Education Center » Roth or traditional 401(k): Which is right for you?

Roth or traditional 401(k): Which is right for you?

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Understanding how these contribution types are taxed can help you decide between them.

If you are eligible for or currently enrolled in your company’s 401(k) plan, you are probably familiar with many of the decisions associated with managing your plan account, like choosing a contribution rate, selecting from the plan’s investment menu and designating a beneficiary. However, your workplace retirement plan may also let you choose between making traditional and Roth 401(k) contributions. Understanding the difference between the two might help you decide which 401(k) option is better aligned with your financial situation.

More than six in 10 plans offer a Roth option, but fewer than 20 percent or so of employees with the option of saving in a Roth 401(k) use it.1 The difference largely has to do with taxes. Once you consider how your investments will be taxed—which differs for both contributions now and distributions later on—you can decide which option is right for you.

These frequently asked questions and answers address some of the information you should consider in making your decision. However, we strongly suggest that you discuss your personal situation with a financial professional before taking any action.

Q: How are contributions treated for tax purposes?

A: Traditional contributions are made with pre-tax dollars, meaning the money comes out of your paycheck before income tax is applied. This amounts to an immediate tax break for saving for retirement, as you will defer the payment of income tax until you withdraw your pre-tax contributions and any earnings.

Roth 401(k) contributions, by contrast, are funded with after-tax dollars: Income taxes are deducted from your paycheck; then your contributions are deducted. In effect, you will not be able to contribute as much, dollar-for-dollar, as with traditional 401(k) contributions if you want to keep your take home pay the same.

Q: How are withdrawals of these two contribution types taxed?

A: With a traditional 401(k), you’ll pay income tax on your withdrawals. In other words, you’ll eventually be taxed on any money you contribute and on any investment earnings in the plan.

On the other hand, qualified withdrawals from a Roth 401(k) are tax-free. This means you won’t be taxed on any potential investment growth in the plan. (You will pay federal—and possibly state—income tax on withdrawals of company matching contributions and their earnings, however.)

Q: How can I determine which plan is right for me?

A: It really depends on your personal circumstances. Many people assume that they’ll have less taxable income in retirement, and that they will be in a lower tax bracket. If that’s the case for you, traditional 401(k) contributions could be a good choice: The tax break you get on your contributions today could be worth more than the savings you might gain from tax-free withdrawals from a Roth 401(k) account.

That said, it’s possible that you’ll be in a higher tax bracket, or that tax rates may rise between now and then. In those scenarios, making Roth 401(k) contributions may help minimize the overall federal income tax you pay on your retirement savings.

Q: Who can contribute to these plans?

A: If an employer-sponsored plan has a traditional and a Roth 401(k) contribution feature, participants would be eligible to make either type of contribution, or both. In 2018, tax laws allow you to contribute up to $18,500 to a 401(k) plan, whether your contributions are traditional, Roth or a combination of the two, as well as an additional $6,000 in catch-up contributions if you are 50 or older and your employer’s plan accepts catch-up contributions. You can make both traditional and Roth contributions, but your combined contributions can’t exceed the limit that would apply to either type of contribution separately.

Q: Are Roth 401(k) contributions eligible for an employer match?

A: Yes. If an employer offers a match on traditional 401(k) contributions, a Roth 401(k) contribution would be eligible as well. That said, you’ll have to contribute a greater percentage of your paycheck if you are making Roth contributions than if you were making traditional 401(k) contributions to receive the same employer matching contribution.

The reason: The match is based on the dollar amount you contribute. Traditional 401(k) contributions come out of pre-tax income, whereas Roth contributions come out of after-tax income, which is smaller. As a result, contributing a set percentage results in larger traditional contributions than Roth contributions triggering a larger match. The following table provides a hypothetical illustration.

How do deferral contributions impact take home pay? It depends on the contribution type.

