I'm a financial planner, and I think most people are better off skipping a Roth 401(k)

  • Many clients ask me if they should invest in a Roth or traditional 401(k), and in most cases, I recommend a traditional 401(k) for retirement savings.
  • If you're a high earner or in your peak earning years, you likely won't be making more in retirement than you are now, which means you could pay less income tax on your money with a traditional 401(k).
  • I do think Roth assets are a healthy part of a retirement plan. They should work alongside taxable assets and pre-tax assets, such as cash in a traditional 401(k) or IRA.
  • Use Blooom to analyze your 401(k) today and see how you can grow your retirement savings »

As a financial planner, clients often ask me if they should choose a Roth or traditional 401(k) to save for retirement, While many investors understand the basic concept of how each account works, they are not sure which account to choose. 

A number of factors guide this decision, with current and future income and tax rates being the most prominent. Roth 401(k)s have attractive benefits, but they're not always a clear winner. Before I get into the details of why I believe a traditional 401(k) is the better option in most cases, let's discuss the difference between the two accounts. 

The difference between traditional and Roth 401(k)s

The major difference between a traditional 401(k) and a Roth 401(k) is how the accounts are taxed. A traditional 401(k) is funded with pre-tax dollars (or money that has not yet been taxed). Since you're able to lower your taxes today when you contribute to a traditional 401(k), you must pay ordinary income taxes when you withdraw from this account in retirement. 

A Roth 401(k) is funded with after-tax dollars (or money that has already been taxed). As long as you follow certain rules, you can withdraw the money tax-free in retirement. 

Other than the tax treatment, these two accounts are the same. Both traditional and Roth 401(k)s have a contribution limit of $19,500 in 2021 (plus a $6,500 "catch-up" contribution if you're age 50 or older). This limit is a combined one, meaning if you split your contributions between both types of accounts, your combined contributions cannot exceed this annual limit.

Your employer may match your contributions up to a certain percentage of your income. Regardless of whether you contribute to a traditional 401(k) or Roth 401(k), the employer match will always go into a traditional 401(k). 

How to decide which type of retirement account to use

An easy way to decide between a traditional 401(k) and Roth 401(k) is to consider your marginal income tax rate today and in retirement. 

If you're a high earner or in your peak earning years right now, it is unlikely that your income will remain that high in retirement. Even if you plan to work in retirement, it may be at a reduced rate. This can result in a lower income tax rate in retirement compared to what you're paying today — meaning you'd pay less taxes on money withdrawn from a traditional 401(k) in retirement than you are on contributions to a Roth 401(k) today. 

Generally, if you expect your income to decrease significantly in the future, contributing to a traditional 401(k) is a better choice. A Roth 401(k) only makes sense if tax rates increase significantly or if you expect to have substantially higher income in retirement. Let that settle in because there's more to consider than tax rates.

Other factors to consider when setting up your retirement savings plan

I think there is room for Roth retirement accounts in everyone's financial plan. Indeed, I always encourage clients to build an investment portfolio that includes a combination of three types of assets, including Roth assets.

Taxable assets

The first type of asset is taxable assets, such as a brokerage account. With taxable assets, you pay income taxes on dividends or interest annually, and capital gains taxes on any appreciation when you sell the assets. The tax rates on dividends and capital gains can be lower than your ordinary income tax rate depending on the nature of the income. 

Tax-deferred assets

The second asset type is tax-deferred assets, such as traditional 401(k)s and traditional IRAs. As I mentioned before, because you receive a tax deduction on money that goes into these accounts, you must pay ordinary income taxes when you withdraw money from these accounts. 

Tax-free assets

The third and final asset type is tax-free assets, which includes Roth 401(k)s, Roth IRAs, and Health Savings Accounts (HSAs). If you follow the rules associated with these accounts, you can withdraw money tax-free in retirement. 

Having a combination of these three types of assets gives you flexibility with income-tax planning in retirement. You can choose which account (or combination of accounts) to use for withdrawals, essentially controlling when you pay taxes. 

How to build Roth assets

You may be thinking, "How do I build Roth assets if I'm contributing to my traditional 401(k)?" There are several ways to do this! 

An easy way to build Roth assets outside of a Roth 401(k) is through a Roth IRA. Roth IRAs have the same tax treatment as Roth 401(k)s, but with a few differences. Roth IRAs have a lower contribution limit — $6,000 in 2021 plus a $1,000 "catch-up" contribution if you're age 50 or older. Your income must also be below certain limits to be eligible to contribute. Please note that unlike Roth IRAs, Roth 401(k)s are not subject to income limitations. 

If you make too much to contribute to a Roth IRA, there's a way to get money through the back door. There are a few rules and considerations (along with proper tax reporting), so make sure you understand how backdoor Roth IRAs work. 

If you're a high earner, you may be in a position to save more than the $6,000 limit that exists with a Roth IRA. Another option, called a mega backdoor Roth IRA, can boost your annual Roth contributions to well over $30,000 each year. Again, certain rules and considerations apply, and your employer's retirement plan must allow after-tax 401(k) contributions. 

The final way to build Roth assets is through Roth conversions. This is where you convert traditional 401(k) or IRA assets to a Roth IRA. You must pay ordinary income taxes on the amount you convert, so this move is ideal in years when you have low income. Since you don't have to convert the full balance, you can decide to convert portions in years when it makes sense. During your working years, partial Roth conversions are useful if you have a period of unemployment or take a sabbatical. Another great opportunity is between the time you retire and age 72 (when you're subject to required mandatory distributions, or RMDs). 

Contributing to a traditional 401(k) today reduces your tax liability now and gives you more options. You can still build Roth assets in other ways and you can control when you pay taxes in the future.

When a Roth 401(k) makes sense

There are a few situations where a Roth 401(k) is a clear winner. If your income is low and you expect your income to increase significantly over time, take advantage of those years when you're in a lower tax bracket and contribute to a Roth 401(k). If you expect your taxable income to increase in retirement, a Roth 401(k) also makes sense. This increase could come from a combination of pensions, Social Security, and withdrawals from tax-deferred accounts like traditional 401(k)s or IRA rollovers.

While I provided some guidelines and ways to think about these accounts, your decision may vary based on your personal situation. Choosing the right account depends on a number of factors that can change throughout your career. Remember, you can always switch back and forth between each type of 401(k) or look for other ways to build Roth assets. Regardless of which account you choose, it's important to save aggressively for your future.

Chloe A. Moore, CFP, is the founder of Financial Staples, a virtual, fee-only financial planning firm based in Atlanta, Georgia and serving clients nationwide.

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