We are a dual-income couple in our mid-50s with over $2 million in our 401(k)s. Should we “sacrifice” the pre-tax benefit and switch to Roth contributions at work?
-Wendy
As with most tax-related questions, the answer is, “It depends.” Depending on your situation, switching contributions to a Roth 401(k) could make sense for a few important reasons, including tax diversity and tax-free growth. However, there may be additional factors that make it more desirable to stick with a traditional 401(k) and open a Roth IRA on the side. You should also consider the tax implications of your choice compared to Pay Now or Pay Later. Many factors and assumptions (such as future tax rates) go into these calculations, but it’s worth figuring out which way will save you the most taxes over your lifetime.
There is no one-size-fits-all answer to this, so it makes most sense to discuss this with a financial advisor or tax advisor. They have advanced modeling programs that can help you understand the different tax implications of staying with a traditional 401(k) or switching to a Roth account. (And if you’re interested in working with a financial advisor, this tool can help you find a match.)
What is a Roth 401(k)?
More employers than ever are offering Roth 401(k) plans as part of their benefits packages. These hybrid accounts combine features of traditional 401(k) plans and Roth IRAs, giving you a corporate retirement option with special tax-free growth features. However, these plans have not yet been fully implemented. The majority of money in employees’ retirement accounts is in traditional 401(k)s, largely because people generally prefer the “pay less taxes now” model.
Unlike a regular 401(k), contributions to a Roth 401(k) do not reduce your current tax bill. These contributions are made with after-tax dollars, so you pay taxes up front and get a huge benefit later. The compromise is tax-free growth. Therefore, if you follow all the rules, you will not have to pay taxes on the earnings in the account when withdrawing.
Rolling all or part of your contributions into a Roth 401(k) gives you greater tax diversity. If you choose a hybrid approach, some of your money will be taxable when withdrawn (Traditional), while another portion will be tax-free (Roth). This gives you more flexibility in future tax planning, another important benefit. (A financial advisor can help you determine whether a Roth 401(k) is right for you.)
Pros and Cons of a Roth 401(k)
Like any other type of retirement account, Roth 401(k)s have advantages and disadvantages. For most people, the benefits outweigh the disadvantages. But the biggest downside – a higher tax burden today – could outweigh these benefits.
First, let’s look at the benefits of Roth 401(k) plans:
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Tax-free profit growth (in most cases)
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Thanks to the SECURE 2.0 Act, minimum distributions (RMDs) from Roth 401(k)s are not required for individuals who turn 73 after December 31, 2023
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No Income Limits on Contributions to a Roth 401(k)
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Tax-free distributions on the money you properly withdraw from your Roth 401(k).
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Lower adjusted gross income (AGI) in the future, which can increase your eligibility for things like tax-free Social Security benefits
Now for the disadvantages:
Here’s a tricky feature that could go either way: Matching contributions to Roth 401(k)s have historically been made on a pre-tax basis. In this case, you won’t pay current income taxes on the game, but you would be taxed on that money and any earnings when you withdraw it in the future. However, the SECURE 2.0 Act gives employers a new option to make these matching contributions into Roth 401(k) accounts, simplifying finances for their employees. Check with your employer to see how they handle Roth 401(k) matches. (And if you need help planning for your retirement, this tool can help you find a financial advisor.)
Roth 401(k) vs. Traditional 401(k)
Now that you understand the pros and cons of Roth 401(k) accounts, let’s look at how they compare to traditional 401(k) accounts.
The main difference between the two is tax timing. With a traditional 401(k) plan, you contribute pre-tax dollars, so the money you contributed now doesn’t count as taxable income. You pay income tax when you withdraw the money. With a Roth 401(k), you contribute after-tax dollars and the money contributed counts as current taxable income. When you withdraw these contributions and the associated earnings, they are not included in your income and you do not pay taxes on them (as long as the money is withdrawn properly).
Advance withdrawals are also treated differently. With a traditional 401(k), distributions taken before age 59½ may result in an early withdrawal penalty of 10% on the total amount. With a Roth 401(k), withdrawals are split proportionately between contributions and earnings, and the 10% penalty is applied only to the earnings portion.
Another important difference: RMDs. Both types currently require RMDs, but that will soon change. Once you turn 73, you must withdraw RMDs from traditional 401(k) accounts. Starting in 2024, individuals who turn 73 after December 31, 2023 will not be required to withdraw RMDs from Roth 401(k)s. (And if you need help planning RMDs, consider working with a financial advisor.)
Roth 401(k) vs. Roth IRA
Although they share some important similarities, Roth IRAs and Roth 401(k)s have some equally important differences.
Roth IRAs have strict income limits that prevent many people from contributing. In 2023, individuals earning more than $153,000 or couples earning more than $228,000 cannot contribute to Roth IRAs. Anyone can contribute to a Roth 401(k), regardless of income.
Roth IRAs also have significantly lower contribution limits. The maximum contribution for 2023 is just $6,500, or $7,500 if you are 50 or older. The maximum contribution to a Roth 401(k) is $22,500, or $30,000 if you are 50 or older. Additionally, Roth 401(k)s offer the potential for employer matches not available to Roth IRAs. (And if you need help choosing a retirement account, consider speaking to a financial advisor.)
Next Steps
There’s a lot to consider when choosing between traditional and Roth 401(k) accounts. To make the best possible decision based on your individual financial situation, speak to your financial advisor or tax advisor.
Tips for Finding a Financial Advisor
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If you have specific questions about your gift and tax situation, a financial advisor can help you. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors working in your region, and you can survey your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Consider a few advisors before choosing one. It is important that you find someone you trust to manage your money. As you weigh your options, consider asking an advisor these questions to ensure you are making the right choice.
Michele Cagan, CPA, is a financial planning columnist at SmartAsset and answers reader questions about personal finance and tax topics. Do you have a question you would like answered? Email [email protected] and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAdvisor Match platform and has received compensation for this article.
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