Retirement
Retirement Planning
Saving for Retirement
9 Min Read | Jun 11, 2024
By Ramsey Solutions
By Ramsey Solutions
Key Takeaways
- The Roth 401(k) is a retirement savings option that taxes your contributions up front, but your withdrawals in retirement are tax-free, including all your growth.
- The traditional 401(k) involves tax-deferred contributions—meaning you’ll pay taxes every time you withdraw money, including on your growth and employer contributions.
- The Roth 401(k) holds the advantage because tax-free growth and withdrawals in retirement mean your savings won’t be affected by future tax rates (since they’ve already been taxed).
- Both Roth and traditional 401(k) contribution limits are currently set at $23,000 ($30,500 if you’re over the age of 50) for 2024.1
A 401(k) is a workplace retirement savings plan that gives employees like you the benefit of having retirement savings taken straight out of their paychecks before taxes. And those automatic contributions are a super convenient way to make sure you’re consistently building your retirement savings.
Fast-forward to 2006 and a new heavyweight in the world of employer-sponsored plans enters the arena: the Roth 401(k).
The Roth 401(k) combines some of the features of the traditional 401(k) with the tax advantages of the Roth IRA. In fact, the tax advantages are where the Roth 401(k) separates itself from a traditional 401(k).
We’re big fans of the Roth 401(k). In fact, in a showdown between a Roth 401(k) versus a traditional 401(k), we’d go with Roth every single time! But let’s dig into the similarities and differences between these options so you can make the best decision for your retirement goals.
Roth 401(k) vs. Traditional 401(k): How Are They Similar?
If you’re debating which 401(k) plan to choose, it might be helpful to start by looking at what they have in common. Here are some of the most important features that both traditional 401(k)s and Roth 401(k)s share:
Automatic Contributions
Like we said before, these are both workplace retirement savings options. With either type of 401(k), your contributions are automatically taken out of your paycheck. Who said saving for retirement wasn’t easy?
Company Match
Both plans usually include acompany match.If you’re ready to invest and you work at a place that offers a match, take it. Your employer is giving youfree money!
Contribution Limits
Both the Roth 401(k) and the traditional 401(k) have the samecontribution limit.
- For 2024, you can save up to $23,000 per year (or $30,500 if you’re over 50) in your account.
- The opportunity to invest that much every year is a huge perk of either type of 401(k), especially when compared to an IRA’s contribution limit of $6,500 (in 2023) and $7,000 (in 2024) per year.2
The Roth 401(k) includes some of the best features of a 401(k), but that’s where their similarities end.
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Roth 401(k) vs. Traditional 401(k): How Are They Different?
Like we mentioned above, the biggest difference between a Roth 401(k) and a traditional 401(k) is how the money you put in and take out is taxed.
Taxes are already super confusing (not to mention a pain to pay!), so let’s start with a simple definition, and then we’ll dive into the details.
A Roth 401(k) is anafter-taxretirement savings account. That means your contributions havealready been taxedbefore they go into your Roth account.
How much will you need for retirement? Find out with this free tool!On the other hand, a traditional 401(k) is apretaxsavings account. When you invest in a traditional 401(k), your contributions go inbefore they’re taxed, which makes your taxable income lower.
Roth 401(k) vs. Traditional 401(k)
Roth 401(k) | Traditional 401(k) | |
Contributions | Contributions are made withafter-tax dollars(that means you pay taxes on that money now). | Contributions are made withpretax dollars(which lowers your taxable income now, but you’ll pay taxes later in retirement). |
Withdrawals | The money you put in and its growth aren’t taxed (score!). However, your employer match is subject to taxes. | All withdrawals will be taxed at your ordinary income tax rate. Most state income taxes apply too. |
Access | If you’ve held the account for at least five years, you can start taking money out tax- and penalty-free once you reach age 59 1/2. You or your beneficiaries can also receive distributions due to disability or death. | You can start receiving distributions tax- and penalty-free at age 59 1/2, no matter how long you’ve had your 401(k). You or your beneficiaries can also receive distributions due to disability or death. |
Contributions
Since your Roth 401(k) contributions are madeafter-tax, you’re paying taxes now and taking home a little less in your paycheck.
Pretaxtraditional 401(k) contributions are taken off the top of your gross earnings before your paycheck is taxed. That will lower your taxable income, meaning a lower tax bill for the year.
So, why would anyone choose a Roth 401(k) if it means they don’t get a tax break now? If you’re only thinking about the years you’re making contributions, that’s a fair question. But hang with us.The huge benefit of a Roth kicks in when you start withdrawing money in retirement—and the years after that.
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Withdrawals in Retirement
The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, thewithdrawals you make in retirement are tax-free.That’s right! The money you put in—and its growth!—is all yours. No taxes will be taken out when you use that money in retirement. (But remember, any employer match in your Roth account will still be taxable in retirement.)
On the other hand, if you have a traditional 401(k), you’ll have to pay taxes on the amount you withdraw based on your current tax rate in retirement.
Here’s an example: Let’s say you have $1 million in your nest egg when you retire. That’s a pretty nice stash! If you’ve got it invested in a Roth 401(k), most of that $1 million is yours free and clear since you already paid taxes on it.
What if that $1 million was in a traditional 401(k)? Well, you’ll have to pay taxes on every penny you withdraw in retirement. Depending on your tax bracket and what the tax rates are when you retire (and who knows what those will be), you could wind up sendinghundreds of thousands of dollarsin taxes to Uncle Sam throughout your golden years. That’s a hard pill to swallow, especially after you’ve worked so hard to build your nest egg!
