Roth vs Traditional 401(k): Pros, Cons, and How to Choose

Speaker 1: (00:00)
Traditional 401 or Roth 401? Which one is better? Which one should you be contributing to in your retirement plan? We're gonna answer that question today, but not only that, we're also gonna talk a little bit about Roth IRAs and traditional IRAs, so you can be putting all of your dollars in the most appropriate place and the best place for you. Stay

Speaker 2: (00:21)
Tuned. Hello

Speaker 1: (00:27)
Everyone and welcome to this episode of the Retirement Power Hour. My name is Joe Allaria. This is episode 40. And again, today we're talking about Roth 401 versus traditional 401. We're continuing our series on 401 s. This is the third video in the series. So far we've talked about how much should you contribute to your 401 which is incredibly important because if you don't put enough in the 401 even the best funds out there are not going to help you enough. And the second video was how should you invest in the 401? So once you know how much to contribute and how to invest your 401 you're almost there, but you're not all the way done. You'll still have to answer the question when you're setting all this up in your retirement account of do I wanna contribute to a Roth 401 or to the traditional 401?

Speaker 1: (01:21)
So let's jump in and talk about what are the differences and what might be the best option for you. So first talking about traditional 401. Well, we know that a 401 is a tax advantaged vehicle. Well, if you didn't know, it is a tax advantaged vehicle. It's somewhere where you can get some tax benefits. And that's what we're talking about when we talk about traditional 401 versus Roth 401 or traditional IRA versus a Roth IRA. We're talking about tax advantages and just different types of tax advantages. So starting with the pre-tax or traditional 401 those two mean the same thing, pre-tax and traditional 401. The tax advantage you get is that you put money into a pre-tax or traditional account before it gets taxed. So again, it's, it's known as a pre-tax contribution. Money goes in, it hasn't been taxed yet. That's the benefit of making a contribution to a traditional 401 or a pre-tax account is you avoid taxes on the front end.

Speaker 1: (02:29)
Then once the money is in the account, it's gonna grow tax deferred, meaning that no taxes are owed along the way. If, uh, you get interest, if you get dividends, if you buy and sell different funds, if you, if you sell a fund at a gain, you don't pay any tax along the way. The only time you pay tax on a traditional or a pre-tax 401 is when you take the money out. So this is down the road. This is at retirement typically beyond age 59 and a half typically. And when you pull the money out at that point, the bad news is it's all taxable at that point. Your contributions, your earnings, they're all taxable at that point. But you were able to get the advantages of paying no tax upfront and all of the tax deferral along the way. So why might someone want to use a pre-tax or a traditional 401?

Speaker 1: (03:31)
Well, the first reason is maybe you have a high income and because of that, you pay more taxes than the average person. So one benefit of using a pre-tax account is it lowers your income. So in, in reality, it lowers your taxable income. So when you go and do your taxes, you're not gonna pay as much taxes. That's the mechanism to help you avoid tax. So I explain to people when you get a W2 from your employer and you made $100,000, if you did no contributions to the 401 and no other pre-tax deductions, and let's just say the W2 says $100,000, that's what's gonna show up on your taxes, that's what you're gonna pay tax on. But now let's say you contributed $10,000 to your 401 in a pre-tax account, pre-tax or a traditional 401. Now your W2 is gonna show $90,000. So 10,000 went into the 401 and only 90 showed up on your W2.

Speaker 1: (04:31)
So you only pay tax on that 90,000. But again, if you're a higher earner and you're paying 32, 35% as your marginal tax rate, it can really help to avoid that tax at that time and again, lower your income so you possibly, you know, either pay less tax at those higher rates, perhaps you could get yourself out of that tax bracket altogether. So that's the benefit of a pre-tax contribution. Another reason to use pre-tax, whether you're high income or medium income, is if you expect your income or your taxes in retirement to be lower than they are today. So if you have high income today, most likely it's gonna be lower when you retire. So that's a good reason to use pre-tax. But if you have some extenuating circumstance where you know you're gonna have a very low income or a very low taxable income in retirement, then you might wanna get that tax break today, pay taxes later whenever your income is lower and thus your taxes are gonna be lower as well.

Speaker 1: (05:33)
So contrast that to now talking about a Roth 401. The tax advantages in a Roth 401 come on the back end. So when you put money into a Roth 401 you don't save any money on taxes at that time. The money goes in after tax. So going back to my example, if you make $100,000 and you put 10,000 into a Roth 401 your W2 still shows 100,000. So you pay tax on the entire amount, but then that money grows tax free. You can pull it out if you follow all the rules of Roth 401 s, you can pull that money out tax free down the road. Again, at retirement beyond 59 and a half in most cases. Uh, and so that's what you can do. That's the benefit there. So who might wanna use a Roth 401? Those of you that are early in your careers, maybe making a little bit of a lower income so you don't pay a high rate of tax now.

Speaker 1: (06:31)
So why not go ahead and pay tax on your contributions now because it's at a low tax rate. If you think you're gonna have a higher tax rate later, I would rather pay tax now at the low rate and then not have to pay later at the high rate. And just in general, a lot of younger workers, people earlier in their careers will wanna use Roth 401 perhaps for a little while. And then maybe if you get to the point where you consider yourself a, you know, higher income and you're paying a higher rate of tax, at that point you can always switch and go pre-tax. And then you're starting to build two buckets. Now, prior to Secure Act 2.0, you had your contributions could go Roth or pre-tax and an employers always went pre-tax. Employer contributions always went pre-tax. Now in today's world, because of Secure Act 2.0, some plans could allow the employer portion to go to the pre-tax bucket or to the Roth bucket.

