What Is a 401(k)? Comparing Roth vs. Traditional Plans

Retirement planning can be complicated. You’ve probably heard of a 401(k) plan — but do you know about all of its benefits? And what type of 401(k) should you get: Roth or traditional? 

The tax advantages of a 401(k) plan can lead to larger returns for identical investments, not to mention the matching that many employers offer, which can dramatically increase your returns. The added bonus of automated saving with a retirement plan can also help avoid lifestyle creep impacting your retirement.

There are a number of important decisions to make when it comes to your 401(k), including your investment contributions, investment choices, and the plan type (Roth vs. traditional).

Typically, the best strategy with retirement planning is to start early and let the magic of compounding work for you. This article is here to help you invest in your 401(k) quickly and confidently. 

What is a 401(k)?

A 401(k) is a tax-advantaged retirement plan sponsored by your employer. It's essentially a dedicated retirement savings and is named after the relevant section of the Internal Revenue Code. It is not an investment itself but rather a platform that offers a set of investment options that you can manage. There are different types of 401(k) plans and each has unique tax benefits.

One key aspect is that your 401(k) is employer-linked. Later, we discuss switching jobs with a 401(k).

Getting started with your 401(k) is straightforward. Your employer sponsors the plan and they’ve chosen a plan provider. Your employer will guide how to access your account or connect you with the plan provider to guide you through the setup process.

The importance of contribution amounts

First, ensure savings outside of your retirement plan cover essential living expenses and establish an emergency fund. You may also want to tackle high-interest debt.

Your next goal is to capture an employer match. Many companies offer matching employer contributions, effectively giving you “free money.” Suppose your salary is $100,000 and one of your work benefits is a 6% employer match on your 401(k) contributions. You should contribute at least $6,000 to your retirement account as your employer contributions will be a dollar-for-dollar match and will essentially double your investment each year. 

In 2023, the annual contribution limit for those under 50 is $22,500, and it increases to $30,000 for those aged 50 or older. While it may not be feasible for everyone to contribute the maximum, your investments will usually be better served inside a tax-advantaged account.

Advanced or aggressive savers should check out the Mega Backdoor Roth 401(k) for another way to maximize their options.

Related: How to save for retirement

Consider how you want to allocate investments

The 401(k) plan offers a limited set of investment options that mainly fall into two categories: mutual funds and lifecycle funds. 

Mutual funds: These investment pools allow you to participate in a diversified portfolio of assets. Your plan provider typically offers mutual funds that track various asset classes, such as large stocks, small stocks, international stocks, bonds, and government securities. Your choice should align with your risk tolerance and investment goals. 

Lifecycle funds: If the investment allocation choices across funds seem daunting, Lifecycle Funds (also called target date funds) offer a simple alternative. You select a target date closest to your expected retirement, and the lifecycle fund will automatically allocate your investments across the different mutual fund options. As your retirement date gets closer, the fund will automatically and progressively shift contributions toward a more conservative mix of bonds and government securities. 

Roth vs. traditional: Which one should you have?

A Roth 401(k) involves contributing after-tax income to retirement savings. This means you'll pay income taxes on the money before you invest it and can look forward to tax-free withdrawals during retirement. This is especially advantageous if you anticipate you'll pay taxes at a higher rate in the future.

Additionally, Roth 401(k)s have no required minimum distributions (RMDs), allowing your investments to grow tax-free for as long as you wish. There are no income limits for contributions.

Conversely, a traditional 401(k) entails pre-tax contributions, reducing your taxable income for the current year. However, withdrawals in retirement are subject to income tax. This option is more favorable if you expect your income tax rate to be lower during retirement. Traditional 401(k)s have required minimum distributions starting at age 72, ensuring you withdraw a specific amount annually. While there are no income limits for contributions, high earners may face limits on the tax deductibility of contributions if covered by a workplace retirement plan.

Related: What is a Roth IRA?

Example of Roth vs. traditional 401(k)

Let’s walk through an example to best understand the tax implications of different retirement accounts.

Meet Sarah. Sarah is a single person living and working in New York City with an annual income of $100,000. She invests 10% of her annual salary, and those investments are expected to grow at a 7% compounded average growth rate for the next 30 years. For simplicity, assume she remains in NYC in the same tax bracket in retirement.

Sarah owes federal, state, city, and FICA taxes amounting to $31,000, leaving her with $69,000 of take-home pay. She invests $6,900 (10%) and has $62,100 for living expenses.

