Retirement planning feels like one of the most overwhelming (and overlooked) financial decisions you can make. There are so many accounts, businesses, and options vying for your attention.
There’s no one-size-fits-all answer here, but you can make an informed decision based on your unique financial situation, goals, and tax preferences. We’ve got the inside scoop from Ryan Ovenden, CFP®, CKA®, Wealth Advisor, to help you understand the difference between investing in a traditional 401(k) or a Roth 401(k). After reading this, we believe you’ll have a better idea of how to have the largest savings possible waiting for you in retirement.
What Is the Key Difference Between a Traditional 401(k) and a Roth 401(k)?
Ryan Ovenden sums it up, “Really it comes down to one thing, and that’s taxes.”
Both a Traditional 401(k) and a Roth 401(k) are “tax wrappers,” as Ryan calls them. They’re not investments themselves but rather accounts that dictate how your retirement contributions (and gains) will be taxed. Here’s how they differ:
- Traditional 401(k): Contributions are made pre-tax, meaning you get a tax deduction now, lowering your taxable income for the year. However, withdrawals in retirement are taxed as regular income.
- Roth 401(k): Contributions are made after-tax, so there’s no deduction on the front end. But the contributions—and any earnings—can be withdrawn tax-free in retirement, provided you follow the rules.
The decision hinges on one question Ryan often asks his clients, “Would you rather pay taxes now or later?”
Short-Term vs. Long-Term Benefits of Each Plan
To help break it down further, Ryan shared this simple comparison:
Traditional 401(k):
- Short-term benefit: Lower taxes this year thanks to the upfront tax deduction.
- Long-term downside: You’ll pay taxes later, potentially at higher rates. Plus, you are forced to take RMD’s (required minimum distributions) at age 73, whether you want to or not.
Roth 401(k):
- Short-term downside: No tax deduction now.
- Long-term benefit: Tax-free growth and withdrawals, making it incredibly valuable over time. Plus, there are NO RMDs, and the entire amount can pass to your heirs tax-free.
Ryan explains, “The longer you can hold a Roth account, the more it makes sense. The younger you are, the more powerful the Roth becomes.” This is due to the nature of compound growth, which can dramatically increase the value of long-term investments.
When Does a Roth 401(k) Make the Most Sense?
While both plans have advantages, Ryan is a self-professed fan of the Roth 401(k). Here are some situations where contributing to a Roth makes a compelling case:
- You’re in a low tax bracket now. Ryan advises, “If you’re young or earning less now versus what you expect in the future, the Roth allows you to lock in today’s lower tax rates.”
- You have kids. Parents with children in the home enjoy tax deductions that may allow them to handle the after-tax impact of Roth contributions more easily.
- You’re focused on long-term savings. For individuals with 10+ years until retirement, the tax-free growth potential of a Roth 401(k) can be a game-changer.
- You prefer flexibility in retirement. Ryan explains, “I’d rather have a bucket of money that’s tax-free than one that requires taxable distributions.” Since Roth withdrawals aren’t taxed, they offer retirees more control over their taxable income in retirement. Plus, with no RMD’s, there are no forced distributions.
- You might have an inheritance in the future. If you may receive land, a rental property or an IRA or 401(k) in the future, those all produce taxable income that may mean you are making more money later than you are now, which means higher taxes. Also, more of your social security benefits will be taxed the more “outside” taxable income you have. Add RMDs as well, and it could be a terrible tax storm with few strategies available to mitigate the tax bill.
- You might sell a business in the future. Most business owners sell their businesses close to or at retirement, when they are also close to turning on Social Security benefits and having to take RMDs. If you add to that significant income for let’s say a 5–10 year buyout of your company, that income could be an even bigger tax burden when you turn 73 and have to take RMDs. If you find yourself in this position, give us a call soon and we’ll go through some proactive strategies to help you through this transition in the most tax-efficient way possible.
When to Consider a Traditional 401(k)
That said, a traditional 401(k) also has its place in many plans. Situations where it shines include:
- You’re in a high tax bracket today. Taking a pre-tax deduction when you’re earning more helps reduce your immediate tax liability.
- You plan to have lower income in retirement. If you expect to be in a lower tax bracket when you make withdrawals, the traditional 401(k) could save you money long-term.
And, as Ryan encourages, “You don’t have to choose one or the other!” A balanced approach—splitting contributions between both options—can hedge against future uncertainties.
Can You Convert a Traditional 401(k) to a Roth 401(k)?
Yes, you can! But be aware of the tax implications before you make this move. When converting, you’ll owe taxes on the amount transferred from the traditional 401(k) to the Roth 401(k)—potentially pushing you into a higher tax bracket temporarily. Converting from a traditional IRA to a Roth is a taxable event.
Ryan advises, “If you’re younger and have 10-plus years for that balance to grow after a conversion, it’s worth a discussion.” But for those closer to retirement, conversion may not be the best strategy. One exception is if you have a year in which you have higher-than-normal itemized deductions, maybe from a large charitable gift or from a costly year of medical bills. Consider a “bunching” strategy to snowball your itemized deductions in that year, and you may be able to do a larger conversion that year to use up those itemized deductions. Another strategy we use, even for clients in retirement, is doing small conversions every year. For example, a $5,000 conversion every year for 20 years, especially if it costs you 8–12% in taxes, is a great way to shift $100,000 (plus the growth for 20 years) into a tax-free inheritance for your heirs, and it reduces your RMDs each year in theory. The example provided is hypothetical and for illustrative purposes only.
Always consult with a financial advisor and tax professional to understand the impact on your specific financial picture, including potential effects on your Medicare premiums or Social Security taxation.
Strategic Tips for Balancing Contributions
If you’re feeling torn between these options, consider this balanced strategy:
- Start by splitting contributions 50/50. This approach provides diversification between taxable and tax-free retirement income.
- Monitor how it affects your current taxes and then adjust. Ryan suggests, “Talk to your accountant about how it played out that year and make adjustments moving forward.”
- Evaluate your long-term goals. Over time, aim to strike a balance between the two accounts that aligns with your retirement strategy.
The Role of Compound Growth in Your Decision
One of the major arguments in favor of the Roth is the impact of compound growth. Ryan illustrated this example beautifully:
- If you invest $500/month for 40 years at 8% returns, the $240,000 invested could grow to $1.5 million! That’s $1,250,000 in growth that will never be taxed!
- Ryan asks, “Would you rather have that in a taxable traditional 401(k) or a tax-free Roth 401(k)?”
The example provided is hypothetical and for illustrative purposes only.
Over long periods, the Roth’s tax-free growth advantage might become impossible to ignore.
Why You Need a Financial Advisor for Personalized Guidance
Choosing between contributing to a traditional 401(k) and Roth 401(k) involves more than simple math. It requires factoring in unknowns like future tax rates, your earning trajectory, and even whether you expect an inheritance or not.
Ryan says, “The advantage of having a financial professional is looking at all the things you don’t even know should be considered.” Find a trusted advisor who will prioritize your best interests. They can help you make thoughtful, personalized decisions for your financial future.
Make the Right Choice for Your Retirement Goals
Whether you choose a traditional 401(k), Roth 401(k), or a mix of both, the key is to be proactive and intentional. Ask the big question—“When do I want to pay taxes?”—and use the insights shared above to guide your decision.
The earlier you start taking control of your retirement savings, the better prepared you’ll be for the future. Need help crafting your plan? Reach out to our team of advisors at Pinnacle Wealth to discuss your options to build more financial confidence and a tax-smart retirement strategy.
