What You Need to Know Before Choosing a 401(k) Plan
Over the past couple of weeks, we’ve covered the basics of good 401(k) investing.
We learned how to avoid some of the most common mistakes investors make with these popular accounts, and I’ve shared some additional steps you can take to maximize the long-term value of your retirement savings.
But there is still one question that I haven’t addressed: How do you decide whether to contribute to a traditional or Roth 401(k) plan?
As I mentioned last week, this can be a difficult question for many folks. And in many cases, there isn’t a clear right or wrong answer.
However, I’ve heard from several readers asking for some guidance on this topic.
So today I’d like to share some general guidelines you can use to make an informed decision.
Before I do, let’s quickly review some of the key similarities and differences between these two types of 401(k)s for those who may not be familiar.
We’ll start with what they have in common.
Both traditional and Roth 401(k)s are employer-sponsored plans that No. 1, allow you to contribute earnings toward your retirement, and No. 2, allow your employer to match a percentage of those contributions.
Both traditional and Roth 401(k) plans have the same annual contribution limits. For 2022, an individual may contribute up to a total of $20,500 to any 401(k) plans. Folks aged 50 or older can contribute an additional $6,500, for a total of $27,000.
And finally, both types of accounts are subject to the same required minimum distribution (RMD) rules. This means folks with either type of account generally must begin taking annual distributions (a fancy word for withdrawals) no later than age 72 unless they’re still working.
However, there are some important differences between these account types as well.
The first is the tax treatment of contributions (the money you and your employer contribute to the account).
In a traditional 401(k), all contributions are made “pre-tax.” This reduces your current taxable income and allows your money to grow tax deferred.
In a Roth 401(k) — just like in a Roth individual retirement account (IRA) — your contributions are made “post-tax.” This has no effect on your current taxable income, but your money can grow tax-free.
The second major difference is the tax treatment of distributions.
In a traditional 401(k), both your contributions and your employer’s matched contributions — and all investment gains they produce — are subject to federal and state income taxes when withdrawn.
In the Roth 401(k), your contributions and any investment gains they produce are generally tax-free. (More on this in a moment.)
However, employer-match contributions in a Roth plan are still considered “pre-tax.” That means these contributions and their investment gains will be taxed as regular income when withdrawn.
The next difference between traditional and Roth 401(k)s has to do with what’s called “qualified distribution” rules.
Either type of account will generally allow penalty-free withdrawals — known as qualified distributions — starting at age 59 1/2, when you leave your job, or upon disability or death.
In a traditional 401(k), any withdrawals that don’t meet these qualified distribution rules are subject to a 10% early withdrawal penalty, in addition to the usual income taxes.
In a Roth 401(k), it’s a little more complicated.
Qualified distributions in a Roth must meet those previous rules plus one more: The account must also have been open for at least five years prior to that distribution.
Individual contributions to a Roth are always tax-free when withdrawn, whether they meet these qualified distribution rules or not.
However, any non-qualified distributions of individual contribution investment gains, employer-match contributions, or employer-match investment gains are subject to both ordinary income tax and the same early withdrawal penalty as a traditional 401(k).
The last major difference between these account types has to do with “rollovers,” or transfers.
In short, a traditional 401(k) can typically be rolled over to any other 401(k) or IRA plan, either traditional or Roth.
But a Roth 401(k) can only be rolled over to another Roth 401(k) plan or a Roth IRA (the latter of which has much lower annual contribution limits).
Ok, now that we’ve covered some of the benefits and drawbacks of each type of account, let’s look at when it might make sense to choose each type.
First, here are some situations where you might choose a traditional 401(k):
1. Your employer doesn’t offer a Roth option.
This one is obvious, but not every employer provides a Roth 401(k) option.
2. You expect your income tax rate at retirement to be significantly lower than it is today.
For example, you might earn a high income now but expect to live on less taxable income in retirement.
