Split Between Roth and Traditional 401 K: A Comprehensive Guide

Choosing between a Roth and Traditional 401(k) can be a daunting task, but understanding the basics can help you make an informed decision.

The main difference between the two is how taxes work. With a Traditional 401(k), you contribute pre-tax dollars, which reduces your taxable income for the year, but you'll pay taxes when you withdraw the funds in retirement.

You can contribute up to $19,500 to a 401(k) in 2022, with an additional $6,500 if you're 50 or older.

Recommended read: Can You Add Funds to a Rollover Ira

If you're struggling to save at all, a traditional 401(k) account might be the way to go, as the upfront tax break can make the difference between not saving and saving at all.

Many people in higher tax brackets who don't need additional Roth savings might also find traditional accounts to be the right strategy.

For those who are already struggling to save, every little bit counts, and the ease and prevalence of traditional 401(k)s can make it more likely that they'll actually start saving.

The most important thing is that they're doing it, and traditional accounts can provide that initial motivation.

For another approach, see: Abandoned 401 K Accounts

If you're considering a 401(k) plan, you have two main options: traditional and Roth. Contributions to a traditional 401(k) are tax-deductible, meaning you'll lower your taxable income and pay less in federal and state taxes.

The primary difference between a traditional 401(k) and a Roth 401(k) is when you pay taxes on these contributions. With a traditional account, your contributions are made with pre-tax dollars, giving you an upfront tax break.

You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions can't exceed the deferral limit – $23,000 in 2024; $22,500 in 2023; $20,500 in 2022; $19,500 in 2021 ($30,500 in 2024; $30,000 in 2023; $27,000 in 2022; $26,000 in 2021 if you're eligible for catch-up contributions).

Here's a comparison of traditional and Roth 401(k) options:

A Roth 401(k) is a type of retirement plan where contributions are made with after-tax dollars, meaning you don't receive a tax deduction when you add funds to your account.

Contributions to a Roth 401(k) are made with after-tax dollars, which means you pay taxes on your contributions up front. This results in an upfront tax payment, but you'll enjoy tax-free withdrawals in retirement.

A traditional 401(k) offers an upfront tax break because your contributions are made with pre-tax dollars, lowering your taxable income and reducing your federal and state tax liability.

Consider contributing to a traditional 401(k) if you expect your income to decrease in retirement, as you'll be in a lower tax bracket and pay less in taxes.

If you're a younger employee, a financial planner might recommend a Roth 401(k) because you're in a lower tax bracket and can pay taxes on contributions while you're young.

You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions can't exceed the deferral limit.

Here's a comparison of different retirement plans:

Remember to consider your individual circumstances and tax situation when choosing between a Roth 401(k) and a traditional 401(k).

One of the best features of a 401(k) is the match program, where an employer matches an employee's 401(k) contributions up to a certain percentage.

Your company may offer a dollar-for-dollar match up to a percentage of your gross income, or a 50 percent match up to a percentage.

Let's assume you earn $40,000 a year and you contribute 5 percent of your income. If your employer offers a 50 percent match, they'll contribute $1,000 to your account annually.

This is free money that you shouldn't turn down, especially if you're a low income earner. A match program helps grow your retirement savings faster.

Company matches are made with pre-tax dollars, and these funds grow tax-deferred. You'll owe income tax on these withdrawals in retirement.

You do not get to deduct the company match from your income. Your employer enjoys the tax benefits.

Discover more: Annual Increase Program 401k

You can begin withdrawing from a 401(k) at the age of 59 1/2 without penalty.

If you withdraw funds at an earlier age, you'll owe income tax on the withdrawn amount and you'll pay a 10 percent penalty.

The money in a 401(k) grows tax-deferred, meaning you don't pay taxes on the money until you withdraw funds in retirement.

You'll owe income tax on the withdrawn amount if you withdraw funds at an earlier age.

Recommended read: What Percentage of Your Pay Should You save for Retirement

Splitting your contributions between a Roth and a traditional 401(k) can be a smart move.

You can split your contributions, but ideally, it might be easier to focus on one aspect of saving entirely.

Employers may allow split contributions, but it's worth considering the benefits of a single approach.

You can choose how to split your contribution up to the annual contribution limit, which is $18,500 in total for 2022.

For example, you might contribute $8,500 to a Roth 401(k) and $10,000 to a traditional 401(k).

There’s also freedom to change where contributions go based on your tax bracket.

Some people choose a split because they prefer a tax diversification savings strategy, which involves spreading their money across different assets to cut their taxable income in retirement and reduce risks.

Additional reading: When Should You Reduce Your Contributions to Your 401k

If you're a younger employee, a financial planner might sway you toward a Roth 401(k), since income is usually lower during our early working years.

You'll be able to pay taxes on contributions while you're in a lower tax bracket, rather than in retirement when your income is likely to be higher.

Contributions to a Roth 401(k) are made with after-tax dollars, so you don't receive a tax deduction when you add funds to your account.

You pay taxes on your contributions up front, but you'll enjoy tax-free withdrawals in retirement if you meet the requirements.

However, a traditional 401(k) might be the cheaper alternative from a tax standpoint if you anticipate taking time off from work later in life or you expect your income to decrease for other reasons.

You can choose a traditional 401(k) and defer taxes until you're in a lower tax bracket, rather than enrolling in a Roth 401(k) during your peak earning years and paying a higher tax rate.

If this caught your attention, see: Do You Pay Taxes on Roth 401 K

Here's a summary of the key differences between traditional and Roth 401(k)s:

Ultimately, the best choice for you depends on many factors, such as your age and your expected income bracket in the future.

The amount you'll pay in taxes is based on your ordinary income tax bracket in retirement, so it's essential to consider your long-term financial goals when deciding between a traditional and Roth 401(k).

Many employers match a portion of their employees' 401(k) contributions, which is essentially free money that can significantly boost your retirement savings.

The contribution limit for employer matching is $19,500 in 2022, plus an additional $6,500 if you're 50 or older, according to the article.

Employer matching is usually vested, meaning you have to work for the company for a certain period before you own the matching funds.

Typically, employer matching is vested at 20% per year, so if you leave the company after five years, you'll own 100% of the matching funds.

Broaden your view: Company Stock in 401 K

This vesting schedule can vary, but 20% per year is a common standard.

If you leave your job, you can take your vested employer matching funds with you, but you may have to roll them over into an IRA or your new employer's 401(k) plan.

In some cases, employer matching may be subject to a waiting period or a certain number of years of service before you're eligible to participate.

Recommended read: Rrsp Matching

Consider splitting your IRA savings between Roth and traditional accounts to take advantage of both tax scenarios and gain flexibility in your working and retirement years.

Carbonaro advises doing half in regular and half in a Roth, as it's allowed to split and can help you balance your savings.

A traditional 401(k) can lighten the burden of saving in Roth, but putting all savings in a traditional account can lead to a "tax bomb" in retirement.

If you have a matching contribution, consider that it will usually be made on a traditional basis, as the savings are not taxed until you take it out.

Contributing 3% each into traditional and Roth can result in 9% savings in traditional with the company match and 3% in Roth of your own savings.

Starting in 2023, the SECURE 2.0 Act of 2022 permits plans to offer a Roth match, allowing you to save more on a Roth basis if your employer contributes to your savings.