Pre Tax Means The Goverment Allows You To Invest Money After Taxes Are Taken Out

11 Minute Read | November 05, 2021

If you've heard of a Roth 401(k), you may be wondering how different it really is from a traditional 401(k). We get it, 401(k)s can be confusing! While these two types of 401(k) accounts have some similarities, they also have some pretty huge differences.

Access to a Roth option is becoming more and more common, so you're in the majority if you have this option at work. Just over the last five years, the number of plans offering a Roth 401(k) option has increased by 32%. As of 2021, about 3 out of 4 workplace retirement plans now offer a Roth option—which is great news for you!¹

And guess what? Younger savers (no surprises here) are starting to take advantage of this new option. Millennials are the most likely group (16%) to contribute to their Roth 401(k) at work.²

If you can contribute to a Roth and traditional 401(k) at work, which one should you choose? Let's dig into some of the differences between these options so you can make the best decision.

What Is a Roth 401(k)?

The Roth 401(k) is a type of retirement savings plan that allows you to make contributions after taxes have been taken out.Then, you receivetax-free withdrawals when you retire.

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The Roth 401(k) was introduced in 2006 and was designed to combine features from the traditional 401(k) and the Roth IRA. With a Roth account, you can take advantage of the company match on your contributions, if your employer offers one, just like a traditional 401(k). And the Roth component of a Roth 401(k) gives you the benefit of tax-free withdrawals.

What Are the Similarities Between a Traditional 401(k) and a Roth 401(k)?

Let's start with what a traditional 401(k) and a Roth 401(k) have in common.

First, these are both workplace retirement savings options. With either type of 401(k) plan, you can enjoy the convenience of having the contribution drafted out of your paycheck.

Second, both can include acompany match. About 86% of companies that offer a 401(k) or similar product provide a match on employee contributions.³ If you work at a place that offers a match, take it. Your employer is giving you free money!

Third, both types of 401(k)s have the same contribution limit. In 2022, the contribution limit is $20,500 per year or $27,000 if you're over 50.⁴ The opportunity to invest that much every year is a huge perk of either type of 401(k), especially when compared to the Roth IRA's contribution limit of $6,000 per year.⁵

The Roth 401(k) includes some of the best features of a 401(k)—convenient contribution methods and the possibility of a company match if your employer offers one. But that's where their similarities end. Let's dig into the distinct differences between these two retirement savings options.

401(k) vs. Roth 401(k): How Are They Different?

The biggest difference between a traditional 401(k) and a Roth 401(k) is how the money you contribute is taxed. Taxes can be kind of 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 apost-tax retirement savings account. That means your contributions havealready been taxed before they enter your Roth account.

On the other hand, a traditional 401(k) is apretax savings 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): Pros and Cons

	Roth 401(k)	Traditional 401(k)
Contributions	Contributions are made with *after-tax dollars* (that means you pay taxes on that money now).	Contributions are made with *pre-tax dollars* (that lowers your taxable income now, but you'll pay taxes later in retirement).
Withdrawals	The money you put in and its growth are not taxed. 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 once you are age 59 1/2. You or your beneficiaries can also receive distributions due to disability or death.	You can start receiving distributions 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

How do those definitions play out when it comes to your retirement savings? Let's start with your contributions.

With a Roth 401(k), your money goes inafter-tax. That means you're paying taxes now and taking home a little less in your paycheck.

When you contribute to a traditional 401(k), your contributions arepretax. They're taken off the top of your gross earnings before your paycheck is taxed.

You may be wondering why anyone would contribute to a Roth 401(k) if it means paying taxes now. If you only look at the contributions, that's a fair question. But hang with us.The huge benefit of a Roth is what happens when you start withdrawing money in retirement.

Withdrawals in Retirement

The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free . Any employer match in your Roth account will still be taxable in retirement, but the money you put in—and its growth!—is all yours. No taxes will be taken out when you use that money in retirement.

By contrast, if you have a traditional 401(k), you'll have to pay taxes on the amount you withdraw based on your current tax rate at retirement.

Here's what that means: 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), that $1 million is yours.

