Which is better, a Roth or traditional 401(k)? The central difference between a Roth 401(k) and traditional 401(k) is the tax treatment of your contributions. Investors make traditional 401(k) contributions before tax while Roth savings occur after tax. Which is best for you will depend on your current/future tax situation, asset mix, and cash flows. For individuals in the upper end of the tax brackets, paying tax now on retirement savings may not make sense.

Think long-term when deciding whether a Roth 401(k) will be better than a traditional 401(k). If Roth accounts are only a small fraction of your assets at retirement, it may not be worthwhile. Further, if you’re already in a high tax bracket, it’s less likely your tax rate will get even higher when you stop working.

Roth vs Traditional 401(k)

In a traditional 401(k), employees make pre-tax contributions. While this reduces your taxable income now, you’ll pay regular income tax when you withdraw the money in retirement.

In a Roth 401(k), employees contribute after-tax dollars to a designated Roth account within the 401(k) plan. You receive no tax benefits from the contribution. When the money is taken out in retirement, it’s tax-free if at least five years passed since your first contribution to the Roth 401(k).

Investors can contribute to both a traditional 401(k) and a Roth 401(k) at the same time. However, the maximum yearly limits apply to contributions in aggregate. If you contribute to a Roth 401(k), any employer matching funds will still go into a pre-tax 401(k).

Outside of the tax treatment, there aren’t many major differences between a Roth and traditional 401(k). Both plans first provide penalty-free withdrawals at age 59½ unless you qualify for an exemption. Like the 401(k), Roth 401(k)s are subject to required minimum distributions in retirement; a key difference between the Roth IRA and Roth 401(k). However, a Roth 401(k) can be rolled over into a Roth IRA when you leave your job or retire which will eliminate the RMD requirement.

Note that if you don’t already have a Roth IRA, the five-year holding period will restart when you do the rollover. Discuss your options with your financial advisor before making any changes.

Which is better?

Using a Roth 401(k) is not always the best choice for an investor. Particularly for high earners, it may be unlikely that you’ll still be in such a high tax rate in retirement. Obviously, tax laws change over time, but all else equal, you’ll need to save a lot to generate a few hundred thousand dollars a year in retirement income.

There isn’t one determining factor which will always make using a traditional 401(k) better than a Roth or vice versa. As with everything in financial planning, it’s important to weigh multiple inputs simultaneously. When deciding the best approach for your tax and financial situation, here are some elements to consider.

Here’s when it may make sense to use a Roth 401(k):

  • You’re in a lower marginal income tax bracket now than you expect to be in retirement
  • If Roth contributions won’t reduce the amount you’re saving for retirement. Maxing out Roth 401(k) contributions reduces your take home pay more compared to pre-tax deferrals. If you can’t keep the same dollar-for-dollar retirement savings, it’s probably best to go back to the traditional 401(k). This calculator can help you estimate the impact of making Roth vs traditional 401(k) contributions
  • Your retirement savings and retirement income (Social Security, pension, etc.) are currently heavily weighted towards tax-deferred assets
  • Adding the Roth contributions to your taxable income won’t cause any adverse tax implications (e.g. triggering the 3.8% Medicare surtax, pushing you into a higher marginal tax bracket, losing other AGI-based tax deductions or planning opportunities)

Here’s when it may make sense to use a traditional 401(k):

  • You’re currently in some of the highest marginal tax brackets and it’s unlikely you’ll replicate the same level of taxable income in retirement
  • Excluding pre-tax contributions from your taxable income is an important part of your tax planning strategy. For married couples, this can be significant: in 2020 and 2021, the maximum reduction is nearly $40,000 or $52,000 for couples 50 and older!
  • If you’re a high earner and already have sizable tax diversification of your assets, perhaps from a Roth IRA, old Roth 401(k), or a brokerage account
  • If it’s unlikely you’ll be able to make a meaningful difference in your tax bucketing strategy. For example, if you plan to change jobs soon, only plan to make Roth 401(k) additions temporarily, etc.

As with any tax strategy, it’s important not to let the tax-tail wag the dog. Regardless of whether you decide to go with a Roth or traditional 401(k), the primary focus should be on your overall savings rate. Especially for high income individuals, maxing out retirement plan contributions alone may not be enough to fund your retirement. A Roth 401(k) isn’t the only way to achieve greater tax diversification in retirement, either. A taxable brokerage account can provide extra income in retirement and tax diversification, as well as the flexibility to access funds before retirement.

This article was written by Darrow advisor Kristin McKenna, CFP® and originally appeared on Forbes.

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