Choosing the right retirement plan can be difficult, especially when you have a lot of options. Most employers offer a pre-tax 401(k) plan. Others, however, offer a Roth 401(k) on top of a traditional 401(k). If you have both options, how do you compare the traditional 401(k) vs. Roth 401(k)? Which account is best for you?
These two retirement plans are sponsored by employers and they usually come with the same contribution limits each year. Your employer match is also the same whether you have a pre-tax 401(k) plan or a Roth 401(k) plan. The main difference between a 401(k) and a Roth 401(k) is when tax benefits are realized. With a pre-tax 401(k) plan, you make contributions with before-tax money, grow your account on a tax-deferred basis, and pay income tax on distributions during retirement.
On the other hand, the Roth 401(k) contributions come from after-tax wages. With this plan, you grow your account potentially tax-free and pay no income tax on qualified distributions.
Here is everything you about a pre-tax 401(k) vs. Roth 401(k) plan and how to pick the right plan.
What is a Roth 401(k)?
Many people know about the pre-tax 401(k) as it is more popular compared to the Roth 401(k). This is because many companies offer different plans depending on their choices and their sizes. For example, many small companies do not offer a pre-tax 401(k). Instead, they prefer a SIMPLE 401(k) or a SIMPLE IRA. This is because a pre-tax 401(k) would be complex and expensive for these companies.
Many people also do not pick the Roth 401(k) because it does not come with upfront tax benefits. They would rather reduce their taxable income with a pre-tax 401(k) rather than chase tax-free withdrawals that come with the Roth plan. So, many companies do not get enough participants in the Roth 401(k) plan.
If you never heard of Roth 401(k), however, it is probably because your company does not have it. But, some companies offer this account, especially large companies.
So, what is a Roth 401(k) plan?
A Roth 401(k) is an employer-sponsored plan that allows you to make contributions to your retirement account using after-tax money through payroll deductions.
With Roth 401(k), you will grow your account potentially tax-free and pay no tax on qualified distributions during retirement.
The Roth 401(K) does not offer upfront tax benefits. But, you never have to worry about tax on your distributions or paying tax on your earnings as long as you follow the IRS withdrawal requirements. The distribution policies on Roth 401(k) are closely related to the Roth IRA withdrawal requirements.
Some employers will contribute to your Roth 401(k) plan. In this case, the employer contribution will be considered a tax-deferred contribution and you will pay an income tax to employer contributions and associated earnings.
What is a pre-tax 401(K) plan?
A pre-tax 401(k) plan also known as a traditional 401(k) is an employer-sponsored retirement plan that allows you to save a portion of your before-tax income toward retirement. Your contributions to a pre-tax 401(k) will be taken directly from your paycheck through payroll deduction. With this plan, you will grow your retirement account on a tax-deferred basis and pay income tax on your distributions during retirement.
The pre-tax 401(K) reduces your taxable income and helps you grow your retirement savings faster. Many companies can match your contributions up to a percentage.
Keep in mind that the employer contributions could be subjected to the vesting process. A vesting period is nothing other than the time you must work for the company before you can claim ownership of your employer contributions to the plan. Some companies have a gradual vesting structure where the vested percentages go higher over time until you become 100% vested.
Related: What does it mean to be vested in my 401(k)?
Pre-tax 401(k) vs. Roth 401(k)
If you are wondering how the pre-tax 401(k) differs from the Rorth 401(k), here is a comparison of both plans and what you should expect from each one of them.
| Features | Roth 401(k) | Traditional 401(k) |
| How it works | An employer-sponsored plan where you make contributions with after-tax wages and pay no income tax on qualified distributions during retirement. | An employer-sponsored plan where you make contributions with before-tax money and pay income tax on qualified distributions during retirement. |
| Tax-deferred contribution limits in 2024 | $23,000 or $30,500 if you are 50 or older | $23,000 or $30,500 if you are 50 or older |
| RMDs rules | RMDs are required when you turn 73 but you can avoid them by rolling over your money into a Roth IRA | RMDs are required when you turn 73 |
| Employer matching | An employer can choose to make contributions to the plan | Most employers will match your contributions up to a certain percentage |
| Total contribution limits (your contribution & employer match) in 2024 | It cannot go over $69,000 or $76,500 if you are 50 or older. If your income is lower than these limits, the total contributions cannot be higher than your income. | It cannot exceed $69,000 or $76,500 if you are 50 or older. If your income is lower than these limits, the total contributions cannot be higher than your income. |
| Early withdrawal penalty | 10% penalty on the non-contribution amount (amount considered to be part of gross income) when you take withdrawals before you turn 59½ unless you meet IRS exceptions. | 10% when you withdraw money before you turn 59½ unless you meet IRS exceptions. |
| Account sponsored by an employer | yes | yes |
| Type of contributions | after-tax money | before-tax money |
| Reduces taxable income | no | yes |
| Loans on the account | yes | You may have options for 401(k) loans |
| Taxes on distributions | Qualified distributions are not taxed | You pay income tax on distributions |
What are the similarities between 401(k) and Roth 401(k)?
