Roth 401(k) Vs. Traditional 401(k) & Roth IRA: The Differences

What Is a Roth 401(k)?

As of 2001, the IRS announced plans allowing companies to offer Roth 401(k) accounts in addition to traditional 401(k) accounts. A Roth 401(k) is an employee-sponsored retirement account that allows you to make after-tax contributions and later tax-free withdrawals. A growing number of companies now offer a 401(k) plan that has both a traditional and a Roth option, allowing employees to allocate contributions to either or both, subject to the maximum 401(k) contribution limits.

Both traditional and Roth 401(k) accounts are generally provided as options within a single plan, making it relatively easy for employees to split their contributions as they see fit, and to change their allocation over time. The only difference between the two types of 401(k) accounts is the tax treatment. Contributions to traditional IRAs are deductible in the year you make them, but taxable when withdrawals are made. Contributions to Roth IRAs are not deductible when you make them, but withdrawals are not taxed. Both are subject to the same total contribution limit and both are eligible for a company match or contribution if there is one. The investment choices will also be the same.

The decision as to whether to contribute to the traditional vs. the Roth 401(k) (or split between them) thus boils down to your tax preference – pay tax on your contribution now and not later with the Roth or pay no tax now but pay tax upon withdrawal with the traditional. Traditional 401(k) contributions are tax deductible for the current year, which translates to a higher paycheck than for those contributing the same amount to a Roth. Therefore, the key tradeoffs driving the Roth vs. traditional decision are your desire to keep more of your current income and your estimate of your tax rate now vs. your tax rate in retirement.

Having a 401(k)plan that offers both a traditional and a Roth is advantageous in that it gives employees the ability to allocate contributions between the two and change the allocation over time as the need for income or the prognosis on tax rates changes. In short, it can be a highly worthwhile benefit to have, though it does require some financial decision-making. Financial and tax advisors can certainly help.

401(k)’s are company-sponsored plans that are only available to employees, whereas IRAs can be opened by individuals. As a general rule, a 401(k) plan from your employer will be preferential over an individual IRA account. While there can be more investment flexibility in a personal IRA, 401(k) plans offer a number of material advantages:

• Much higher annual contribution limits ($20,500 vs. $6,000 for an IRA in 2022 for those under 50)
• The potential for a corporate match or additional corporate contributions
• The ease of payroll deductions and a system that keeps track of your contributions all year.
• No income limits on contributions or deductibility
• The ability to borrow against a 401(k) plan

The choices are a bit more complicated when your company offers a Roth 401(k) option because you can take that option for some or all of your contribution or you can stick with the traditional 401(k) plan and have a Roth IRA in addition. We explore that choice for you below.

Note: This article contains a general overview of IRAs and 401(k) plans. There are numerous details about eligibility, deductibility, non-deductible contributions, spousal plans and other characteristics of these retirement plans that could affect your individual situation. For reference, you should consult IRS Publication 590-A for IRAs and the IRS web page on 401(k) plans for 401(k) information

What Are Traditional And Roth IRAs?

Traditional and Roth IRAs are retirement accounts that individuals can set up and manage by themselves. IRAs are easy and inexpensive to set up and can be established through brokerage firms, mutual fund companies, and banks. (The investment options available in IRAs depend on the type of institution you open it with. A Vanguard IRA, for example, will make Vanguard mutual funds available.)

Contributions to a traditional IRA are generally tax-deductible, while contributions to a Roth IRA are not. But the money in a traditional IRA will be taxable when you ultimately withdraw it, while the Roth IRA contributions will not be taxed upon withdrawal.

Roth IRAs are thus similar to Roth 401(k) plans in terms of taxation. The main differences are that 401(k) plans allow larger annual contributions but will restrict your investment choices to whatever your plan sponsor (i.e. your employer) allows.

Can You Have Both A Roth IRA And A Roth 401(k)?

The short answer is yes – the IRS permits you to have a Roth or traditional IRA in addition to a 401(k) plan or other 401(k) plan. However, there are restrictions:

• The most you can put in your individual IRA under 2022 rules is $6,000 plus a $1,000 catchup if you are age 50 or older. Note that the $6,000 limit is for all personal IRA plans combined. You can have a traditional and a Roth or multiple accounts, but they will all be subject to the combined limit of $6,000. (Also, you have to have earned at least that much during the year to make the contribution. If you earned only $3,500 for the year, that would be the maximum contribution.)
• There are income limits to making Roth IRA contributions. If your income is too high, Roth IRA contributions would not be allowed. The income limits are $129,000 for individuals and $204,000 for married couples filing jointly. Note that if you are married and live with your spouse but file separately, and you earn more than $10,000, you cannot contributor to a Roth IRA. (There are partial contributions allowed – see the full details on the IRS website here.)
• If you or your spouse have a 401(k) or another type of retirement plan at work (whether you contribute or not), you are limited as to how much you can take as a tax deduction in your IRA. You cannot deduct anything at all if you earn more than $78,000 individually or $129,000 jointly. (Below these income levels, there are partial deductions allowed. For full details, see the IRS website here.) That means that if you are adding a personal IRA to a 401(k) plan at work, you may not be able to deduct your IRA contributions, making it more appropriate to have a Roth IRA than a traditional one.