Speaker 1: (07:31)
Once again, if you choose Roth, you're gonna be paying more tax on the money that they're putting in right up front. And if you choose pre-tax again, that's gonna be that tax deferred bucket. So what should you do? What's best for you? Well, I think most people would wanna choose a mix of both because most people are sort of in the middle of the road. Now, those of you who are, again, maybe you consider yourself very low income, maybe you're in a very low tax bracket, you could be just fine doing all Roth. And those of you that are higher income on the 35% marginal tax rate or the 32%, you might wanna go ahead and do all pre-tax. But a lot of folks are in the middle. So plans will allow you in most cases to maybe do a percentage to Roth and do a percentage to pre-tax.

Speaker 1: (08:17)
That gives you some tax diversification. So we know about investment diversification. We don't wanna put all of our eggs in one basket. It's no different for taxes. Sometimes we wanna have some, some options at retirement, some pre-tax money, some Roth money, and give ourselves some options on what accounts to withdraw from at that time. So we don't know the exact situation that we're gonna be in in the future and we don't know the tax environment in the future. So by having some diversification, it spreads that tax risk out for us now and in the future. Now, a couple points on Roth 401 and traditional 401 that are different than Roth IRAs and traditional IRAs. And we'll transition into talking about IRAs now. A couple points though. In a Roth 401 or traditional 401 there's no income limits. In other words, you could make a million dollars a year and you could still contribute to a Roth 401 if you wanted to, unlike a Roth IRA where there are income limits and restrictions.

Speaker 1: (09:21)
In other words, in a Roth IRA, if you make too much money, you can't contribute to a Roth IRA. So it's important to note that Roth is just a tag. It's a tax tag, traditional or pre-tax. These are just tax tags. The actual vehicle is the IRA or the 401. These are sections of our tax code that have their own rules. So the IRAs are gonna operate under IRA rules. The 401 s are gonna operate under 401 rules. Saying Roth just by itself doesn't automatically mean one or the other. We need to be specific when we say Roth, what we're talking about. And people will often confuse and think, "Well, hold on. If I, if I put, uh, money in a Roth 401 I can't put money in a Roth IRA." No, that's not true. So you have a certain contribution amount toward 401 s, whether it's Roth or traditional.

Speaker 1: (10:24)
And then you have potentially a contribution amount per year that's limited and it's a different number that you can put towards Roth IRAs or traditional IRAs. And they're not gonna really impact one or another. So I could put the maximum Roth 401 contribution in per year, and as long as I make under the, the income restricted amount, I can go ahead and then max out my Roth IRA. Now, different years have different limits. They change every year. So when you've got contribution limits, that's how much you can put into these vehicles. And then you've got income phase outs, and that tells you as long as you make up to a certain amount, you can participate. For example, in a Roth IRA, you can participate in traditional IRA, uh, contributions and take a deduction. But these phase outs change every year. So I would say for up-to-date information on these limits and these phase out ranges, you can refer to our YouTube channel.

Speaker 1: (11:23)
We've got videos that will have more up-to-date information for the current tax year. So I didn't wanna do a deep dive into Roth IRAs, but I did think it was worth mentioning. And one more thing I did wanna mention is the backdoor Roth IRA, just because, again, we're talking about Roth contributions, we're talking about income restrictions. And a backdoor Roth IRA is just another way to get money in a Roth IRA, but it takes two steps instead of one. This is for people who are over that income limit for making Roth contributions, putting money directly in a Roth IRA. If you make too much money, you can't do that. But there's another method. It's called the backdoor Roth IRA, and it allows you to make a non-deductible contribution to your traditional IRA and then make a Roth conversion from the traditional IRA to your Roth IRA.

Speaker 1: (12:16)
Again, the purpose of this video is not to go in depth about IRAs and backdoor Roth IRAs, but we have more resources for you about how to properly do a backdoor Roth IRA transaction so that you don't cause unintended tax consequences. So in summary, what's better? Roth, traditional, 401 IRA, you have to look at your own situation. And really, you need to have someone look at it, someone who's qualified to give you advice and to guide you. And so on that note, if that's you and you want help in this area, and you want some counsel, you can go to retirementpowerhourpodcast.com. And on the website, you can click work with me. That's gonna trigger a phone call. You can schedule a call with one of the members of our team, and we'll have a conversation with you and kinda talk through these decisions with you and see what might make the most sense for you.

Speaker 1: (13:13)
Also, you might have other questions. Can I retire? When can I retire? How much should I be saving if I wanna retire at a certain point? These are all things that we've talked about on our previous videos in this series. If you haven't seen those videos, go watch those. Figure out how much you need to contribute. Figure out how you should be investing your 401. And all of these videos are purely educational and not intended as personal advice. So on that note, again, contact someone, contact us so we can talk through your specific situation and start working toward more customized recommendations for you. So with that, I wanna thank you for watching this video of the Retirement Power Hour, and I hope it was helpful. Be sure to tune into our future videos in this 401 series. We've got more good information to come. But again, with that, I wanna thank you for watching Retirement Power Hour, where we help listeners invest wiser and retire better.

Speaker 1: (14:06)
Take care.

Speaker 3: (14:07)
Thank you for listening to the Retirement Power Hour Podcast. All material discussed on this podcast is for educational purposes only and should not be construed as individual tax, legal, or investment advice. Investing involves risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results. Joe Allaria is an investment advisor representative of Carson Allaria Wealth Management, a registered investment advisory firm. Information discussed on this podcast may be derived from third parties that are believed to be reliable, but Carsonal Allaria Wealth Management does not control or guarantee the accuracy or timeliness of such information and disclaims all liability for damages resulting from such sources. Any references to third parties are provided as a convenience and do not constitute an endorsement.