Your retirement is likely the largest financial goal you have. If you have a 401(k) available at work, it can be an incredibly powerful tool in your arsenal to help you save for that goal. With annual contribution limits as high as $23,000 for people under age 50 or $30,500 for those age 50 and up, you might even be able to become a millionaire by retirement from your 401(k) alone.
401(k) plans come in two distinct styles: traditional and Roth. The differences between them can have a big impact on both your current financial situation and what your overall financial profile looks like in retirement. If you've got both available to you in 2024, choosing between them might seem a bit daunting at first. This article can help you weigh several key factors to come up with a great decision for yourself.
What are the key differences between the two?
In a Traditional 401(k), the money you contribute comes out of your paycheck before tax. While inside the plan, that money grows tax-deferred. Once you reach a standard retirement age (typically 59 and a half), you can withdraw the money from your plan without penalties, but you will pay ordinary income taxes on those withdrawals.
In a Roth 401(k), on the other hand, you contribute after-tax money to the plan. While inside it, the money again grows tax-deferred. Once you reach a standard retirement age, you can withdraw the money from your plan without facing penalties or ordinary income taxes.
In addition, once you reach age 73 (rising to 75 by 2033), you face required minimum distributions (RMDs) on the money inside your traditional 401(k). Starting in 2024, Roth 401(k) plans are no longer subject to those RMDs during the original account owner's life. That can make a big difference for retirees who have managed to build a substantial nest egg in their plans.
Why pick a traditional 401(k)?
Despite the potential disadvantages once you reach retirement, there are still often good reasons to pick a traditional 401(k) over a Roth 401(k).
First, because the money you contribute is tax-deductible, it is easier to come up with a significant amount of cash to invest. Say you're in the 24% Federal tax bracket and face a 5% state income tax rate. Every $1,000 you invest in a traditional 401(k) will cost you only around $710 of spendable income. If you're looking to make a major contribution to your retirement account, that difference can quickly add up.
Second, the tax trade-off can work to your advantage if you don't expect to have a huge nest egg in traditional-style retirement accounts by the time you hit retirement. Say you deposit $30,000 in a high-income year late in your career, and then, once you retire, a $30,000 withdrawal from your 401(k) is your only source of income in a year before you start Social Security. In that sort of situation, you can easily save money on taxes overall.
Third, there are situations where financial benefits phase out based on your income level. If you buy your own health insurance, for instance, premium subsidies are based on your income and household size. Similarly, the child tax credit has income levels where the benefit starts to phase out. Getting the reduction in adjusted gross income that comes with a traditional 401(k) contribution may help you keep your income low enough to qualify for subsidies and benefits such as those.
Fourth, if you are part of the financial independence, retire early (FIRE) movement, you might want to put at least some money into a traditional 401(k). This is because strategies to access your retirement money early don't let you avoid the taxes on the gains in your Roth 401(k) for those early withdrawals.
Fifth, a traditional 401(k) can be a great source of money to tap to cover expensive healthcare costs later in life. This is because medical expenses that exceed 7.5% of the income of a person age 65 or up become deductible expenses. Even if a major medical expense means a very large withdrawal from a traditional 401(k) for a senior, the tax burden won't bite nearly as badly.
Why pick a Roth 401(k)?
The Roth 401(k) can be a clear winner for people who want to -- and are able to -- max out their retirement plan contributions throughout long stretches of their careers. This is because the contribution limits are the same whether you contribute to a Roth 401(k) or a traditional one. Since money in a Roth 401(k) is not taxed once you reach a standard retirement age, any given account balance in a Roth 401(k) translates to more spending power than the same balance in a traditional 401(k).
In addition, the Roth 401(k) can be a tremendous tool for people who start saving for retirement early in their careers. Compounding over the space of 45 years can potentially turn a single year's $20,000 contribution into over $1 million, all on its own. That can be a really nice bucket of completely tax-free money to have simply for forgoing a small tax break from that initial contribution.
Finally, Roth 401(k)s no longer being subject to RMDs during the original account owner's life makes them great tools for keeping income down in retirement and for estate planning.
From the perspective of keeping your income down in retirement, money can now be compounded in a Roth 401(k) for the duration of the original account owner's life. That means any dividends, interest, or capital gains in the account remain tax-free. When Roth 401(k)s were still subject to RMDs, if you invested the money once you withdrew it, it could be subject to investment-related taxes.
When it comes to estate planning, your heirs would much prefer to inherit money from a Roth 401(k) than a traditional one. While both types of inherited 401(k)s are typically subject to RMDs (with certain exemptions for spouses), distributions from an inherited Roth 401(k) are tax-free. That's a huge benefit to heirs compared to distributions from an inherited traditional 401(k), which faces ordinary income taxes.
Get started now
If you still can't decide whether to contribute to a Roth 401(k) or a traditional 401(k), you can split your contributions between the two if your employer allows. Just note that your contribution limits are the total you're allowed to contribute across both plans.
Either way, it's still January 2024, so you still have most of the year ahead of you to get as much as you can into your 401(k). Make today the day you get started and improve your chances of reaching retirement with a financially comfortable nest egg.