Both 401(k) and Roth 401(k) are employer-sponsored plans and they offer tax benefits to the account holder. The employer can make contributions to these two accounts. In addition, both accounts have the same maximum tax-deferred contributions and total contributions allowed.
Furthermore, the pre-tax 401(k) and Roth 401(k) plans come with required minimum distributions(RMDs) when you reach 73. The pre-tax 401(k) comes with income tax on your distributions while the Roth 401(k) does not, unless you received an employer match. In this case, you will pay tax on the amount your employer contributed to your Roth 401(k) and associated earnings.
What is the difference between a pre-tax 401(k) and a Roth 401(k)?
The main difference between a pre-tax 401(k) and a Roth 401(K) is when you realize tax benefits. With pre-tax 401(k), you get upfront tax benefits since your contributions come from before-tax money. If you are in a higher tax bracket, you can easily move into a lower tax bracket by contributing to your pre-tax 401(k) plan.
The Roth 401(k), on the other hand, does not give you direct tax benefits since your contributions come from after-tax wages. When you retire, the tax liability will only apply to your employer contributions and related earnings or if you make unqualified distributions.
Additionally, both accounts require RMDs when you turn 73. However, there is a trick you can use to avoid RMDs on your Roth 401(k) plan. According to the Internal Revenue Service (IRS), you can roll over your Roth 401(k) into a Roth IRA if you want to avoid RMDs.
pre-tax 401(k) vs. Roth 401(k): Contribution limits
You and your employer can make contributions to these two accounts and contribution limits are the same for both accounts. The contribution limits to pre-tax 401(k) and Roth 401(k) in 2024 are $23,000. If you are 50 or older, you get an extra $7,500 catch-up contribution. In other words, you can contribute up to $30,5000 to your 401(k) plans if you are 50 or older.
Since your employer may also make contributions to your 401(k) or Roth 401(k) plans, there is a limit to the total amount that can be contributed to your account.
If you are 50 or older, the total contribution to your account including your employer match cannot exceed $69,000 or $76,500 or 100% of your compensation, whichever is less.
Contribution limits to 401(k) plan in 2023
The contribution limits to either pre-tax 401(k) or Roth 401(k) in 2024 are $22,500. If you are 50 or older, you can contribute up to $30,000. With your employer match, the total contribution to the plan cannot exceed $66,000 or 100% of your compensation, whichever is less.
401(k) vs. Roth 401(k): RMD requirements
The IRS gives you tax benefits to encourage you to save for retirement. By delaying taxes on your wages, you get to grow your accounts fast. Eventually, those taxes must be paid no matter what. That is why you must start taking distributions from your account when you turn 73.
For your pre-tax 401(k), any distributions you take will be taxed as an ordinary income.
For Roth 401(k), on the other hand, the tax will only apply to your employer’s contributions and earnings from those contributions. If your employer does not match your plan, you will still be required to take RMDs, but you will not pay taxes on your withdrawals. This is because your contributions were taxed already.
Failure to make the required minimum distributions may result in a 50% tax penalty on the money you did not distribute on time. For example, if you were supposed to withdraw $4,000 and only took out $3,000, you may have to pay half ($500) of that $1,000 you did not take out in taxes.
Should you choose a pre-tax 401(k) or a Roth 401(k)?
When it comes to choosing a good retirement plan, it all depends on your financial situation and retirement goals.
Here is how to choose between a Roth 401(k) and a pre-tax 401(k) plan. Let’s use the following two questions to help you decide.
- Do you currently have a high income and expect a lower income during retirement?
- Are you OK with paying taxes now and never having to worry about it during retirement?
If you have a high income now and you are expecting a lower income in retirement, it would make sense to choose a pre-tax 401(k) plan. This is because a pre-tax 401(k) will reduce your current tax liability by lowering your taxable income. Your contributions can also put you in a lower tax bracket which might save you more money in taxes.
If you think you will have a higher income during retirement, it would be wise to choose a Roth 401(K) as long as you are OK paying taxes now. Having a higher income during retirement means that your income tax will also be high. That is why you need a Roth IRA to lower your taxes during retirement.
Can I have a Roth 401(k) and pre-tax 401(k)?
Yes, you can have both accounts if your employer offers them. It is possible that your employer could offer both retirement plans. However, if you choose to go with both accounts, your contribution limits cannot go over the limits allowed on a 401(k) in any given year.
Since each plan allows a maximum contribution of $23,000 or $30,500 if you are 50 or older in 2024, having both plans means that the cumulative contribution from both plans should not exceed these limits. You must divide your money into both accounts in a way that your total contribution will not go higher than early contribution limits.
For example, you can allocate $15,000 to your traditional 401(k) and put the remaining $8,000 into your Roth 401(k).
What happens when I contribute more than allowed to my 401(k) account?
In case you contribute more than the limits allowed, have your employer fix the error. This is possible when it is done before the due date of your tax return.
You can also have your plan administrator correct the error right away.
Leaving money in your 401(k) that is not supposed to be there (any money above the allowed limits), will result in double taxation.
More tips
What is a SIMPLE IRA and how does it work?
What is a Roth IRA and how does it work?
