Roth 401k vs Traditional 401k: Which is Better?

The total amount you can contribute to a Roth or Traditional 401k per year is $22,500 or $30,000 if you are 50 or older. The amount you could have in a Roth or Traditional 401k could potentially exceed these limits if your employer offers a match.

Keep in mind that it is possible to contribute to both a Roth and Traditional 401k at the same time. However, the total amount you contribute between both accounts can't exceed the limits listed above. (Contribution rules are as of 2023.)

Both the Roth and Traditional 401k offer the same investment options. Typically, you can't invest in individual stocks through a 401k plan. Instead, you can invest in stocks through mutual funds and ETFs. Although there are thousands of these funds available, most 401k plans limit you to a small selection of these funds.

Whether you go with a Roth or Traditional 401k, there are a few things that you want to look out for when choosing funds. First, you want to check the performance of your fund. Look at how the fund has performed over the past decade. You can do this by using an investment research firm, such as Morningstar.

Secondly, you want to look out for investment funds that have low fees, typically called expense ratios. Even a relatively small fee, such as a 1% fee, can make a drastic difference in how much money you end up with in retirement. You want to look for funds with an expense ratio (fee) below 1%.

One of the main benefits of using a 401k is an employer match. Most employers (not all), offer a match that can range between 3% and 5% of your total compensation. For example, say that you make $100k per year and your employer offers a 3% match.

If you were to contribute $3,000 into a 401k (3% of your total compensation), your employer would match that contribution by putting an additional $3,000 into your 401k. Keep in mind that employers use different match formulas so talk to your company to understand how your plan works.

Many experts consider an employer match to be "free money." In general, you want to contribute enough to a 401k, whether that be Roth or Traditional, to get the full match. If your employer does not offer a match, it might be better to use a Roth or Tradtional IRA to save for retirement.

As previously stated, the main difference between a Roth and Traditional 401k is how the accounts deal with taxes. When you contribute to a Traditional 401k, you get a tax break today, and then have to pay taxes when you withdraw the money in retirement. What does this mean exactly?

When you make a contribution to a Traditional 401k, your employer will take out a percentage of your paycheck to put into the 401k before those dollars have been taxed. The IRS also allows you to use the amount you contributed to your Traditional 401k to reduce your taxable income.

Lets look at these concepts through an example. Say that you make $100k per year and you decide to contribute 5% of your total compensation ($5,000) to a Traditional 401k per year. Every month, your employer will take $416.60 of your paycheck pre-tax and put it into your Traditional 401k.

Additionally, the $5,000 that you contributed to the Traditional 401k can lower your taxable income from $100,000 to $95,000. Once you take the money out of a Traditional 401k, you will have to pay taxes on the money at your ordinary income tax rate.

On the flipside, you pay taxes on the dollars that you contribute to a Roth 401k today, but then you don't have to pay taxes in retirement as long as you use the money for qualified withdrawals (we will look at that below.) Unlike a Tradtional 401k, contributions to a Roth 401k do not lower your taxable income today since you are getting a tax benefit in retirement.

On a final note, the passing of the SECURE Act 2.0 in 2022, changes one other tax item for the Roth 401k. It used to be that your employer match on your Roth 401k had to go into a seperate Traditional 401k account. So, if your employer offered a 3% match on your Roth 401k, that match would go into a Traditional 401k.

This means that the money you contrbuted to a Roth 401k would be tax free in retirement, but the amount your employer contributed would be subect to taxes. However, the SECURE Act 2.0 will allow both your contributions and your employer match to go into a Roth 401k - meaning you can maximize the tax benefits. This will not take effect until 2024 or later.

In general, you can start to withdraw money from a Traditional 401k once you are 59 and a half years old. Keep in mind that when you withdraw that money, you will have to pay taxes on the money you withdraw at your ordinary income tax rate.

Additionally, if you try to withdraw the money in a Traditional 401k before you are 59 and a half years old, you will be subject to a 10% penalty and income taxes on the amount you withdrew.

You can start withdrawing money from a Roth 401k as long as two rules are met. First, you need to be 59 and a half years old. Second, you need to have had the account open for at least 5 years. When you take money out of a Roth 401k, you will not owe any taxes.

Similar to a Traditional 401k, you can incur a 10% penalty and income taxes if you try to withdraw the money from a Roth 401k before you are 59 and a half, or before you have held the account for 5 years.

A required minimum distribution is the minimum amount you must withdraw from certain retirement accounts per year once you reach a certain age as mandated by US tax laws. For a traditional 401k, you must start taking RMDs once you are 73 years old. The amount you are required to take out is calculated by dividing the balance in your account by your remaining life expectancy.

