Roth 401(k) vs. Traditional 401(k)

By now you know I think Roth IRAs are a great way to save for retirement. But there may be an even better way to save (more) in a Roth. Most 401(k) plans now offer the option of contributing to a traditional 401(k) or a Roth 401(k).

If you’ve been with an employer for a long time, you no doubt have done all your saving in traditional 401(k) plans. That’s great. But I now want you to check with your plan and see if there is a Roth option available. If so, I think you should consider making your new contributions into the Roth 401(k). Don’t touch what you already have saved in the traditional. Just leave it growing.

The strategy I am talking about is to plow new contributions into a Roth. Here’s why I think that can be a smart move:

You will be building up retirement money that will be 100% tax-free when you use it.

Money you withdraw from a traditional 401(k) will be taxed as ordinary income. Money you withdraw from a Roth 401(k) will not be taxed.

Of course, there’s a trade-off: Money you contribute to a 401(k) reduces your taxable income for the year, whereas money you contribute to a Roth 401(k) is from pay that has already been taxed.

So why am I suggesting you front-load payment of the tax today (the Roth) rather than delay payment for when you make withdrawals (the traditional)? Well, for starters, tax rates right now are near historic lows. That may not be the case years from now when you retire. As for the idea that you will have less income in retirement and thus be in a lower tax bracket (regardless of whether rates change), be careful here. If you have done a good job saving for retirement, you may find your retirement income (401(k) withdrawals, IRA withdrawals, Social Security, a pension if you have one) may not be all that much lower.

You can contribute more with a Roth 401(k), and there’s no income limit.

In 2023, you can contribute at least $22,500 to a 401(k). If you’re 50 or older, the limit is $30,000. And everyone eligible to participate in a 401(k) can use the Roth. There is no income limit on who can save in a Roth. That is quite different from a Roth IRA. In 2023 the contribution limit for a Roth IRA is $6,500 ($7,500 if you are at least 50 years old). And there is an income limit on who can contribute to a Roth IRA. In 2023, individuals with income below $138,000 and married couples who file a joint tax return with income below $218,000 can make the full contribution to a Roth.

You are creating “tax diversification.”

I want to be clear, the money you have saved in a traditional 401(k) is a great accomplishment. But adding Roth savings now creates a smart complement to all that you have saved. Having some money in a Roth 401(k)—as well as a Roth IRA—gives you the flexibility to make withdrawals in retirement without owing any tax. And if there is a year where you need to make a big withdrawal (maybe for a new roof, or a kid’s wedding, or that bucket list adventure you’ve worked so hard for) the money withdrawn from a Roth won’t be counted as taxable income. Withdraw the same money from a traditional account, and it all counts as taxable income, which could bump you into a higher tax bracket for the year.

It’s also important to understand that your Medicare premiums are based on your taxable income. This tends to surprise folks when they become Medicare-eligible. By having some retirement money in a Roth, you may be able to manage your taxable income in retirement to keep your Medicare premium lower, as Roth withdrawals do not count as taxable income.

You give yourself more flexibility.

There is no required minimum distribution (RMD) with Roth accounts. That means you only have to withdraw money when you want to. All money in traditional retirement accounts is subject to annual RMDs once you turn 72.

Again, I want to be very clear on what not to do: Do not convert money you have already saved in a traditional 401(k) to your plan’s Roth 401(k). That is an entirely different matter, and one you should always consult with a tax pro on before making that very taxable decision.

What I am talking about is what to do with your ongoing contributions in 2023, 2024, 2025 etc. If your plan now offers a Roth option, you can choose to make all your new contributions into the Roth. I think it’s a smart move, especially for those of you who have been saving in a traditional 401(k) for years.

If you do start saving in a Roth 401(k), just be aware, that your employer will still make its matching contribution into your traditional 401(k) account. It’s just an odd quirk of how 401(k) plans operate.