Should I Contribute to a Standard 401(k) or a Roth 401(k)?

By Shana Francis, CPA, Tax Manager

Should I Contribute to a Standard 401(k) or a Roth 401(k)?

Why contributing to a Roth 401(k) retirement plan may be the better option

In addition to a standard 401(k) plan, most employers now offer the option to contribute to a Roth 401(k).  If you have the option to choose either a regular 401(k) or a Roth 401(k) – how do you know which is the better option for you? This article discusses the basics of the two plans and why you might just want to choose the Roth 401(k) over the traditional 401(k) plan.

Standard 401(k) vs. Roth 401(k): Key differences

A Roth 401(k) differs from a traditional 401(k) in that with a Roth 401(k) plan, your contributions are “after-tax” contributions. This means that your current taxable wages are not reduced for the Roth 401(k) contribution even though you do not have access to the funds. The upside, at retirement (the time of the payout), there is no tax due. All of the appreciation on the initial contribution is tax-free. Compare this with a traditional 401(k) in which contributions are made with pre-tax dollars (your current taxable wages are reduced), and subsequent retirement withdrawals, including all of the earnings on the contributions, are subject to income tax at ordinary income tax rates. Keep in mind however, that any employer “match” contributions and the earnings associated with such contributions will be taxable upon withdrawal no matter what type of 401(k) plan you have.

Also, Roth 401(k)s are subject to a “five-year rule” which does not apply to traditional 401(k) plans. In order to take tax free (and penalty free) distributions from a Roth 401(k), you must have held the account for at least five years. No such rule applies to regular 401(k) plan accounts, but early withdrawals from a regular 401(k) plan are subject to income tax and likely subject to a 10% penalty as well.

How are Standard 401(k) and Roth 401(k) plans similar?

Both types of retirement plans have the same contribution limits. In 2022, you can contribute up to $20,500/year. If you are over 50, you can contribute an additional $6,500 catch up contribution, for a total of $27,500.

Traditional/regular 401(k) plans are subject to Required Minimum Distributions (“RMD”) at age 72. For regular 401(k) plans, this would be the entire account balance. While employees may make contributions to an employer sponsored Roth 401(k), any employer match is required to be deposited into a traditional 401(k) account. As a result, these contributions and appreciation/earnings related to the employee’s Roth contributions, whether tracked in a separate account or combined with employees’ other traditional 401(k) account, are subject to RMD requirements at age 72 as well. With respect to your employer sponsored Roth 401(k) plan; however, you have the potential to avoid RMD requirements that do generally apply to a Roth 401(k) plan balance by rolling it over into a Roth IRA where there is no RMD requirement.

Roth 401(k): Tax savings and estate tax planning advantages

In most cases, we think the Roth 401(k) is the way to go. While you will see a little less in your paycheck by contributing to a Roth 401(k) (since contributions are made with after tax dollars and your paycheck is reduced by the applicable Federal and state income taxes), all of your future withdrawals are completely tax free. The younger you are, the better this planning technique as your retirement funds have longer to grow on a tax free basis. Having tax free accounts to draw from in retirement makes your retirement dollars more impactful. Add to that potential estate tax planning benefits that a ROTH 401(k) offers and it becomes the obvious choice.

If you think you might have a taxable estate, making after tax contributions now (i.e. paying income taxes now), allows you to whittle away the value of your estate, while at the same time leaving your heirs an asset that is completely tax free to them.

Additionally, younger savers are often in the lower/lowest tax brackets for much of their early career. As such, any “pre-tax” contributions during these years put into a regular 401(k) plan are not generating significant tax savings. However, upon retirement, it is likely these same individuals will be in the highest tax brackets, a Roth 401(k) would have been the better choice by far.

Finally, as mentioned earlier, if you do not think you will need 401(k) assets to pay some or all of your living expenses in retirement, a Roth 401(k) provides the potential opportunity to avoid RMD requirements.

If you are not sure that you can commit to contributing all of your salary deferrals to a Roth 401(k) due to cash flow limitations, you can always split your contributions between the two plans. As long as your combined contributions do not exceed the contribution limits ($20,500 for 2022), you can split your contributions between the two plans as you see fit.

Roth 401(k) plans have the potential to be a great tax savings vehicle. However, every individual’s tax situation is unique, so we recommend that you contact your Keiter Opportunity Advisor if you are interested to learn whether a Roth 401(k) could be advantageous for you.

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About the Author

Shana Francis

Shana Francis, CPA, Tax Manager

Shana has 15 years of experience in public accounting, specializing in providing tax compliance and consulting services to high net worth individuals, including corporate executives and entrepreneurs. Her areas of expertise include income, gift, and trust and estate compliance and planning services. She is a member of the Firm’s Family & Executive Advisory Services team.

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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.


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