Employee Mental Health: Is Your Company Doing Enough?
While it may not be your job to solve employees’ physical and mental health problems, you can enhance workplace mental health by being open and...
Roth vs Traditional 401K - Which is Best?
Let’s say your company offers a 401K with both Traditional and Roth investment options. Which one should you choose?
Other blogs you may be interested in:
If your employer offers a 401K retirement plan that includes both a Roth and Traditional 401k option, you may be wondering which investment option is best for you. The answer depends on your current taxable income, your expectations for future tax rates, and your long-term financial goals.
While it may be hard to predict, does it make more sense for you to delay paying taxes on your savings until retirement, or paying taxes on your savings right now? And ultimately, how does that affect your take home pay?
Introduction to Retirement Savings
Retirement savings are a cornerstone of personal finance, and understanding your options is key to building a secure future. While both a Roth and Traditional 401K help you grow your retirement savings, they differ in how and when you pay income taxes, their tax treatment, and how employer contributions are handled.
Starting your retirement savings early can make a significant difference, thanks to the power of compounding over time. Many employers also offer matching contributions, which can boost your savings even further—essentially providing “free money” to help you reach your goals faster.
If you don't have time right now to consider which option is best for you, enroll in either one to simply get your retirement savings going. Be sure to maximize the employer match and then find some time in the future to determine whether Roth, Traditional, or some combination of the two is best for your situation.
Eligibility and Contribution Limits
Eligibility for both Traditional and Roth 401(k) plans is typically determined by your employer, so it’s important to review your employer's plan details to see which options are available to you.
The IRS sets an annual contribution limit for 401K contributions — whether Traditional, Roth, or a combination of the two. For 2025, the maximum contribution limit is $23,500. However, if you are age 50 or older, you can take advantage of a catch-up contribution amount of an additional $7,500, which allows you to save even more as you approach retirement. For those ages 60-63, the 2025 catch-up contribution increases to $11,250 per year.
It’s important to note that, pending IRS rule finalization, employees earning more than $145,000 (adjusted for inflation) will be required to make their catch-up contributions as Roth contributions starting in 2026. This change could impact your tax planning strategy, so be sure to stay updated on the latest IRS rules.
Do employer contributions count toward annual maximum limits?
Employer contributions, such as matching or profit sharing contributions, are a valuable part of many 401K plans. These contributions do not count toward your personal annual contribution limit, but they may be subject to vesting schedules set by your employer.
When planning your retirement savings, consider both your own contributions and any employer contributions to maximize your total retirement account balance.
Traditional 401K (Pre-Tax Contributions)
A Traditional 401K is sometimes referred to as the pre-tax option. Contributions are made with pre-tax dollars, also known as pre-tax contributions, meaning you are literally taking the income you decide to save and the tax that you should have paid on those dollars today and pushing both of them off to retirement. This has two significant impacts:
- Reduces your current taxable income to where you pay a smaller amount of tax THIS year. The tax-deferred nature of a traditional account allows your investments to grow without paying taxes until withdrawal.
- Delays your responsibility in paying ordinary income tax on those dollars when you use them in retirement. Traditional accounts can provide significant income tax savings, especially if you are currently in a higher tax bracket and expect to be in a lower tax bracket in retirement.
What you won’t know is how much future tax you’ll have to pay on the dollars invested in a Traditional 401K. That tax bill will be at the mercy of whatever tax brackets happen to be in place when you start using your invested money during retirement. The choice to use a traditional account is largely dependent on your current and expected future tax brackets.
Roth 401K (Post-Tax Contributions)
The Roth option is sometimes referred to as the post-tax option because you pay taxes on the income you earn and then make the contribution into the Roth portion of your 401K. Roth 401 K contributions are made on an after-tax basis, using after-tax dollars, meaning you pay taxes now before making the contribution.
