When it comes to your 401(k) plan, you may have a choice to make regarding contributions: pre-tax (traditional) or after-tax (Roth). The optimal choice depends on your current tax situation, expected future tax circumstances, and your estate planning goals.

Traditional Vs. Roth 401(k) Plans

The main difference between a traditional and a Roth 401(k) plan is essentially the same as the difference between a traditional and a Roth IRA: the way they’re taxed. Contributions to a traditional 401(k) are made with pre-tax dollars — that is, they’re deductible. Funds grow on a tax-deferred basis and both contributions and earnings are taxable when they’re withdrawn. Contributions to a Roth 401(k) plan are made with after-tax dollars — that is, they’re nondeductible. But qualified withdrawals of both contributions and earnings are tax-free. Plus, you can participate in a Roth 401(k) plan regardless of your income.

Salary deferral limits for traditional and Roth 401(k) plans are the same: for 2024, $23,000 plus an additional $7,500 in catch-up contributions if you’ll be 50 or older by the end of the year. The limits on combined employee and employer contributions are $69,000 and $76,500, respectively (up to 100% of compensation).

Distribution rules for traditional and Roth 401(k) plans are also similar. Penalty-free withdrawals (tax- and penalty-free withdrawals for Roth plans) are available when you reach age 59½, pass away, or become disabled (with limited exceptions). In addition, for a Roth 401(k), the account must have been open for at least five years.

Another important difference between the two types of plans is that traditional 401(k) accounts are subject to required minimum distribution (RMD) rules when you reach a certain age. Specifically, age 73 for those who turn 72 this year or after, increasing to age 75 for those who reach that milestone after 2032. For Roth 401(k) accounts, RMDs aren’t required beginning in 2024.

From a tax perspective, with a Roth 401(k) you pay tax at the time of your contributions, while traditional 401(k) funds are taxed when you withdraw them. Mathematically speaking, that means the best choice depends on whether you expect to be in a higher or lower tax bracket after you retire.

If you’re a high earner and expect to be in a lower bracket when you retire, you’re better off with the upfront tax break offered by a traditional 401(k). If you expect to be in a higher tax bracket in retirement (for example, if you’re early in your career and expect your income to grow substantially in the future, or you believe Congress will raise taxes down the road), then consider a Roth plan and pay the tax now.

Estate Planning Factors

Taxes during your lifetime aren’t the only factor, however. It’s also important to consider the estate planning implications. The elimination of RMDs for Roth 401(k)s makes them a powerful estate planning tool. So long as you don’t need the funds for living expenses, you can leave them in the account, growing on a tax-free basis, for life. And if the account is at least five years old, your heirs will be able to withdraw the funds tax-free.

With a traditional 401(k), the RMD rules will force you to draw down the account, regardless of whether you need the funds, leaving less for your heirs. Plus, withdrawals by your heirs will be taxable.

Contact us if you need assistance deciding which 401(k) account is best for your situation.