A Roth 401k also requires you to take RMDs once you are 73 years old. However, this is changing in 2024 thanks to the passing of the SECURE Act 2.0. Starting in 2024, you will no longer have to take RMDs from your Roth 401k. This will give you more flexibility with your withdrawals in retirement.

In short, we think the Roth 401k is better than a Traditional 401k. Although both accounts provide a range of benefits such as an employer match and high contribution limits, the Roth 401k does offer a few more things that pushes it ahead of a Traditional 401k - in our opinion.

1) Tax benefits

Taxes should be your primary consideration when trying to decide between the Roth and Traditional 401k. You will typically here something like this. If you expect taxes to be lower in the future, you should invest in a Traditional 401k. If you expect taxes to be higher in the future, you should invest in a Roth 401k.

In this regard, we think the latter is more likely to happen which is why a Roth 401k would be a better bet. In other words, if taxes go up in the future, it would make more sense to pay taxes today at a lower rate and then enjoy zero taxes in retirement.

It can be tempting to get a tax break today through a Traditional 401k, but once you are in retirement, you are not going to enjoy paying taxes. Even if taxes don't rise significantly in the future, knowing that you will not have to pay taxes once you retire can be a huge emotional relief.

2) No RMDs starting in 2024

The second reason that pushes the Roth 401k in front of the Traditional 401k is that you will not be required to take RMDs starting in 2024. If you invest in a Traditional 401k, you will be required to pull out a certain amount of money each year once you are 73.

For some, RMDs are not that big of a deal as you were going to pull money out of the account regardless. However, having more flexibility over when you pull the money out of the account can be beneficial.

An IRA is an individual retirement account that is held outside out work. Although a 401k is a great way to save for retirement, using an IRA in tandem can be beneficial. The two most popular types of IRAs are the Roth and Traditional IRA.

We would recommend using a Roth IRA in tandem with a Roth 401k. A Roth IRA will offer the same tax benefits that a Roth 401k does, but it also gives you a few more benefits.

1) More investment options: A Roth 401k is limited to a small selection of investment funds based upon your plan. However, since a Roth IRA is not a work place plan, you do not have limitations on what you can invest in. So, if your Roth 401k does not offer all of the investments you want, you can open a Roth IRA to get access to those investments. You can open a Roth IRA through an online broker or robo advisor.

2) You can withdraw the base amounts: A secondary advantage to using a Roth IRA is that you can withdraw the base amounts you contribute to the account before you reach your retirement age. You can't do this with a Roth 401k.

In general, it is a bad idea to pull money out of your retirement accounts. However, in an absolute dire situation, you can pull money out of your Roth IRA as a last resort. Keep in mind you can only pull out your base contributions and not any money you have earned from your investments within the account.

Related - Roth IRA vs Roth 401k: Which is Better?

How to Use a Roth 401k and Roth IRA in Tandem

1) Contribute enough to a Roth 401k to get an employer match

If your employer offers a Roth 401k with a match, you can invest enough into the account to get your employer's match. So, if you make $80,000 per year and your employer offers a 4% match, you should contribute $3,200 (4% of your annual salary) so that your employer will match that with another $3,200.

Having a match can boost how much money you have in your Roth 401k over long periods of time. The average 401k match is typically between 3% and 5% of your salary. If your employer offers a Roth 401k, but does not offer a match, jump straight to step 2 below.

2) Open a Roth IRA and max fund it

Once you contribute enough to a Roth 401k to get your employer match, it might be a good idea to start diverting dollars to a Roth IRA if you still have money you are able to invest. You might be asking yourself why?

A Roth 401k offers many benefits, but one of the disadvantages is that you don't have as much control over your investments. You only get to choose from select investment funds for your plan. Investing dollars into a Roth IRA will give you much more control over what you are able to invest in.

You can look for other investments to hold within a Roth IRA that are not available through your Roth 401k if it makes sense for you to do so. Contribute the maximum amount you are allowed to a Roth IRA ($6,500 per year or $7,500 per year if you are 50 or older).

3) Jump back to your Roth 401k

If you still have money you are able to invest after going through options one and two, you can jump back over to your Roth 401k. A Roth 401k will provide the tax benefits of the Roth IRA, but also has a much higher contribution limit meaning that you can invest more money into a Roth 401k.

The bottom line is that both the Roth 401k and Traditional 401k can be used to help save for your retirement. In our opinion, the Roth 401k edges out the Traditional 401k due to the way the account is taxed and no RMDs starting in 2024.

Keep in mind that deciding between a Roth and Traditional 401k will come down to your individual needs. We recommend speaking with a licensed financial advisor if you need help deciding. On a final note, using a Roth IRA in tandem with a Roth 401k can provide additional benefits as you save for retirement.

If you want to learn more about investing as a whole, you can check out our guide on how to invest for beginners.