Because those dollars have already been taxed, you will not be responsible for paying taxes on them when you use them at retirement. Qualified withdrawals from a Roth 401K are tax-free if you meet certain conditions, such as reaching retirement age and satisfying the five-year holding period.
The Roth option is an effective retirement tool because it’s not just the dollars you contribute that are tax-free, but also any gain that comes from the investment of those dollars.
Qualified Distribution Rules
Navigating qualified distribution rules can be complex, so you may want to consult a tax professional to help you avoid unexpected taxes or penalties and to ensure your withdrawals are qualified.
Qualified withdrawals from Roth 401K accounts
For Roth 401K accounts, a qualified distribution is both tax-free and penalty-free if it meets two key requirements:
- The distribution occurs at least five years after your first Roth contribution, and
- You are at least 59 1/2 years old, disabled, or deceased.
Qualified withdrawals from Traditional 401K accounts
Qualified distributions for Traditional 401K accounts are available once you reach age 59 1/2 or if you separate from service (i.e. you quit, resign, are fired, or laid off) after that age. While you won’t face early withdrawal penalties, you will need to pay income taxes on the amount withdrawn, since contributions were made on a pre-tax basis.
Minimum Distributions Requirements
When it comes to required minimum distributions (RMDs), the rules differ between Traditional and Roth 401K accounts.
Required minimum distributions for Roth 401K
Roth 401K accounts are generally exempt from RMDs during the account holder’s lifetime, especially if the funds are rolled over into a Roth IRA. This allows your retirement savings to continue growing tax-free for as long as you wish, giving you more control over your retirement income strategy.
Required minimum distributions for Traditional 401 K
Traditional 401K account holders must begin taking minimum distributions starting at age 73. The specific amount you’re required to withdraw depends on your account balance and life expectancy. Failing to take your RMD may result in costly penalties.
Retirement Tax Rate Considerations
Your retirement tax rate can have a major impact on how far your retirement savings will stretch. But there is a lot of unknown regarding what the future tax rates may be, as state and federal income tax rates, Medicare premiums, and Social Security benefits all play into your future tax rate.
If you are in a higher tax bracket today, you may want the advantage a traditional 401K offers by taking an immediate tax break now and reducing your current taxable income. However, you will have to pay income taxes on withdrawals in retirement.
On the other hand, Roth 401K plans require you to pay income taxes on your contributions now, but offer tax-free growth and tax-free withdrawals in retirement. Making after-tax contributions creates a powerful advantage for anyone who expects to be in a higher tax bracket later or for those who value the certainty of tax-free income in retirement.
Traditional vs Roth – how do I decide based on taxable income?
Deciding which option to invest in is largely dependent on your current tax obligations and what your future tax position may look like. If you typically owe on your taxes, you may want to take advantage of the Traditional pre-tax 401K contributions option to reduce your current taxable income.
If, however, you are a bit younger, it is incredibly important to recognize the power of Roth accounts. They give you the ability to pay tax on your income today and not be responsible to pay taxes on any of those gains — which may be substantial over a 20, 30, or 40-year period of time. The younger you are and the lower your current tax rate, the more sense it makes to look at contributing into a Roth 401K.
Please keep in mind that you can use a combination of both the Traditional and Roth 401K, which personally is my approach. I put enough money into the Pre-Tax part of my 401K to reduce my current tax bill down to a point that I’m comfortable with it, and then everything else I can afford to save goes into my Roth. Although I have a need for a tax break today, I love the idea of a tax-free bucket of money in retirement and all the flexibility that will provide. This strategy covers both of my wishes!
Final Thoughts on 401K Investments
Remember, investing involves risk, and past performance is not a guarantee of future results. For help with creating your specific strategy, I recommend you consult with a financial professional or tax advisor to help you tailor your retirement strategy to your specific needs.
If your company is interested in getting an employer-sponsored 401K started, please contact your Stratus HR rep today. Not a current Stratus HR client? Book a free consultation and our team will contact you shortly.