It goes without saying that your retirement savings will last longer if you’re not paying taxes on your withdrawals. That’s what gives a Roth 401(k)—and a Roth IRA, for that matter—a huge advantage over a traditional investment account! And it’s why we always say you should take advantage of all the Roth options you have.
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Access
Another slight difference between a Roth and traditional 401(k) is your access to the money. In a traditional 401(k), you can start receiving distributions at age 59 1/2 no matter what. With a Roth 401(k), you can start withdrawing money without penalty at the same age . . . as long as you’ve hadthe account for at least five years.3
If you’re still decades away from retirement, you have nothing to worry about! But if you’re approaching 59 1/2 and thinking about starting a Roth 401(k), it’s important to be aware that if you take money out of the account within the first five years of opening it, you’ll pay a penalty. We’ll break this down more when we go over the Roth 401(k) withdrawal rules in a minute.
It's also important to remember that traditional 401(k)s have required minimum distributions (RMDs). That means the IRS will require you to take money out of your traditionalaccounts once you hit age 73 (if you turn 72 in 2023 or later).
What about all you Roth 401(k) owners out there? Well, you used to be subject to the same RMD rules as traditional 401(k) holders. But thanks to the SECURE 2.0 Act, employees with a Roth 401(k) will no longer be forced to take RMDs starting in 2024.
Why We Recommend the Roth 401(k)
If you’reinvesting consistentlyevery month—whether it’s in a Roth 401(k), a traditional 401(k), or even aRoth IRA—you’re already on the right track! The most important part of wealth building is consistent savingevery month, no matter what the market is doing.
We’ve already talked through the differences between these two types of accounts, so you’re probably seeing why a Roth 401(k) is such a great investing option. But just to be clear, here are the biggest reasons the Roth comes out on top.
Tax Benefit
It may be tempting to get a tax break now so you can get a little more in your paycheck today. But think about it this way: You’re already doing the hard work of saving for retirement. Why wouldn’t you do all you can to make that money go even further when you retire?
Here’s something else to think about: No one knows how the tax brackets or tax percentages will change in the future, especially if you’re still decades away from retirement. Do you want to take that risk? It may hurt a bit to pay taxes on your contributions now, but your future retirement self will thank you.
Emotional Toll
Like it or not, it’s hard to separate emotions from investing. Imagine getting to your retirement years and watching your $1 million nest egg reduced to less than $800,000 because of taxes! You’d much rather pay taxes now than see all that money fly out the door later. You’ll miss $100,000 in retirement a lot more than $100 in a paycheck now.
Once you can get into the habit of investing 15% of every paycheck to your Roth 401(k) early on, you won’t even miss the money you’re paying in taxes. And when you get to retirement, you’ll be glad you don’t owe the government part of your hard-earned nest egg.
Work With an Investment Pro
We’ve gone over all the pros and cons of both traditional 401(k)s and Roth 401(k)s. The Roth option wins top prize in our book because of the tax advantages you’ll enjoy when you start making withdrawals in retirement.
But if you still have questions about how a Roth 401(k) works or which plan works best for you, reach out to an investing expert. Our SmartVestor program can connect you with a financial advisor or investment pro who has years of experience and can walk you through your options.
Next Steps
- We recommend investing 15% of your gross income every month for retirement. Check out our Retirement Calculator to get an idea of how much your money could be worth by the time you retire if you start investing today.
- Converting your traditional 401(k) funds to a Roth account might save you on taxes in retirement, but it also means a bigger tax bill once Tax Day rolls around. Talk with a tax advisor before making that decision.
- If you want to learn more about Roth 401(k)s versus traditional 401(k)s, sit down with an investment professional. If you need help looking for one, try our SmartVestor program.
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Frequently Asked Questions
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Who is eligible for a Roth 401(k)?
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If your employer offers it, you’re eligible. Unlike a RothIRA, a Roth 401(k) has no income limits. That’s a fantastic feature of the Roth option! No matter how much money you earn, you can contribute to a Roth 401(k).
If you don’t have access to a Roth option at work, you can still take advantage of the Roth benefits (as long as you meet the income requirements) by working with your investment professional to open a Roth IRA.
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What are Roth 401(k) contribution limits?
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For 2023, the 401(k) contribution limit is $22,500. This contribution limit applies toallof your 401(k) contributions, whether they’re in a Roth or traditional 401(k). That means if you’re contributing to both, the combined total of your contributions can’t exceed that amount. And in case you were wondering, your employer’s contributionsdo notcount toward the limit.
If you’re 50 or older, you can also pitch in an extra $7,500 as a catch-up contribution—which increases your contribution limit to $30,000.
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What’s the difference between a 401(k) and an IRA?
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A 401(k) is an employer-sponsored plan for retirement savings. Employees can set aside a specific amount from each paycheck to go automatically into their 401(k) for retirement savings. There are two basic types of 401(k)s—traditional and Roth. Both are employer-sponsored retirement savings plans, but they’re taxed in different ways.
An Individual Retirement Account (IRA) is a tax-favored savings account that allows you to invest for retirement with some special tax advantages—either a tax deduction now with tax-deferred growth (with a traditional IRA), or tax-free growth and withdrawals in retirement (with aRoth IRA).
Unlike a 401(k), an IRA is not sponsored by an employer. Instead, you can open an IRA through a bank, brokerage firm, or with help from afinancial advisor.
This article provides generalguidelines about investingtopics. Your situation may beunique. To discuss a plan for your situation, connect with aSmartVestorPro.RamseySolutions is a paid, non-clientpromoter ofparticipating Pros.
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About the author
Ramsey Solutions
Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.
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