Roth vs. Traditional 401(k): What’s the difference?

Scored a new job? Congrats! Ready for all the first day paperwork – including enrolling in a 401(k)? If it sounds overwhelming, don’t worry. Whether your employer offers either or both plan types, we’re here to help with understanding the difference between a Roth vs. Traditional 401(k) – and the income tax implications of each.

Deciding which account is right for you depends on a few factors. So, read on as we highlight the differences between Roth vs. Traditional 401(k)s.

What is a 401(k)?

When it comes to planning for retirement, a 401(k) is a popular option. It’s a retirement savings account sponsored by your employer, and it’s a great way to start building a nest egg for your golden years. 401(k)s typically consist of various mutual funds that range from conservative to aggressive.

401(k)s can give your money a tax shield while your account grows. Additionally, if your employer offers a matching contribution, you can give your investments an extra boost to help grow your retirement savings. Your 401(k) contributions could help lower your taxable income and potentially your tax bracket.

However, you should be mindful of the nuances of each type of retirement account.

For 401(k)s, there are two types:

• Traditional 401(k)
• Roth 401(k)

Traditional and Roth 401(k)s are available to Form W-2 employees, depending on the plan’s eligibility requirements. While they share many similarities, their differences can significantly impact your retirement savings, financial planning efforts, and taxes.

What is a Traditional 401(k)?

A traditional 401(k) is a retirement savings account that allows you to set aside a portion of your salary pre-tax through paycheck withholding. That means, you don’t pay taxes on the amount you contribute in a given year. Instead, you pay taxes when you withdraw the funds.

What is a Roth 401(k)?

The Roth 401(k) is a retirement savings account funded with after-tax dollars through paycheck withholding. That means, you pay taxes on the amount you contribute in a given year, rather than when you withdraw the funds.                           

Is a 401(k) pretax? Getting down to the differences

Determining if a 401(k) is pre-tax hinges on if you’re contributing to a Roth account or a traditional account. That’s right — one of the fundamental differences between a traditional 401(k) and a Roth 401(k) is when you pay taxes.

To make it easy, here’s an overview of how you’re taxed through the life of each account type.

*Both Traditional and Roth 401(k)s require you to take minimum distributions starting at the age of 72 or when you retire from the company sponsoring the plan if later and if allowed by the plan

Under recent legislation:

• If you turn 72 after 2022, your required minimum distributions don’t start until age 73.
• After 2023, RMDs will no longer be required for Roth 401(k)s.

Roth 401(k) and taxes: What you need to know

As mentioned above, you pay taxes on your contributions upfront. When you withdraw the money in retirement, you don’t owe any taxes on your contributions and earnings if you follow the rules (meaning your withdrawal is considered qualified).

One of those rules is the 5-year rule. If you take money out before you’ve held the account for at least five years, you’ll incur a 10% penalty when you file your tax return.

Another quirk of Roth 401(k)s is that employer matches are not allowed. If you choose a Roth 401(k) and your employer matches your contribution, it will need to go into a Traditional 401(k) or other pre-tax plan. This means you will have both a Roth 401(k) and another pre-tax account.

Traditional 401(k) and taxes: What you need to know

As covered above, your contributions are pre-tax, meaning you reduce your taxable earnings by the same amount in that tax year. However, the money you put in will eventually be taxed. When you do withdraw the money, your contributions and earnings will be taxed as ordinary income.

How much can you put in a 401(k)?

In 2022, employees could put in up to $20,500 ($27,000 if age 50 or over). In 2023, employees can put in up to $22,500 ($30,000 if age 50 or over).

The amount is updated for inflation on a yearly basis. And the amounts are the same regardless of if you put money into a Traditional or Roth 401(k) retirement plan. That said, if your company offered both, you could split your contributions if you wanted. For example, you could put $11,000 in one account and $11,500 in another.

Employer contributions don’t count toward your employee contribution limit mentioned above. The company match does factor into an overall cap on contributions. The 2022 cap on both employee and employer contributions is $61,000 ($67,500 if age 50 or over), and the 2023 cap is $66,000 ($73,500 if age 50 or over).

Additionally, if you have a higher income, the IRS limits how much of your compensation is eligible to be contributed to a 401(k). The compensation limit is $305,000 for 2022 and $330,000 for 2023.

Can anyone contribute to a 401(k)? No, in addition to being an employee, your company must offer a 401(k) plan in order for you to contribute. So, for example, if you’re an independent contractor, you would not be able to contribute to a 401(k) sponsored by the company that is paying you.

For details on other retirement plan types that might work for you, learn about an individual retirement account (IRA) and check out our post on plans that offer a self-employment deduction.

Which account is right for you?

Deciding which type of 401(k) is right for you depends on your financial situation, retirement goals, and employer contribution match.

Generally speaking, a Roth 401(k) may be beneficial to you if you expect to be in a higher tax bracket when you retire. On the flip side, if you think you’ll be in a lower tax bracket during retirement than you are in now, a traditional 401(k) may be the better option. Opening either type of account could help lower your taxable income and even tax bracket either immediately or in the future.

It’s best to consult a financial advisor for additional help on weighing your options.

Need help navigating your taxes?

Whether you’ve put money in a Traditional or Roth 401(k), H&R Block can help you navigate your taxes. Make an appointment with one of our tax pros today. Or, if you prefer to file on your own, our online tax filing product can help you.