Traditional or Roth 401(k) Contributions

On the path to financial independence (FI), a retirement savings plan is one of the most powerful tools for building wealth, with compound interest on your side. Retirement accounts are available in two popular flavors: Traditional and Roth. These words simply indicate the tax treatment of the account’s contributions and distributions.

Although having multiple contribution options makes retirement planning more complicated, we will explore the advantages and disadvantages of each so you can make well-informed decisions in alignment with your unique situation and desired outcomes. Even if you continue your current retirement savings strategy, you will have greater clarity and confidence when you understand the what, how, and why to support your personal decisions. Let’s study the road map before moving in either direction.

What's the Difference Between Traditional and Roth?

Whether you choose to contribute to retirement accounts through an employer-sponsored plan, such as a 401(k), 403(b), 457(b), or an individual retirement arrangement (IRA), the investment earnings within the account are tax-deferred (not taxable along the way) until the funds are withdrawn.

You may be offered the following contribution options for each of your retirement accounts:

Traditional (Pre-Tax): Contributions are made with income that is either excluded or deducted from taxable income, effectively reducing taxes owed in the year of deposit. There are no income limits when making pre-tax contributions to employer-sponsored retirement plans, but the deductibility of IRA contributions is subject to income thresholds, depending on your tax filing status and family’s access to employer-sponsored plans. The earnings within traditional retirement accounts grow tax-deferred, but future distributions are taxable as ordinary income.

We view traditional retirement accounts as assets on the balance sheet, but the IRS sees them as income that has not yet been taxed. The withdrawals are fully taxable, including your original contributions and the account earnings that compounded along the way.

Roth (After-Tax): Contributions are made with dollars included in taxable income. All earnings within the account grow tax-deferred, and then all distributions may be withdrawn tax-free if qualified distribution rules are met. There are no income limits to contribute to a Roth employer-sponsored retirement plan, but there are income thresholds to contribute to a Roth IRA directly. If you want to learn more about Roth IRAs and their specific contribution and distribution rules, here is a comprehensive article.

Which one do I choose? Do I pay the income tax now or later?

As mentioned, traditional retirement account contributions receive a tax benefit in the current year, reducing taxable income and taxes owed. On the other hand, Roth contributions receive no tax benefits today, but future withdrawals may be received tax-free, reducing taxable income in retirement.

Side Note: Even if you contribute to a Roth retirement plan at work, any employer matching or non-elective contributions may be traditional contributions. We see a Roth 401(k) as one big pot, but the IRS is waiting in the wings for the pre-tax portion, including earnings on those amounts.

Although you may be tempted to base your contribution decisions solely on your current tax rate vs. your anticipated tax rate in retirement, I encourage you to consider the various benefits and unintended consequences of each route, as listed below.

TRADITIONAL (PRE-TAX)

Advantages

• Current income is reduced at the marginal tax rate when contributing, but the marginal and effective taxation may be lower when income is distributed. This is common when families plan to retire early or don’t anticipate other substantial sources of taxable income in retirement. Fewer retirees have access to private and public pensions than in prior decades.
• Future tax legislation may reduce tax rates in the years you distribute retirement income, although this assumption is out of our control. I suggest making financial decisions based on what is currently known.
• Traditional retirement assets can later be converted to Roth IRAs when income is lower. This is especially beneficial if you expect to have gap years of low income between retirement and when other income sources begin, such as Social Security, pensions, or required minimum distributions (RMDs).
• Traditional contributions may lower your current income enough to make you eligible for other opportunities, such as health insurance subsidies (Premium Tax Credits) or student financial aid.
• You can donate traditional IRA assets directly to charity without incurring taxes once you reach age 70 1/2. These are called Qualified Charitable Distributions (QCDs).
• Your traditional contributions may reduce state income tax and then be distributed while living in a state with lower or no state income tax.