An employer offers matching contributions equal to 50% of employee salary deferrals up to a maximum of 6% of eligible compensation. Assuming an employee has pre-tax eligible compensation of $50,000, the maximum match he or she may receive is $1,500. This means the employee must contribute $3,000 in salary deferrals to receive the maximum match (6% of $50,000). The example below illustrates the difference in the employee's take home pay if traditional or Roth contributions are elected.

If using Roth contributions

If using traditional 401(k) contributions

Pre-tax compensation

$50,000

$50,000

Traditional 401(k) contributions

$3,000

Taxable income

$50,000

$47,000

Federal income tax liability

$6,939.50

$6,279.50

After-tax compensation

$43,060.50

$40,720.50

Roth 401(k) contributions

$3,000

Take home pay

$40,060.50

$40,720.50

Difference of $660 in take home pay

The above example demonstrates that an employee will be left with a lower amount of take home pay by deferring Roth 401(k) contributions at a level necessary to maximize the employer matching contributions. An employee should ensure that the impact on take home pay is taken into consideration when determining what type of deferral to make to a 401(k) plan. You should talk to your tax advisor before making any financial decisions.

*This example assumes the taxpayer's total gross income for the year is $50,000 and his/her filing status is single. For 2018, this means the taxpayer is in the 22% federal income tax bracket and his/her effective tax rate, without taking pre-tax 401(k) contributions into account, is 13.9%. The example does not take into account deductions, exemptions or other adjustments to taxable income. The example also does not take into account FICA withholding or state and local income tax.

Q: When can I take withdrawals from a Roth 401(k) account?

A: You (or your estate) can take qualified withdrawals if (i) five years have passed since the first day of the year in which you made your first Roth contribution and (ii) you have reached age 59½ or become disabled. (Your estate can take qualified withdrawals after you’re deceased, as long as you reached the five-year holding period.) If you take non-qualified withdrawals, you’ll have to pay regular income taxes plus a 10% additional federal tax on any earnings. (You may qualify for certain exemptions; consult your tax advisor.)

Note that company matching contributions are made on a pre-tax basis, and these contributions (plus any earnings) will be subject to federal (and possibly state) income tax upon withdrawal.

Q: Do both types of plan require minimum distributions (RMDs)?

A: Yes. With both types of 401(k) contributions, you generally must begin taking withdrawals at the age of 70½. However, you can roll a Roth 401(k) account balance into a Roth IRA, which is not subject to the RMD rules during your lifetime.2

Q: How do the plans address rollovers?

A: When you retire or leave your job, you can roll your traditional 401(k) account balance into a traditional IRA, your new employer’s 401(k) plan (as long as it accepts rollovers) or another qualified employer-sponsored plan. You may also convert a traditional 401(k) account balance into a Roth IRA, and you would owe taxes on the transaction.

Likewise, you could roll a Roth 401(k) balance into a Roth IRA, another Roth 401(k) or a Roth 403(b) account.

Each choice may offer different investment options and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment, and provide different protection from creditors and legal judgments. These are complex choices and should be considered with care.

Q: May loans and hardship withdrawals be taken from a Roth account balance if a plan allows them to be taken from a traditional 401(k) account balance?

A: Yes. As long as your plan allows it, both pre-tax and Roth 401(k) account balances are available for 401(k) loans and hardship withdrawals.

Selecting the right contribution type for you can help you make the most of the money you set aside. That said, choosing the right contribution type isn’t nearly as important as how much you contribute and when you contribute it—so, whether you elect traditional or Roth 401(k) contributions, make sure to contribute as much as you can, as early as possible.

Learn more

  • Looking for more information on Roth 401(k)s? View brochure >
  • If your 401(k) plan is through Merrill Lynch, use the Roth 401(k) Comparison Calculator on Benefits OnLine® to model different hypothetical scenarios by changing the retirement age, contribution amount and possible tax bracket. Go to Benefits OnLine® >
 
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Neither Merrill Lynch nor any of its affiliates or financial advisors provides legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

1 Source: Consumer Reports, July 2016.

2 Upon rollover to a Roth IRA, the rolled over funds are subject to the account holder�s 5-year holding period applicable to the Roth IRA.

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