If you have a 401(k) at work, you’re probably familiar with the standard advice about such plans: make sure to contribute enough to receive any employer match and make the maximum contribution if you’re able. But some employers offer both a traditional 401(k) and a Roth 401(k), and it can be difficult to determine if it makes sense to switch. It is worth understanding how the two types of retirement accounts work along with five questions to ask yourself to select which one is best for you.
Traditional vs. Roth 401(k)s
Regardless of the kind of 401(k) account you use, you still have the same contribution limit: in 2021, you can save a total of up to $19,500, plus an additional $6,500 if you’re over age 50. When you reach retirement, both kinds of 401(k)s have required minimum distributions (RMDs) for account holders over the age of 72. This is a significant difference from a Roth IRA, which has no distribution requirements. The owner of a Roth 401(k) could eliminate their distribution requirement by rolling it into a Roth IRA, though he or she would want to compare the particulars of both accounts before doing so.
The primary difference between a traditional and a Roth 401(k) is when taxes are paid. If you contribute to a traditional 401(k), you are putting pre-tax dollars into the account. In other words, contributing to a traditional 401(k) will provide you with a tax break in that year, as your contribution will help lower your taxable income. When you take money out of the account in retirement, you’ll pay ordinary income taxes on those withdrawals.
The Roth 401(k) essentially works the opposite way: contributions are made with post-tax dollars, providing no tax benefit in the year of the contribution, but withdrawals are tax-free as long as you’re over age 59 ½ and have held the account for at least five years.
The decision between a traditional or a 401(k) account is often framed as being purely a decision about when to pay taxes, and taxes should certainly be a driving factor in choosing the type of account. However, the tax issues to consider are multi-faceted, so below are some questions to ask yourself to help you decide if switching to a Roth 401(k) makes sense for you:
Do you expect to have a higher or lower income in retirement than you do today? Generally speaking, you want to plan your contributions to and withdrawals from retirement savings such that you pay your taxes when in the lowest possible bracket. If you currently earn less than you expect to generate in retirement, it often makes sense to pay your taxes now and contribute to a Roth 401(k), instead of paying taxes later in life when your income is higher. This is why you’ll often see Roth 401(k)s and Roth IRAs recommended to young savers, especially those with lower current income. On the other hand, if you’re a high earner now, you might save money by lowering your taxable income today via a traditional 401(k) contribution and then paying taxes on your withdrawals during retirement when you would be in a lower tax bracket.
Can you commit more of your salary to 401(k) savings than you currently do? If you’re making a traditional 401(k) contributions now, switching to a Roth 401(k) will be more “expensive” to you in that doing so will also increase your tax bill. Making the maximum contribution to a traditional 401(k) would require $19,500 out of your salary, but maxing out a Roth 401(k) would require $19,500 plus some increase to your tax bill. If you don’t have the budget flexibility to switch to a Roth 401(k) and still maintain the same level of savings, you are probably best off staying in a traditional 401(k).
Would increasing your taxable income have any negative tax implications for you and your family? Your traditional 401(k) contribution reduces your taxable income, whereas a Roth 401(k) contribution does not. It’s possible that adding your Roth contributions to your taxable income could raise your income enough to push you into a higher marginal tax bracket or make you ineligible for certain other deductions that you’ve relied on in the past. Before you decide to make the switch, you should make sure you understand the full range of tax implications the decision may have.
Do you already have some assets in a Roth 401(k) or IRA, or are all of your retirement assets in qualified accounts like traditional IRAs or 401(k)s? If your current portfolio is entirely or nearly all qualified retirement assets, it may make sense to contribute to a Roth 401(k). Having a diversity of types of accounts with your retirement savings will allow you to diversify your income sources in retirement, which can be helpful from a tax perspective. Roth 401(k)s give you access to untaxed income in retirement, and you could even eliminate the RMD requirements by converting to a Roth IRA.
Additionally, a major advantage of the Roth 401(k) for high earners is that they can make direct contributions regardless of income level, which is not true for a Roth IRA (though it is possible to make a backdoor contribution to a Roth IRA). The Roth 401(k) is a simple way for earners at all levels to save into Roth assets, and the higher contribution limit for the 401(k) as compared to the IRA will let individuals save more quickly.
Do you expect a period of low income in the future? Instead of diversifying your savings to achieve a mix of Roth and traditional assets, you can instead convert some of your traditional 401(k) or IRA assets into Roth assets to achieve the same goal. If you convert from a traditional to a Roth asset, you will pay ordinary income tax on the amount you convert in the year of the conversion. If you expect years of lower income in the future, perhaps after retirement but before Social Security payments begin, those years can be prime opportunities to convert assets in pre-tax retirement accounts to Roths. Strategic conversions allow you to take advantage of the up-front tax benefit of a traditional 401(k) account while also providing you with flexibility in timing and optimizing your tax burden. You can convert traditional to Roth assets at any time, not just when your income is low, but conversion can be a particularly attractive alternative to saving directly into a Roth 401(k) especially in lower income years.
Both traditional and Roth 401(k)s are powerful savings vehicles for retirement and both offer significant benefits to savers. It’s important to note that you don’t necessarily have to choose between the two, either: as long as your total contributions stay below $19,500 or $26,000 for those over 50, you can put money into both accounts annually. If you’re still not sure which approach to saving is right for you, a qualified financial advisor can help you assess your individual situation and recommend a strategy.
Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.