Ask an advisor: Traditional or Roth 401(k)? My company offers both

Ask an advisor: Should I get a traditional or Roth 401(k)? My company offers both

November 15, 2022 6:44 PM

A young man faces two diverging paths for his 401(k): Roth or traditional.

Welcome back to "Ask an Advisor," the advice column in which financial professionals answer pressing investment questions. The topics range from retirement to taxes to wealth management — or even advice on advising — and the questions are from real people.

This week's query is a financial advisor's dream: a young engineer just starting his career, far from retirement but eager to get started saving for it. In addition to his youth, he has another advantage: an employer that offers not only a traditional 401(k) but a Roth option as well. But with youth comes inexperience, and this young man needs help understanding the difference between the two plans.

The Roth 401(k) has become an increasingly popular option in recent years. Like a Roth IRA, it allows savers to contribute dollars on which taxes have already been paid and to make tax-free withdrawals later. And as with a traditional 401(k), a workhorse of employee-sponsored retirement plans, employers increasingly chip in as well. In 2011, just 49% of employer-provided plans offered a Roth option. By 2020, that number had exploded to 86%.

As our engineer begins his savings journey, which path should he choose? Here's what he wrote:

Dear advisors,

I'm a 24-year-old structural engineer in Providence, Rhode Island. My company offers two types of 401(k): traditional and Roth. Which plan should I go with? Or should I get both?

For context, I make $62,500 a year. Whichever account(s) I choose, my company will match 50 cents for every dollar I contribute, up to 6% of my salary. In other words, they'll match up to 3% of my earnings — but if I choose both traditional and Roth, this 3% would be divided between the two accounts. (For example, 1.5% could go to the traditional one while the other 1.5% goes to the Roth.)

Which retirement plan should I choose? If both, how much should I contribute to each?

—Pondering in Providence

Here's what advisors wrote back:

Go Roth, young man

Henry Hoang, a certified financial planner and the founder of

Bright Wealth Advisors

in Orange County, California:  

The million-dollar question here is, "Will your tax rates at age 60 be higher or lower than your income tax rates today?"

If you expect tax rates to be higher in the future, the Roth 401(k) is the way to go. If you expect tax rates to be lower in the future, the traditional 401(k) is the way to go.

Nobody has a crystal ball, but we can still make an intelligent guess. Since you are just starting out in your career, with over three decades before you reach retirement age, odds are your income and tax bracket will increase in the future. Secondly, with the U.S. national debt balance hovering over $31 trillion, odds are tax rates will increase at some point over the next three decades.

With income at $62,500, I would recommend contributing the 6% into your Roth 401(k).

By paying your taxes today, which I believe to be at a discounted rate, 100% of your account will be tax-free money in retirement.

You will move up to the next tax bracket when your income exceeds $89,076. At that point, you might consider splitting your combinations between Roth and traditional 401(k) accounts.

Don't sleep on traditional

Cody Garrett, a certified financial planner and the head of

Measure Twice Financial

in Houston, Texas:

Since you are beginning your working career and will likely increase your income moving forward, many advisors would suggest you contribute to a Roth 401(k), pay taxes now, benefit from tax-free growth and distribute tax-free income when your income is potentially higher. But this assumption ignores your desired retirement time horizon and your future sources of taxable income. Although you are young with decades of future variables ahead, it's not too early to begin thinking about financial independence — the future ability to work because you want to, not because you have to.

If you're planning to become work-optional before traditional retirement ages (60+), you may have opportunities to distribute income from your retirement accounts at a much lower effective (average) tax rate than 22%. For example, a single filer without other income sources would need to distribute income of over $235,000 to reach the 22% effective tax rate using current brackets. And a married couple filing jointly would need to distribute over $470,000! I advise most employees who plan to retire early to contribute to traditional instead of Roth as long as they intentionally develop an early distribution strategy.

Remember that your employer's matching contribution will be pre-tax, even if you contribute your portion to an after-tax Roth 401(k). Some employees prefer to contribute their portion to Roths and somewhat hedge the tax decision.

Lastly, this is not a permanent decision. If you change your mind, you can switch your future elections between traditional and Roth 401(k) contributions. Visualize your current and future sources of income and reconsider your decision annually.

Remember, you can always convert

Nicholas Bunio, a certified financial planner at

Retirement Wealth Advisors

in Downingtown, Pennsylvania:  

Someone young is probably going to make a lot more money decades later, and that means higher taxes later on.

Also, by the time this person retires, there could be higher tax rates anyway, simply due to the amount of debt our nation has.

I'd take the Roth option — you give up the tax deductibility of your contributions, but the Roth option is tax-free in retirement.

Now, the non-Roth option would be taxable in retirement. But you can always convert that amount over to Roth later. Plus, while this employer match is "found money"... let's face it, the bulk of your 401(k) will come from your contributions, which you can put into the tax-free account.

Learn by the numbers

Bryan Minogue, a certified financial planner and the founder of

Kardinal Financial

in Madison, Wisconsin:  

Based on your situation, I would lean towards Roth contributions. As you start your career, you are in a relatively low tax bracket compared to where you likely will be in the future and even in retirement. As a result, it's generally best to contribute to a Roth, taking the relatively low tax hit today but allowing for tax-free withdrawals in the future.

A general rule of thumb is to contribute to Roth when you are in the 10% to 12% tax brackets and contribute to traditional if you are in the 32%+ tax brackets. For the 22% to 24% tax brackets in-between, it's more of a toss-up and down to personal preference and circumstances.

Mix it up

Erik Baskin, the founder of

Baskin Financial Planning

in Sugarcreek Township, Ohio:

This is a complex decision that relies on many inputs. To simplify, generally you want to make Roth contributions when you are in a relatively low lifetime tax bracket, and traditional contributions when you are in a relatively high lifetime tax bracket. Being only 24 and making $62,500 as an engineer, I would bet your income will only grow from here. Thus, the Roth is probably the best choice at this time. You could always do a mix of the two to have some diversification if you want.

As for how much to contribute, you definitely want to get that match, since it's free money — so go with 6%, for sure. After that, I would make sure to max out a Roth IRA ($6,000 for 2022) that you can open up at any financial institution. Then, if you can still save more you can go back and increase your Roth 401(k) contributions.