Is a Traditional 401(k) or Roth 401(k) Right for You?

If you've looked into enrolling in your company's retirement plan but have hesitated because there are too many choices to make, and you feel as though the options haven't been very well explained to you, you're not alone.

Studies have shown that many investors who could be enrolled in an employer-sponsored 401(k) plan, aren't. One reason often cited is confusion over the process: There are too many choices; selecting the investments, choosing the contribution amount, and even choosing the account type. Some people may be handed a brochure on their first day of work without further explanation. But setting up a 401(k) doesn't have to be a daunting task if you understand your options.

Before we get into the types of accounts, let's tackle the menu of investment options. If you're overwhelmed by the number of choices in your plan or if there's only mediocre investments to choose from, a target-retirement fund with a date coinciding with your 65th or 70th birthday is often a great option. In your younger years, the fact that you're saving at all matters more than your investments' growth rates; tax-deferred compounding means that by the time you retire, you'll have far more money to take out than you put in.

Traditional 401(k) Chances are if you work for a big company, your employer offers a traditional 401(k). According to a report by the Society for Human Resource Management, as many as 90% of employers offer some sort of traditional 401(k) or similar plan.

Taxes Your money goes into a traditional 401(k) account pretax--before it even hits your paycheck. By scooping it out before it becomes taxable income, it provides you with a tax benefit today. Let's say you make $50,000 per year, but save $5,000 in a traditional 401(k). Your taxable income is lowered to $45,000, so you would pay less in taxes now.

The government is going to come looking for its tax money at some point, though. You can start withdrawing money from your traditional 401(k)s without incurring a 10% penalty at age 59 1/2 (or 55, if you are already retired). You will be taxed ordinary income tax rates on the money withdrawn from the account.

Contribution limits The contribution limit for 2017 is $18,000, or $24,000 if you're older than 50. (This does not include employer match.)

Employer match If you have a traditional 401(k) and your employer offers a match, invest at least up to the match amount. For example, if your employer's matching policy is $0.75 of every dollar up to 5%, invest at least 5%. If you make $50,000, that's $1,875 per year that your employer is offering to give you; you're effectively turning it down if you don't make the full contribution.

Most likely to benefit If you have a good reason to believe your tax bracket will be lower or the same as it is now when you're in retirement, a traditional 401(k) can be a good way to go.

Also, if you are on the cusp of qualifying for certain tax credits and deductions, lowering your taxable income through traditional 401(k) contributions could benefit your situation.

Roth 401(k) Your company may offer a Roth 401(k) in addition to a traditional 401(k) option. According to the research report from the Society for Human Resource Management, 55% of employers offered these types of retirement savings plans.

Taxes The main difference between the Roth 401(k) and the traditional is when the money is taxed. Roth 401(k) contributions are made with aftertax dollars, so you do not receive a tax break today. However, the balance of your Roth contributions and earnings are not taxed when you take a qualified distribution when you retire.

Contribution limits The contribution limit for 2017 is $18,000, or $24,000 if you're older than 50. (This does not include employer match.) Some Roth advocates like to point out that because the money is aftertax, the effective contribution rate is higher.

Employer match Like with the traditional, invest at least enough to take advantage of your full company match.

The company match works a little differently with Roth 401(k)s, though. According to the IRS, your employer can only allocate your designated Roth contributions to your designated Roth account. Any employer contributions to match designated Roth contributions must be directed into a pretax account, just like matching contributions on traditional, pretax 401(k) contributions.

Most likely to benefit If you believe your tax bracket will be higher in retirement than it is now in the early days of your career, a Roth 401(k) can be a great option.

Additionally, if you plan to roll over to a Roth IRA, rolling over a Roth 401(k) is simpler than rolling over a traditional 401(k) because you would not owe taxes on the conversion. (More on that below.)

Aftertax 401(k) Do not confuse a Roth 401(k) with an aftertax 401(k). Traditional and Roth 401(k) savers will always come out ahead of aftertax 401(k) savers, and most investors probably don't need this account type. (See the example below.)

Which One Is Better? If you're like many people, you might not know whether your marginal tax rate will be lower in retirement than it is now. If you did, you would know with certainty which account type is the better choice.

Even though it seems like the Roth saver would come out ahead because all the investment earnings come out tax-free, that's not necessarily the case.

Here's a simplified example. Let's follow $10,000 invested in a traditional 401(k) for 10 years, where the tax applied at end of holding period. Let's say that that initial contribution earns a 5% return every year. When we take the money out, it is taxed at a 25% rate.

($10,000*1.05^10)*0.75 = $12,216.71

Now let's put the same amount into a Roth 401(k), where the tax rate is applied to the contribution amount (in other words, you are funding the account with aftertax contributions).

(0.75*$10,000)*1.05^10 = $12,216.71

The variable that would cause the outcome to differ is if you are in a different tax bracket. In the previous example, if you started your career in the 25% tax bracket but ended it in the 33%, you would have come out ahead with the Roth, as your traditional 401(k) balance would shrink to $10,913.59 after factoring in your higher tax rate in retirement.

By contrast, the aftertax 401(k) is funded with aftertax dollars and the earnings are also taxed. This is why the aftertax 401(k) option doesn't have a chance of outperforming the Roth or traditional 401(k) options; they really only make sense for investors who have already maxed out contributions to tax-advantaged account types such as traditional or Roth 401(k)s.

[(0.75*$10,000)*1.05^10] = $12,216.71

Then you subtract the contribution amount, which you already paid taxes on. $12,216.71-$7,500 = $4,716.71. The $4,716.71 difference is the earnings, which would be taxed at ordinary income rates. Assuming you are in the 25% tax bracket: ($4,716.71*0.75 = $3,537.53). To figure out your aftertax balance, you would then add your post-tax earnings back to your aftertax contribution amount.

$7,500+$3,537.53 = $11,037.53

Why Not Choose Both? If you have both types of plans available to you, another option would be to choose both the traditional and Roth 401(k). The benefit of this is tax diversification. Like asset-class diversification, diversifying your portfolio among account types with different tax treatments ensures that at least some of your assets will be well-positioned whatever may come; you're not casting your lot with a single outcome, as explained in this article.

At some point (age 70 1/2 currently) investors will need to take required minimum distributions from their 401(k) accounts. If you come into retirement with a few different account types, you can exert more control over how much you pay in taxes in any given year by choosing how much to withdraw from each account type each year.

(One note: Roth IRA accounts do not require minimum distributions, meaning you decide exactly how much to withdraw, and when. If that appeals to you, it's simpler to roll a Roth 401(k) into a Roth IRA because you would not owe taxes on the money rolled over. Rolling a traditional 401(k) account into a Roth IRA does require that you pay tax on the rollover amount at your ordinary income tax rate.)