For most people, a Roth 401k is a better choice than a traditional 401k.

The exception? If you’re a high earner and you save enough – maxing out your retirement plan and saving additional amounts in a bank or brokerage account – you are in the minority of employed who should probably contribute to a traditional 401k, not a Roth.

Why do we feel the need to write this?

Too often, clients come to us having saved in their 401k for decades, thinking it would be enough for retirement … and then discover it’s not enough. The most common mistakes we see:

1. They did not save anything in addition to their 401k, and
2. They did not expect their taxes to be so high when taking money from their 401k and sometimes discovered too late that they would have to cut back during retirement.

We admit this advice is the financial equivalent of saying broccoli is better for you than French fries. It’s easy to understand but not always easy to follow.

What is a Roth 401k?

A Roth 401k is a company retirement plan, just like a traditional 401k. There are identical versions for employees with a 403b retirement plan. The amount you and your employer contribute will grow tax-free while inside the account. There are annual contribution limits. Generally, you can defer up to $22,500 (2023 limit). If you are 50 or older, you can contribute $30,000. Your employer’s contribution is on top and has its own limitations.

How is a Roth 401k different from a traditional 401k?

The difference is in the tax treatment.

1. Directing a portion of your paycheck into a Roth 401k means you receive no tax deduction. By contrast, with a traditional 401k, your contribution reduces your taxable income dollar-for-dollar.
2. When you take money from your traditional 401k, you owe tax at ordinary tax rates, as if it were salary income. By contrast, money withdrawn from a Roth 401k is tax-free and penalty-free if you meet certain guidelines. The Roth account must have been open for at least five years, and you must be at least 59 ½ years old when you take the distribution.

In other words, you pay tax now (Roth), or you pay tax later (traditional).

Why is a Roth 401k better than a traditional 401k for most employees?

Forced saving.

• • Because you are paying tax now, not later, a Roth 401k effectively forces you to save more while you’re working because you have less disposable income. Your paycheck tax withholding will be higher, so your paycheck will be smaller.

Protection against tax rates rising.

• • If tax rates increase while you are retired, being able to take money out of a Roth 401k, tax-free, provides some protection. No one can predict future tax rates, but many observers who study the US Government’s ever-increasing debt load see tax increases as likely.

Lower your tax bill in retirement.

• • You may be surprised by how much tax you will owe in retirement, especially if you have a large 401k, a generous Social Security benefit, and maybe even a pension.

Lower Medicare Part B premiums in retirement.

• • The difference between the highest and lowest Part B premium in 2023 is almost $5,000 per person annually. Your gross income determines the premium. If your annual taxable required distribution from your 401k is lower because a portion is in a Roth, your Part B premium will likely be lower.

A substitute for a Roth IRA.

• • If your taxable income is high, you may be unable to make an annual contribution to a Roth IRA. That means – short of doing a Roth conversion -- you may have little or no Roth money at retirement. A Roth 401k has no such income limitations on making contributions.

Everyone’s situation is different, and deciding whether to make Roth contributions to your 401k often requires careful analysis. But it’s worth doing that analysis as part of a comprehensive financial plan. Too often, people opt for a traditional 401k to save tax today. It does save tax today. But it may not be the right strategy for your long-term plan.