Pros and Cons to Choosing a Roth 401(k) Over Traditional 401(k) — and Vice Versa

My husband and I have tussled over whether to have him contribute to a traditional 401(k) or Roth 401(k) more times than I can count. 

"We'll be in a lower tax bracket when we retire."

"Who knows what the government will do by then?"

Does anyone else have these uh… fun discussions?

Roth 401(k)s have been around forever, so it's funny (or annoying) that we keep having this same discussion. But we do, and I can only assume that others also wonder whether they've made the right retirement savings vehicle decision.

Agonizing about whether to plunk your money into a traditional 401(k) or Roth 401(k)? Read on for more information about each, and maybe, just maybe, you'll give up the discussion once and for all.

What Are Traditional 401(k)s and Roth 401(k)s?

Employees can choose between a traditional 401(k) and a Roth 401(k). They're both employer-sponsored plans which give you an array of investment options. Some employers also match a portion of your 401(k) contributions, but that's generally where the similarities end. 

Traditional 401(k) contributions and any earnings from the investments are tax-deferred. In other words, you pay the taxes on contributions and earnings when you withdraw your savings in retirement. You also don't have to pay Income taxes on matching funds until you withdraw money.

On the other hand, you make tax-deferred contributions to a Roth 401(k) plan. You benefit from tax-free income — all interest, dividends and capital gains are tax-free. The employer match, however, will still be taxable in retirement, so keep that in mind.

You can contribute up to $19,500 for 2021 ($26,000 for those age 50 or older) for both types of accounts.

Pros to Choosing a Roth 401(k) 

Take a look at the pros and cons of a Roth 401(k).

• Your contributions and earnings grow tax-free. The most obvious benefit of choosing a Roth 401(k): Your earnings grow tax-free and you pay no taxes when you start taking withdrawals in retirement.
• You protect yourself emotionally later on. Here's what I mean by this. Imagine you do choose a traditional IRA. Let's say you save $2 million for retirement, then have to fork over, say, $400,000 in taxes. (I'm making up this amount.) How will that feel? Investing in a Roth 401(k) saves the "I owe what?" question you may invariably have down the road.
• Higher earners can take part. Unlike a Roth IRA, which only allows earners to contribute as long as they earn less than $198,000 (married filing jointly) or less than $125,000 (single). However, you can contribute in a reduced capacity up to $208,000 and $140,000, respectively, with a Roth IRA. Mind these limits or you'll pay additional taxes — not so with a Roth 401(k).

Cons to Choosing a Roth 401(k)

On the other hand, you'll also experience some downsides to choosing a Roth 401(k). Check them out before you decide:

• Will your tax bracket actually be higher? If your tax rate will be higher in retirement, making Roth contributions now could make sense. Better to pay taxes now rather than later, when you could pay higher rates.  
• You'll have to take RMDs. Again, the Roth IRA is the only type of retirement savings vehicle that doesn't require you to take RMDs, which could become problematic if you want to leave money to your beneficiaries (unless, again, you transfer the money to a Roth IRA). 
• Not as many investment choices. You may find that you don't have access to as many investment choices with a Roth 401(k) compared to an IRA. Actively determine what you have access to and whether they fit your needs and goals.

Pros to Choosing a Traditional 401(k)

Think a traditional 401(k) makes sense for you? Let's find out why you might want to choose a traditional 401(k) in lieu of a Roth 401(k). 

• Where you live in retirement may help you. Let's say that you live in a state that collects both state and federal income tax, but you plan to move to Florida or Texas when you retire. You won't have to pay income tax, so a traditional 401(k) might make sense.
• Consider whether you'll go into a lower tax bracket. If you expect to be in a lower tax bracket in retirement, a traditional 401(k) may make more sense than a Roth account. 

Cons to Choosing a Traditional 401(k)

Finally, the cons:

• Withdrawals are taxed at your income level when you withdraw. In other words, you may pay more in taxes because your income might be higher when you make withdrawals compared to when you make contributions.  
• Nobody knows what future tax rates will look like. There's really no way to know what tax rates will look like in the future, and it's also next to impossible to determine what they will look like based on historical trends.

Which One Works Best for You?

You may also want to consider not making it an either-or decision if your employer offers both a Roth 401(k) and traditional 401(k). Your employer can also contribute to both, but remember that with a Roth 401(k), matched funds go into a separate tax-deferred account and you'll pay taxes upon retirement for that.

No matter which direction you go (or if you choose both), you're setting yourself up for success later. You can also do some "fancy footwork" as well! You must take required minimum distributions (RMDs) starting at age 72 (or at age 70½ if you turned 70½ in 2019 or earlier). To get around this when you retire, you could roll over funds to a Roth IRA to avoid those RMDs, because a Roth IRA has no RMDs. You can continue to grow your assets tax-free and any heirs you have also won't have to pay taxes.

The biggest unknown (if only we had a crystal ball…): Knowing how the tax brackets or tax percentages will change in the future.