If $1 million is in a traditional 401(k), you'll pay taxes on your withdrawals in retirement. If you're in the 22% tax bracket, that would mean $220,000 of that $1 million is going to taxes. 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 nest egg will last longer if you're not paying taxes on your withdrawals. That's a great feature of the Roth 401(k)—and a Roth IRA too for that matter.

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. With a Roth 401(k), you can start withdrawing money without penalty at the same age, but you alsomust have held the account for five years.

If you're still decades away from retirement, you don't have anything 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 you won't have access to the money for five years.

Why We Recommend the Roth 401(k)

If you're investing consistently every month—whether it's in a Roth 401(k), a traditional 401(k) or even a Roth 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.

But if choosing between a traditional 401(k) and a Roth 401(k), we'd go with the Roth every time! We've already talked through the differences between these two types of accounts, so you're probably already seeing the benefits. But just to be clear, here are the biggest reasons the Roth comes out on top.

Tax Benefit

It may be tempting to delay paying taxes so you can get slightly more in your paycheck now. But think about it this way: You're already doing the hard work of saving for retirement. If you can get that money to go even further, wouldn't you want to take advantage of that opportunity?

Here's another thing to consider: No one can know 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?

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 a lot more than $100 in a paycheck now.

If you can get into the habit of contributing 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.

If you can get into the habit of contributing 15% of every paycheck to your Roth 401(k) early on, you won't even miss the money you're paying in taxes.

Who Is Eligible for a Roth 401(k)?

If your employer offers it, you're eligible. Unlike a Roth IRA, 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 by working with your investing pro to open a Roth IRA. Just keep in mind that income limits do apply when you contribute to a Roth IRA.

What Are Roth 401(k) Contribution Limits?

For 2022, the 401(k) contribution limit is$20,500. This contribution limit applies to 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.⁶ And in case you were wondering, your employer's contributions do not count toward the limit.

If you're 50 or above, the contribution limit increases to$26,000.⁷

How Much Should I Invest in a Roth 401(k)?

We recommend investing 15% of your income into retirement savings. If you have a Roth 401(k) at work with good mutual fund options, you can invest your entire 15% there. Let's say you make $60,000 a year. That means you would invest $750 a month in your Roth account. See? Investing for the future is easier than you thought!

What Kinds of Mutual Funds Should I Choose for My Roth 401(k)?

Diversifying your portfolio is key to maintaining a healthy amount of risk in your retirement savings. That's why it's important to balance your investment among four types of mutual funds: growth and income, growth, aggressive growth, and international funds.

If one type of fund isn't performing as well, the other ones can help your portfolio stay balanced. Not sure which funds to select based on your Roth 401(k) options? Sit down with an investment professional who can help you understand the different types of funds, so you can choose the right mix.

Should I Roll Over My Traditional 401(k) to a Roth 401(k)?

There isn't a one-size-fits-all answer when it comes to rolling over your retirement savings to a Roth account. If it makes sense for your situation, a Roth conversion is a great way to take advantage of tax-free growth on your accounts. But keep in mind that rolling over a traditional 401(k) means paying taxes on it now. And if you're converting a large sum all at once, it could bump you into a higher tax bracket . . . which means a bigger tax bill.

For example, if you're rolling over $100,000 and you're in the 22% tax bracket, that means you have to come up with $22,000 cash to cover the taxes. Don't pull that money out of the investment itself!

If you can pay cash for the taxes without taking money out of your nest egg and you're still several years away from retirement, it may make sense to roll it over. But before you roll over accounts, make sure to sit down with an experienced investment professional. They'll help you understand the tax impact of rolling over your 401(k) and how you can be prepared for it.

Talk With an Investment Pro About Your Roth 401(k)

If you want to learn more about your Roth 401(k) or other investing options, find an investing pro in your area. A financial advisor can help you understand your investments and make confident decisions.

A do-it-yourself approach to investing is never a good idea. Even the pros work with a financial advisor! Your family's future is way too important to wing it.

Looking for a qualified investing pro? Try theSmartVestor program! It's a free way to find top-rated financial advisors near you. Start building a relationship with an investing pro who understands the financial journey you're on.

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Ramsey Solutions

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.