If she invests 10% ($6,900) of her after-tax dollars in a taxable brokerage account, her investment earnings will grow to $52,500 over 30 years. When it’s time to withdraw, she’ll owe about $11,500 in capital gains taxes, reducing her retirement savings to $41,000.

What if she chooses to invest?

If Sarah chooses to invest her 10% ($6,900) in a Roth 401(k) instead, she’ll still end up with $52,500 after 30 years. However, her investment gains are untaxed and her retirement fund balance remains at $52,500. This is 28% more than the regular brokerage account.

Now, if Sarah decides to invest pre-tax income in a traditional 401(k), she’ll have more to invest: $10,000 compared to the $6,900 after tax. This will also yield a tax deduction, reducing her taxable income to $90,000, resulting in a tax liability of $27,000. This leaves Sarah with $63,000 for living expenses. Sarah’s investment will grow faster as she started with a larger input, and her retirement fund reached $76,000 after 30 years. When it’s time to withdraw her funds, she’ll have to pay taxes, reducing her balance to about $51,000.

Comparing the Outcomes

• Taxable brokerage: $62,100 in year 1 and $41,000 in retirement. 
• Roth 401(k): $62,100 in year 1 and $52,500 in retirement.
• Traditional 401(k): $63,000 in year 1 and $51,000 in retirement

We assumed Sarah remained in the same tax circumstances today and in retirement. However, this might not be an appropriate assumption. If Sarah is at the peak of her career, she may expect reduced income in retirement or move to a low-tax state. If Sarah is starting her career, she may believe her taxes may be higher later. She may also want to avoid the possibility of unforeseen tax increases by the government. 

Related: What is a traditional IRA?

Other 401(k) considerations

Here are a few other important considerations to keep in mind when evaluating your retirement savings plan:

• Access to Funds: Roth 401(k)s allow you to withdraw your contributions at any time without penalty or taxes, providing flexibility for emergencies. Traditional 401(k) withdrawals before age 59 ½ typically incur a 10% penalty in addition to income taxes.
• Required Minimum Distributions: Traditional 401(k) plans require you to withdraw money starting at age 72. This will be a specified amount of your total balance and reduces flexibility in tax planning for retirement.
• Social Security: Roth withdrawals are not counted as taxable income, which can help reduce taxes owed from Social Security payments. However, the reduction in taxes today from a traditional 401(k) may be more valuable. 

What happens to 401(k) if you leave your job?

Any 401(k) plan you have will be tied to your employer. While you can typically maintain investments in the plan, you’ll likely be charged regular record-keeping fees once you leave that employer. You likely cannot continue contributing to a former employer’s 401(k) plan, so if you begin again at a new employer, your investments will be spread out unnecessarily across providers. 

The latter point is important as many individuals end up losing track of 401(k) plans over time as they switch jobs or when leaving an inheritance. A comprehensive study by Capitalize suggests that there is a staggering $1.6 Trillion in lost or forgotten 401(k) plans.

Fortunately, it is a simple process to transfer your 401(k). With a new employer, their plan provider can walk you through the transfer just as they would for your initial account.

Alternatively, you can roll over your 401(k) into an IRA at any brokerage such as Webull.

If you’d rather not deal with the hassle of organizing the transfer yourself, you can utilize a service like Capitalize, which will locate and transfer all your 401(k) plans for you for free.

FAQs

Can I save for retirement without a 401(k)?

An Individual Retirement Account (IRA) offers the same tax advantages as a 401(k). However, IRAs do not come with employer matching and have much smaller maximum contributions. In addition, the Roth IRA is subject to income limits that the 401(k) does not have.

What if my company does not match?

The tax advantages of the 401(k) and IRA are tremendous compared to the normal brokerage account. If you don't have employer matching contributions, and you prefer more investment choices, then first contribute to an IRA and then contribute to the 401(k) only after reaching the annual IRA limits, or if restricted from the Roth IRA due to income limitations.

If you prefer the simplicity of Lifecycle Funds or a more limited set of investment options, then the 401(k) may still be a good choice relative to the IRA. Aggressive savers will use both! 

Can you take a loan from your 401(k)?

Employer plans have different rules for 401(k) withdrawals and loans, so check with your provider for details. In general, withdrawals prior to age 59 ½ have penalties (excluding Roth contributions), but 401(k) loans can avoid penalties and taxes. 

Plans typically require that loans are paid back with interest within five years of taking the loan. And if you leave your company, you may be stuck paying the loan back in full in a very short time window.

If an emergency does come up, it may be cheaper to take a 401(k) loan and pay yourself back rather than taking out a personal loan or relying heavily on credit cards.

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