Should You Take the Roth 401k Option?
If you work for even a moderately-sized company, there’s a decent chance that they offer you some kind of retirement plan, like a 401(k). According to the Bureau of Labor Statistics, as of 2020, 67 percent of private industry workers had access to employer-provided retirement plans. And among those employers, about 88 percent also offer a Roth 401(k) option. So – given a choice between the two, how do you decide which one may be better for you? Should you take the Roth 401(k) option?
Let’s start off by doing a little comparison. Both the Roth and the traditional 401(k) have the same contribution limit: that 100% of your pay, up to a total of $22,500 for 2023, or up to $30,000 if you’re age 50 or older this year. You can also contribute to both types of accounts in the same year, as long as you keep your total contributions under that limit.
Where we see a difference between the Roth 401(k) and the traditional is in the taxation of your contributions and distributions.
Taxation of Contributions and Distributions
In a traditional 401(k), your contributions are made on a pre-tax basis, which reduces your current adjusted gross income (AGI) and therefore it reduces the taxes that you must pay this year. With a Roth, your contributions are made after tax, which means they have no effect on your AGI or your current tax bill. But here’s a cool thing: If you have any matching contributions from your employer, the SECURE 2.0 Act allows those contributions to be made to your Roth 401(k). Prior to 2023, those matches could only be made into a pre-tax account. Check with your employer to see if that’s available for you. Just remember that if you elect to have the employer’s contribution go to the Roth 401(k), you will be taxed on that amount in the year the employer contribution is made.
On the withdrawal side, all distributions from a traditional 401(k) are taxed at ordinary income rates. With the Roth, you won’t pay any taxes at all on your “qualified” distributions.
But, as you may have guessed, there are rules for withdrawals in either type of account. With a traditional 401(k), withdrawals of contributions and earnings are taxed, and you might be penalized if you take out the funds before age 59 ½, unless you meet one of the IRS exceptions. With the Roth 401(k), qualified withdrawals of contributions and earnings are not taxed at all. But in order to be qualified, you must have held the account for at least five years, AND you must be age 59 ½ or older, or have taken the withdrawal due to a disability or the death of the owner. If you take a distribution from the ROTH 401(k) that is NOT a qualified distribution, you will pay taxes and maybe penalties on the earnings portion of the distribution.
How can you decide?
Okay, so having compared the two, how do you decide which option might be better for you?
It really comes down to taxes. Just like with any Roth-or-Traditional decision, if you think your income and tax rates will be higher in retirement than they are now, then the Roth may be better. On the other hand, if you think your income and tax rates will be lower in retirement, meaning it’s more beneficial to have lower taxable income today, then the traditional 401(k) may be the better option.
Keep in mind that future tax rates are unknown, but even if you believe that tax rates are generally going up in the future, that doesn’t mean your specific income and tax rates will. This is one of the benefits of projecting your future cash flows for years into the future as we do with our Bucket Strategy planning. It allows you to estimate how your income might change over time and to infer what the impact on your taxes might be.
Along with taxes, there are a few other factors to also consider when thinking about traditional vs Roth 401(k) contributions:
First, there’s access: If you make too much to qualify for a Roth IRA, the Roth 401(k) has no income limits, giving you access to the Roth’s tax-free investment growth potential.
Also, future withdrawals: Qualified withdrawals from a Roth won’t increase how much of your Social Security benefits are taxable and they won’t increase your Medicare premiums. Plus, after this year, you won’t have required minimum distributions at age 73 from a Roth 401(k).
Then there’s flexibility: The Roth 401(k) is in a way less flexible than a traditional 401(k) because of that five-year rule. Even if you are age 59½, your distribution won’t be qualified unless you’ve also held the account at least five years. That’s something to keep in mind if you’re getting a late start. And even if you’ve met the 5-year rule with the 401(k), if you transfer it to a new Roth IRA and don’t have any other Roth IRAs, you start a new 5-year clock.
So there’s lots to consider. But – if, after all this, you still can’t decide, you can always split the difference and contribute to both types of accounts. If your income varies from year to year and your plan allows for it, you can switch back and forth throughout your career or maybe even during the year. Doing this will diversify your tax situation in retirement, which in our opinion can be a good thing.
It all comes down to planning. Here at Lucia Capital Group, we help our clients make decisions like these every single day. How can we help you the most? Let’s talk.
The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be profitable for a client's or prospective client's portfolio, thus, investments may result in a loss of principal.
IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.
Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.
Distributions of principal from a Roth 401K are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth 401K was established, whichever is longer. Your investment options are limited with a Roth 401(k) to those offered by the plan administrator; charges and fees may be incurred.
The information provided is based on current laws, which are subject to change at any time. Lucia Capital Group is not affiliated with or endorsed by the Social Security Administration or any government agency.
Social Security rules can be complex. For more information about Social Security benefits, visit the SSA website at www.ssa.gov, or call (800) 772-1213 to speak with an SSA representative.
Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.