Disadvantages

• Traditional contributions and earnings on those amounts are fully taxable as ordinary income when distributed. Your taxable income and effective tax rates may be higher in retirement, based on future income needs and other sources of taxable income.
• Future tax legislation may increase tax rates when you distribute income in retirement. Again, this assumption is out of our control.
• Taxable distributions may increase the portion of Social Security benefits included in taxable income (up to 85%) and increase Medicare Part B + D premium surcharges by up to thousands of dollars per year.
• Required minimum distributions (RMDs) begin at age 72, forcing taxable distributions from these accounts each year even if you don’t need the money to support living expenses. The mandatory withdrawal percentage increases each year and can cause a heavy tax burden if an intentional distribution or conversion strategy is not implemented. Begin with the end in mind.
• If inherited, traditional retirement accounts must be fully withdrawn by some non-spouse beneficiaries within ten years (based on current legislation). Large pre-tax accounts may cause an unexpected tax burden for beneficiaries in their own highest earning years.
• Surviving widow(er)s may be subject to higher tax rates and Medicare premium surcharges if high levels of taxable income continue to be received when filing as a single taxpayer.
  
  

ROTH (AFTER-TAX)

Advantages

• All withdrawals can be received completely tax-free, including the earnings if you meet the qualified distribution rules. Direct contributions to Roth IRAs may be withdrawn at any age for any reason without taxes or penalties.
• Taxable income may be reduced in retirement if you have a balance between pre-tax, taxable, and tax-free accounts. Retirees value the flexibility to strategically withdraw from Roth and after-tax brokerage accounts to control taxable income, especially when unexpected expenses arise.
• Reducing taxable income in retirement may open up eligibility for other opportunities, such as health insurance subsidies (PTC), student financial aid, and even a 0% effective tax rate when income stays below the standard deduction amount ($25,900 for a married couple in 2022, $12,950 for single).
• Since Roth distributions are not included in taxable income, they may help to reduce the portion of Social Security benefits included in taxable income and lower Medicare premiums (IRMAA) in traditional retirement.
• Inherited Roth assets can be withdrawn entirely tax-free if meeting the distribution rules, eliminating tax burdens for beneficiaries.
• Unlike traditional retirement accounts, Roth IRAs do not have required minimum distributions (RMDs)!

Disadvantages

• Since Roth contributions are not tax-deductible, your current taxable income is not reduced.
• If you elect to contribute to Roth instead of traditional in your employer’s retirement plan, your net pay will be reduced due to additional income tax withholding.
• Your taxable income and effective tax rates may be lower in retirement than in the years of your original contributions.
• Future tax legislation may change the tax treatment of Roth distributions. This is out of our control.
• Direct contributions to Roth IRAs have income limitations, and backdoor Roth IRA conversions may be subject to the pro-rata rule and cause additional taxation. It is best to consult a tax professional to ensure accurate money movement and reporting on Form 8606.
• Roth IRA distributions could incur a 10% additional tax (penalty) if earnings are withdrawn without meeting the qualified distribution rules.
• Having no traditional accounts or taxable income in retirement can limit your ability to take advantage of the effective 0% tax rate up to the standard deduction amount or to receive health insurance subsidies. It sounds funny, but having some taxable income in retirement is a good thing!
  
  

How to Measure Twice® and Keep Finance Personal®

I hope the advantages and disadvantages of both contribution options help you think more critically about your personal savings strategy. As with dozens of financial decisions, there is no rule of thumb or definitively right answer for choosing traditional or Roth on the path to retirement.

Review your balance between pre-tax, taxable, and tax-free accounts each year. Viewing each account individually and then understanding them together as a total portfolio can provide insightful opportunities to align your money with your unique retirement objectives.

“Traditional vs. Roth” goes beyond tax rates. Be careful not to make contributions solely based on your current marginal tax rate, even if your taxable income falls within the lowest 10% or 12% tax brackets. As shown below, the 12% marginal tax bracket for a married couple filing jointly starts at an adjusted gross income (AGI) of $46,451, but the 12% effective tax rate doesn’t appear until AGI of $144,640. It could make sense for a family with lower income while working to contribute to traditional 401(k)s if expecting to derive retirement income solely from account distributions. Likewise, I have seen instances where it is rational for high-income families to contribute to Roth, anticipating significant pension income and RMDs in traditional retirement.
 

Although there seem to be only two options on the surface, there are endless possibilities for balancing taxation, cash flow, and investments during the accumulation (saving for retirement) and decumulation (spending in retirement) stages. You do not have to go full speed in one direction, and you can take detours along the way. “Plan” is a verb, not just a noun!