When saving for retirement, investing in either a traditional 401(k) or a Roth 401(k) is a smart idea if your employer offers one. But they aren't exactly the same. Each type comes with its own pros and cons.
The main, and most well-known, difference between a traditional 401(k) and a Roth 401(k) is the time at which your money is taxed, but there are other factors to consider as well, such as which plans your employer offers, any potential employer match, your state of residence and your bandwidth for saving.
Ultimately, neither one is best for everyone; it's an individual choice and depends on your personal circumstances. But if you're choosing between a Roth 401(k) or traditional 401(k), here are a few things to consider.
With a traditional 401(k), contributions are made with pre-tax dollars. This means that any money you put in comes straight from your paycheck, reducing your taxable income for the year. The money won't be taxed until you withdraw it during retirement.
If you make $50,000 per year and put $5,000 in a 401(k), you'll only pay income taxes on $45,000, Ed Slott, certified public accountant, founder of IRAhelp.com and author of "The New Retirement Savings Time Bomb," tells CNBC Make It.
With a Roth 401(k), contributions are made with after-tax dollars. So if you make $50,000 per year and put in $5,000, you'd still pay full tax on the $50,000. And when you withdraw the money in retirement, you don't have to pay taxes again.
"You don't get a deduction," Slott says. But, "you get something for your money for not getting a deduction. You get to have that money grow tax-free." Since Roth 401(k) contributions are already taxed, the investment is all yours as it compounds interest over time.
If you expect to be in a lower tax bracket in retirement, a traditional 401(k) may make more sense than a Roth account. But if you're in a low tax bracket now and believe you'll be in a higher tax bracket when you retire, a Roth 401(k) could be a better option.
However, keep in mind that attempting to project future tax rates can be difficult, since no one knows how things will change going forward.
Slott points out that young people tend to be in lower tax brackets and have decades to save for retirement. Combined, these factors generally make someone a good candidate for a Roth account.
"The greatest money making asset any individual can possess is time, and young people have more of it. So, with young people, it's a no-brainer," Slott says. "It's a slam dunk to go for the Roth 401(k)."
Aside from determining whether pre-tax contributions are most beneficial for you, your state of residency should also be considered, says Marianela Collado, a CPA and financial advisor at Tobias Financial.
If you currently live in a state that collects both state and federal income tax, but plan to move to a state that doesn't collect income tax, like Florida or Texas, during retirement, it may be smart to elect a traditional 401(k).
That way, you'll get a larger tax break on your distributions during retirement, Collado says.
In 2021, the annual contribution limit for both traditional and Roth 401(k)s is $19,500, plus an additional $6,500 catch-up contribution for participants age 50 or over.
This is much more than allowed with a Roth IRA, where contributions are limited to $6,000, plus an additional $1,000 for participants age 50 or over. That could make Roth 401(k)s an attractive option for people who want to save more post-tax.
But it's important to note that even if you choose a Roth 401(k), all company matches will go into a traditional 401(k). That means that you will owe income tax on any employer contributions, and the earnings on those contributions, when you withdraw the money during retirement.
A few other things to know: With both types of 401(k)s, you're required to begin taking minimum distributions at age 72. And early withdrawals made before you turn 59½ are typically subject to an additional 10% penalty.
If you're torn between the two, you can also consider putting some money into both, since tax risk diversification is important too, Slott says. Again, trying to predict future tax rates is challenging. Just like investment diversification reduces risk, putting money into retirement accounts with various tax advantages can reduce tax risk.
Contributing to just one option is like "having all your eggs in one basket," Slott says.
However, keep in mind that you can still only contribute a combined $19,500 in 2021.