With a traditional 401(k), you can essentially get a tax deduction now (while you’re in a higher tax bracket) and pay taxes later (when you expect to be in a lower one).
3. You want maximum flexibility with rollovers in the future.
A traditional 401(k) gives you the option to transfer to either type of 401(k) or IRA (traditional or Roth) down the road to better adjust to changing circumstances.
4. You’re opening a new account close to expected retirement.
As I mentioned before, you must hold a Roth 401(k) for at least five years to make qualified distributions. If you’re less than five years from retirement, you may not be able to take full advantage of the tax benefits of a Roth.
5. You want to reduce your current taxable income to take advantage of other tax benefits.
Contributing to a traditional 401(k) could potentially reduce your income enough to lower your income tax rate or make you eligible for certain tax credits. Depending on your income, it might even allow you to contribute to a Roth IRA when you otherwise couldn’t.
On the other hand, here are some situations where a Roth 401(k) might make more sense:
1. You expect your income tax rate will be significantly higher in the future and/or at retirement.
For example, you might have a modest current income but a large amount of retirement savings. Or you might be a younger employee who expects your income to grow significantly over time.
With a Roth, you can pay taxes at your current lower tax rate and avoid having to pay them at your higher expected tax rate in the future.
2. You expect tax rates in general to be much higher when you retire.
Of course, there’s no way to know for sure what income tax rates will look like five, 10, or 20 years down the road. But given historical tax rates and the current state of the U.S. government’s finances, it’s not unrealistic to expect tax rates to move higher from here.
3. You don’t qualify for a Roth IRA and want to diversify your taxable investments.
If you earn too much income to contribute to a Roth IRA and have significant taxable investments, it might make sense to contribute to a Roth 401(k) to protect some of your money from deferred taxes.
4. You believe there’s a significant chance you may need to make a non-qualified withdrawal.
As I mentioned earlier in this series, it’s generally a terrible idea to withdraw from your 401(k) before retirement. And I would urge you to take every reasonable step (like building up a rainy day fund) to make sure you don’t need to.
But if your circumstances are such that an early withdrawal may be necessary, a Roth 401(k) will generally allow you to avoid paying taxes or penalties on the portion you contributed. These guidelines may be sufficient for many folks to make an informed decision. However, if you’re anything like me, you still may not have a clear choice in mind.
In that case, you might consider choosing both.
You see, many folks don’t realize you’re allowed to contribute to both a traditional and a Roth 401(k) each year. Your total contributions to both must remain under the annual limit, but you can divide that total any way you’d like.
Regardless of your current tax rate, contributing to both types of 401(k) can provide tax diversification, as I mentioned before. It can also give you more control over your annual taxable income in retirement.
For example, in years where your other taxable income is lower, you could choose to withdraw more from your traditional account and less from the Roth. In years where it’s higher, you could withdraw more from your tax-free Roth.
Now, if you’re currently only contributing enough for your employer’s match, then you can effectively follow this approach by contributing to a Roth 401(k) alone.
Because of the different tax rules in a Roth, your contributions will grow tax-free, while your employer’s match will grow tax-deferred like in a traditional 401(k).
However, if you’re contributing more than your employer’s match up to the annual contribution limits, you’ll likely want to contribute funds to both types of accounts.
(If your employer won’t allow you to contribute to both each month, many will still allow you to switch your contribution types from year to year, or even month to month in some cases.)
Contributing to both a traditional and Roth 401(k) will also protect you from any potential tax changes in the future. For example, it’s not impossible that the government might someday decide that Roth distributions should no longer be tax-free.
To be clear, I’m not predicting this will happen. But when it comes to tax policy, there’s no telling what the future might look like.
Splitting your funds between a traditional and Roth 401(k) would ensure you can still take advantage of some tax benefits, even in this kind of worst-case scenario.
That’s it for this week. As always, if you have any questions or comments on what we covered, I would love to hear from you at [email protected]. Please note that I can’t respond to every email, but I read them all.