This week marks National 401(k) Day, celebrated on the first Friday after Labor Day every year. It’s a great reminder that very few of us today have access to a traditional pension. Instead, most of us bear responsibility for building and managing our own retirement savings.

When building a retirement nest egg through an employer-sponsored defined contribution plan such as a 401(k) plan, you must make several key decisions, including which account type to fund: a traditional 401(k) or a Roth 401(k).

Pre-tax vs. after-tax contributions

With a traditional 401(k), you make pre-tax contributions to a tax-deferred retirement savings account. Because contributions are made “above the line,” they lower your taxable income and required tax withholdings for the tax year. As a result, the overall impact on your paycheck may be less than you might think.

For example, if your total tax rate is 30% and you contribute $500 pre-tax to a traditional 401(k) account, you will reduce your net pay by only $350. The $500 goes into your retirement account and is immediately invested, but the favorable tax treatment means that it effectively only costs you $350 in the current year.

You can defer taxes with a traditional 401(k), but not avoid them. In exchange for the current tax-year discount, you must pay taxes on future distributions from the account, including earnings.

Roth 401(k) contributions are the opposite, from a tax perspective. Contributions to a Roth 401(k) account are “below the line,” after taxes are deducted from your pay. You do not get the $150 current tax-year discount. But in contrast to a traditional 401(k), all future qualified distributions are tax free.

Is a Roth 401(k) or a Traditional 401(k) Better?

To decide whether a Roth 401(k) or a traditional 401(k) account is better for you, you will need to think about how your tax rate now compares with your expected tax rate in the future. If you think your income and tax rate will increase in retirement, a Roth 401(k) may make sense. If the reverse is true, you may benefit more from a traditional 401(k).

In making this analysis, keep in mind that many retirees are surprised that their marginal tax rate does not go down much in retirement—if at all. This could be because of a variety of reasons such as:

  • A younger still-working spouse
  • Investments in rental properties or other income sources
  • Continuing to work part-time, serve on boards, or start a business
  • Highly appreciated traditional 401(k) accounts with required minimum distributions (RMDs)

Also, according to the Congressional Budget Office, average federal tax rates are currently at their lowest in decades.

Average Federal Tax Rates figure
Additional considerations may include:
  • Does your employer match contributions to a traditional 401(k) differently from a Roth 401(k)?
    Carefully read your plan rules to understand how any matches are made. Often employers will have different mechanisms and accounting for matches, given the difference in tax treatment.
  • How long do you have before you need to make a withdrawal?
    As Roth 401(k) contributions are made after-tax, there are fewer penalties if an emergency arises. Similar to a traditional 401(k), you may pay a 10% early withdrawal penalty and taxes on the earnings in the account, but you will not pay taxes on the contributions you had made.
  • How much financial flexibility do you have currently?
    Since a pre-tax contribution today will decrease your current-year taxes, you will be able to spend or save more. Do you have current-year obligations that you must meet and therefore need a higher paycheck?
  • How much financial flexibility do you want in the future?
    Traditional 401(k) accounts require minimum distributions (RMDs) starting at age 72. So do Roth 401(k) accounts, but this can be avoided easily if the assets are rolled into a Roth IRA. In this way, you can better time the income you want vs. must take in any calendar year. Additionally, beneficiaries of a Roth 401(k) or a Roth IRA are not subject to RMDs nor taxes on withdrawals.

Summary of key features of traditional and Roth 401(k)s

Traditional 401(k)

  • Contributions are made pre-tax, i.e., they reduce taxable income
  • Paychecks higher
  • Taxes on contributions and growth are deferred until distributed
  • Required minimum distributions (RMDs) start at 72
  • Beneficiaries are subject to RMDs and taxes on withdrawals

Roth 401(k)

  • Contributions are made after-tax, i.e., they don’t reduce taxable income
  • Paychecks lower
  • Tax-free distributions
  • Required minimum distributions (RMDs) start at 72, but can be avoided if rolling 401(k) assets into a Roth IRA
  • Beneficiaries to Roth 401(k) or Roth IRA are not subject to RMDs or taxes on withdrawals

Consider diversifying 401(k) accounts for future flexibility

Just as you would diversify your investments, don’t overlook the potential benefits of managing your future income and marginal tax rate by building both traditional and Roth 401(k) savings. By splitting your contributions between traditional and Roth 401(k)s, you may be able to have the best of both worlds: some current-year tax benefit and some future flexibility in managing withdrawals for the maximum tax benefit.

For example, in high-income retired years when your tax rate is also high, you can draw more income from a Roth 401(k) account. In lower-income years, you can withdraw more income than is required from a traditional 401(k) account.

Need advice?

It can be difficult for individuals to understand the tradeoffs between a traditional and Roth 401(k), given how they affect current-year tax treatment of contributions and future tax treatment of distributions. Building your retirement assets with an eye toward your future withdrawal strategy can help with retirement and estate planning.

AMG builds comprehensive, tax-aware financial plans that clearly show these tradeoffs and help clients make informed decisions about what is best for their unique situation.

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