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Young Professionals

Roth 401(k) vs. Traditional 401(k): Understanding the Key Differences

4 minute read time

SUMMARY

While both Roth 401(k)s and traditional 401(k)s can be a part of an employer-sponsored retirement plan, the way that contributions and withdrawals are taxed differs. This article explores the definitions, similarities and key differences between these retirement savings vehicles.

Whether you’re getting set up with your first 401(k) plan or are reviewing your plan and wondering if it’s time to recalibrate, you should find out whether your employer offers a Roth 401(k) account option in addition to a traditional 401(k) plan.

Both options offer unique benefits and can play a significant role in a retirement strategy, and choosing isn’t necessarily an either-or decision.

Similarities

Both types of 401(k) plans are part of employer-sponsored retirement savings plan, but how they function and what that means for your taxes differs. Both traditional and Roth 401(k) plans have the same annual contribution limits, which in 2024 is $22,500, with an additional catch-up contribution of $7,500 for those aged 50 and older. Keep in mind that if you split your contribution between a Roth and a traditional 401(k), the annual limit applies across both accounts.

When it comes to employer matches, employers can offer matching contributions for both types of 401(k) plans. One thing to note, though, is that these matches are typically placed into a traditional 401(k) account, regardless of whether contributions go into a traditional or Roth 401(k).

Differences

The most significant difference lies in how contributions and withdrawals are taxed. Traditional 401(k) contributions are tax-deferred, offering an upfront tax break, while Roth 401(k) contributions are made with after-tax dollars, leading to tax-free withdrawals in retirement.

A traditional 401(k) allows contributions of a portion of pre-tax salary into the account. These contributions reduce taxable income for the year, which provides an immediate tax benefit. The investments in a traditional 401(k) grow tax-deferred, meaning taxes aren’t paid on the earnings until the money is withdrawn.

By contrast, contributions to a Roth 401(k) are made with after-tax dollars, meaning they don’t reduce taxable income for the year. Instead, the advantage lies in the withdrawal phase: Qualified withdrawals from a Roth 401(k) are entirely tax-free, provided the account has been held for at least five years and the account holder is at least 59½ years old.

What is the right solution for me?

Whether you decide to prioritize pre-tax or Roth after-tax contributions boils down to tax efficiency and your personal situation.

If you believe that your income tax rate today is higher than it’ll be during retirement, you may want to consider pre-tax contributions. With these contributions, your money will grow tax-deferred, and taxes will only be taken when you start to withdraw.

On the other hand, Roth after-tax contributions make the most sense for someone who believes their current income tax rate is lower than it’ll be during retirement. By contributing after-tax, you will have no tax liability on your retirement assets when you start to withdraw.

For some, it might be wise to split your contributions between traditional and Roth 401(k) accounts. Having both traditional and Roth accounts can provide tax diversification, giving more flexibility to manage tax liabilities in retirement. Withdrawals can be strategically made from either account depending on the tax situation each year.

If you have questions about whether a Roth 401(k) or traditional 401(k) makes sense as a part of your financial plan, connect with an advisor. A Johnson Financial Group advisor can help you curate a plan that’s right for you.