Traditional vs. Roth 401(k) Deferrals: Which One is Right For You?

One of the most common questions I receive from plan participants wanting to start contributing to a 401(k) is which type of deferral is “better” – Traditional or Roth. The truth is, one is not necessarily better than the other. The right type of deferral will depend on your personal situation. Here’s an overview of how Traditional and Roth deferrals work, how they’re different and which situations they’re best suitable for.

Traditional 401(k) Deferrals

Traditional 401(k) deferrals work by the employee specifying an amount to be deducted from their paycheck and deposited to an account in their employer’s plan. The funds are invested in mutual funds, stocks or bonds – based on the right asset allocation approach for you and investments offered by the retirement plan – for future growth to fund your retirement.

Traditional 401(k) contributions are made on a pre-tax basis, which simply means that income taxes are not withheld on those amounts set aside for retirement. Instead, you pay income taxes when you take a distribution from the Plan.

Roth 401(k) Deferrals

Roth 401(k) deferrals work similarly to Traditional 401(k) deferrals. Employees also specify an amount to be deducted from their paycheck and deposited into an account in their employer’s plan. However, the major difference that comes with Roth 401(k) deferrals is that contributions are made on an after-tax basis. This means that taxes are withheld on the amounts you contributed, and the net amount after withholding is invested for future growth. When it comes time to take a distribution from the Roth 401(k) account, no tax is due as long as you have a qualified distribution – it was already paid when you set the money aside earlier.

Choosing the Best Option for You

Now that you understand the difference, which option should you choose? This answer largely depends on income tax rates. If you expect income tax rates to increase in the future, a Roth 401(k) contribution makes more sense, as it’s better to pay the lower income tax rate today and avoid the higher income tax rate in the future when you are taking distributions. On the flip side, if you expect income tax rates to decrease in the future, a Traditional 401(k) contribution is preferable.

Additionally, if you expect to earn a much higher income in the future than right now, which would bump you to a higher income tax bracket down the road, it may be more advantageous to contribute to a Roth 401(k) to take advantage of the lower tax bracket you’re in now.

Without a crystal ball, it is difficult to know what approach is best for you. You might consider making both Traditional and Roth deferral contributions.

For example, if your retirement plan allows, you could split your 10% 401(k) contribution and elect 5% Traditional and 5% Roth. Be sure to consult with your accountant/tax advisor, a wealth advisor, or your Human Resources representative for more details.

Note: Non-Deposit Investment Services are not insured by FDIC or any government agency and are not bank guaranteed. They are not deposits and may lose value.