Tax Game

The main game we’re playing when determining whether to make traditional 401k contributions or Roth contributions is the tax game. When playing the tax game, here are some questions we ask ourselves: Would you rather pay taxes now or later? What if tax rates go up in the future? Will you be in a higher tax bracket now or later? Which option would give you more peace of mind?

If you are in a higher tax bracket (>32%), the tax savings now from deferring that income could make a big difference later. This is because when you stop working, you have a likelihood of being in a lower tax bracket. Theoretically, when the money comes out of your account as a distribution, you pay a lower tax rate than when the contribution was made. 

However, if you’re not disciplined enough to invest that tax savings today, the growth in a Roth account will beat what you have in a traditional account. The huge advantage of a Roth 401k, though, is tax-free withdrawals, meaning your savings today are unaffected by future tax bracket adjustments because the money has already been taxed.

One final tax consideration causes us to look closely at the Roth option, no matter your age. Let me explain. Even if you find yourself in a lower income tax bracket when you stop working, the withdrawals you need to take from your traditional retirement accounts to meet your expenses and fun could push you into a higher tax bracket. That, in turn, could subject a higher percentage of your Social Security benefits to federal income tax. And the kicker, which we help our clients avoid if possible, is pushing you into a tax bracket where you pay a surcharge on your Medicare Part B & D premiums (called IRMAA). All these together may mean that giving up the tax deduction today by making Roth contributions may be well worth having tax-free withdrawals later. With your complete financial picture, we can advise you on the best strategy.

The Big Attraction

So why not use a Roth IRA and contribute to your traditional 401k, too? Direct contributions to a Roth IRA have income limits, so you may not qualify. If you have good investment choices in your 401k, that Roth option is attractive because it’s not subject to income limits, has much higher contribution limits, and having your retirement contributions all in one place makes life, well, simpler. 

Things to Watch

Before we finish, I want to mention a few important things to remember if you decide to switch some or all your contributions from pre-tax to Roth. First, you’ll have less in your paycheck because you aren’t deferring federal or state taxes. That means you’ll want to ensure you’ve adjusted your budget to account for the diminished cash coming into your bank account each pay period. Also, if you start a Roth 401k close to when you plan to take withdrawals, be aware that the Roth account has to have been open for five years before the distributions of growth are tax-free. Finally, and this is a major benefit, Roth 401k withdrawals are tax-free to your beneficiaries. How do you like the idea that any money from the Roth account will be 100% free of tax to your heirs? It makes their distribution strategy more straightforward and pain (tax) free.

Bottom Line

If you can’t tell, we favor the Roth option. That being said, why not do some of both? When you have both, you have flexibility in your withdrawal decisions. We can help you determine the best withdrawal strategy and manage your distributions. The bottom line is that you really can’t go wrong with either. Just invest, consistently! Choosing either type of 401k account is one of the best ways to build wealth and obtain your goals of freedom and generosity. If you want to discuss what option is best for you, click here.