The fundamental difference between traditional pre-tax 401(k) contributions and Roth 401(k) contributions comes down to when those contributions are included in taxable income. Roth 401(k) contributions are made after income taxes have been taken out of your paycheck, whereas traditional pre-tax 401(k) contributions are made before income taxes come out and are referred to as "pre-tax" contributions.
Here's why that matters:
Traditional pre-tax savings in a 401(k) vs. after-tax savings in a Roth 401(k) contributions: How does tax treatment differ?
Traditional pre-tax contributions could
help reduce the income taxes you pay now by lowering your adjusted gross income. The contributions wouldn't lower your take-home pay as much as Roth
401(k) contributions, where income taxes have already been taken out.
If you're a younger employee and can afford to pay the income taxes now, it may be better to consider Roth 401(k) contributions. These contributions have already been subject to income tax, so no additional income taxes are due when you withdraw the amount of your contributions. Earnings on Roth contributions can also be withdrawn tax-free if the requirements for qualified distributions are satisfied.Footnote 1
However, if you're further along in your career and earning a larger salary, a traditional pre-tax 401(k) contribution may save you more on income taxes in the long run. It may be to your advantage to defer the income taxes until you retire — especially if you think your tax bracket might be lower.
What are the contribution limits for traditional pre-tax and Roth 401(k) contributions?
"The most important thing is to save and, if your employer offers both options, you have more choice and the flexibility to save in a way that's best for your situation."
— Margie Feola, Director, Product Management, Bank of America
What if my employer offers both type of savings — traditional and Roth 401(k) contributions?
The most important thing is to save and, if your employer offers both options, you have more choice and the flexibility to save in a way that's best for your situation. Consider participating in at least one of these to help you save and invest more for your retirement goals if your employer offers both. You may choose one or the other or a combination of the two as long as, taken together, they don't exceed the annual contribution limit on 401(k) elective deferrals. In either case, there may be tax liability on your employer contributions, so talk with your tax professional.