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

Individuals with access to 401(k)s may therefore be in a position to take advantage of both a 401(k) and a personal IRA. How do you decide which ones to contribute to and how much?

Here are some considerations on how to answer that for yourself:

• In order to take maximum advantage of the 401(k) benefits listed above, it will generally be beneficial to maximize your 401(k) contributions before adding a personal IRA. For example, if your employer matches any contributions you make to your 401(k), every dollar invested in the plan is immediately worth $2. (Note that employer contributions and the resulting gains are kept in a separate account and fully taxable upon withdrawal).
• One reason you might opt to have an IRA before maximizing your 401(k) plan would be the flexibility to invest in something that is unavailable in your 401(k) plan. Most 401(k) plans limit you to a selection of mutual funds picked by your employer. Having an IRA could expand your investment horizon to include individual stocks or alternative assets such as cryptocurrencies or real estate.
• The Roth vs. traditional decision depends on your estimated tax bracket in retirement vs. your current bracket and your need for current income. The general assumption is that your tax bracket will be lower in retirement, which favors the traditional.
• It can be difficult to predict your tax bracket several decades in advance, so for most people, the decision on a Roth vs. traditional comes down to how much they can afford to contribute out of current earnings. Since a contribution to a traditional account is pre-tax, it will take less of your earnings to maximize a traditional 401(k) plan than a Roth 401(k).

To put some numbers on it, the table below shows the cost of maximizing contributions to a traditional 401(k) vs. a Roth 401(k) for someone under 50. (*NOTE – the second column below shows the amount you would need to earn, before taxes, in order to put the same $20,500 into a Roth 401(k) as post-tax dollars.)

Tax bracket	Cost in 2022 to maximize a traditional 401(k)	Cost in 2022 to maximize a Roth 401(k)
24%	$20,500	$26,974
35%	$20,500	$31,538

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Now, let’s compare the cost of maximizing a Roth 401(k) by itself vs. maximizing a traditional 401(k) combined with a Roth IRA. (*NOTE – the third column below shows the amount you would need to earn, before taxes, in order to invest $6,000 is post-tax dollars into a Roth 401(k).)

Tax bracket	Cost in 2022 to maximize a Roth 401(k)	Total amount contributed to plans with Roth 401(k)	Cost in 2022 to maximize a traditional 401(k) + Roth IRA	Total amount contributed to plans with a traditional 401(k) + Roth IRA
24%	$26,974	$20,500	$28,395	$26,500
35%	$31,538	$20,500	$29,731	$26,500

Click to enlarge

To arrive at a decision for your specific situation, there may be other considerations. Don’t expect that there is a magic formula that will tell you the exact amounts to put in which types of accounts. Instead, consider creating a table for yourself of various options and see how they will affect your current income and the amount of money in your plans. Arriving at an approximate answer will be all you need to take action on it. And remember that you can change your contributions at any time if you find yourself in need of more take-home pay or in a position to contribute more than you originally thought.

FAQ

Can You Rollover A 401(k) To A Roth IRA?

You can roll over a traditional 401(k) into a traditional IRA or a Roth IRA. You can also roll a Roth 401(k) into a Roth IRA. You cannot roll a Roth 401(k) into a traditional IRA.

(Because the owner of a Roth 401(k) or a Roth IRA has already paid taxes on the money that was contributed to the account, rolling it to a traditional IRA would expose those monies to a 2nd round of taxes when they are withdrawn. So rolling a traditional 401(k) into a Roth IRA could result in your paying taxes on the entire rollover. Check the IRS rules on rollovers.)

What are Roth 401(k) Contribution Limits?

Roth 401(k) plans have the same annual contribution limits as traditional 401(k)s. In 2022, the limit is $20,500 with a catchup option of $6500 if at least 50 years of age.

Can Employers Contribute to a Roth 401(k)?

Yes. Employers can contribute to 401(k) plans. If the plan calls for an employer match, they are obligated to make that contribution, but additional contributions are discretionary and usually tied to profits. All employees must be treated equally and the possibility of employer contributions is addressed in the plan documents.

What are the Pros and Cons of a Roth 401(k)?

Pros

• Same benefits as a traditional 401(k)
• Eligible for employer match and contributions if there are any
• Can borrow against it
• No taxes on qualified withdrawals or gains
• No income limitations

Cons

• No tax deduction for contributions
• Limited investment selection compared to Roth IRA

Can You Withdraw From A Roth 401(k)?

Withdrawals from a Roth 401(k) are subject to the same rules as traditional 401(k)s. They are not taxed if they represent a qualified distribution. Qualifications for withdrawal include:

• Having the account for at least 5 years
• Attaining the age of 59½
• Upon death or disability

If you wish to withdraw from the plan itself, you can stop making contributions. Your ability to roll the assets to a Roth IRA or withdraw them will depend on your age and other criteria.

How Are Roth 401(k)s Taxed?

No taxes are applied to Roth 401(k)s.

Can You Choose The Investments In A Roth 401(k)?

Yes. You can choose from the available list in your plan.