The Big Question: When Do You Want to Pay Taxes?

The grand debate between a Roth 401K vs. Traditional 401K comes down to one simple question:

Do you want to pay taxes now or later?

A Roth 401K has you paying taxes upfront, but then your money grows tax free and you withdraw it tax free in retirement. 

A Traditional 401K, on the other hand, saves you on taxes today, but you’ll pay income tax when you withdraw funds later (on both your contributions AND your earnings within the account). 

I’ve always been a Roth fan (tax free growth? Yes, please!). But over the years, I’ve realized it’s not always the obvious winner, it really depends on your income, tax bracket, long term financial goals and ultimately your plans for the future (which might be unknown). 

In this blog, I break it down a bit so you can decide which option makes the most sense for you and make an informed decision.

What’s the Difference Between Roth 401K and Traditional 401K?

Roth 401K: Pay Taxes Now, Save Later

Note: refer to my blog about Roth IRAs and the way they work to get some additional insight.

• Contributions are made after tax, meaning you pay tax on it today and then the remainder goes into the account to be invested.
  
• Your money grows tax free
  
• Withdrawals in retirement are tax free (after age 59½ and so long as you’ve adhered to the 5 year holding rule).
  
• Think of it as paying taxes now so your future self doesn’t have to.

Traditional 401K: Save Taxes Now, Pay Them Later

• Contributions are made pre tax, which means you lower your taxable income by the amount you contribute. In other words, you get a tax break today while still putting money away for your future.
  
• Your money grows tax deferred, meaning it isn’t taxed throughout the years while it’s growing, but…
  
• Future withdrawals in retirement are taxed as ordinary income.
  
• You get the immediate benefit of lowering your taxable income today.

Roth 401K vs. Traditional 401K Example

Let’s use a simple example.

• Your Income: $100,000
  
• Tax bracket: 20%
  

• Contribution: $10,000

If you contribute to a Roth 401K, your full $100,000 of income is taxed (you owe $20,000 in taxes in the current year).

If you contribute to a Traditional 401K, your taxable income drops to $90,000, so you owe $18,000. 

That’s a $2,000 tax savings today just by opting to contribute to your Traditional 401K. 

But the big question is, what happens when you withdraw in retirement? Will the tax savings today be worth it when I could have been growing my account tax free in the Roth?

“I’ll Be in a Lower Tax Bracket Later…” Or Will You?

This is the most common argument for choosing a Traditional 401K:

“I’ll be in a smaller tax bracket in retirement, so I’ll save by paying taxes later.”

But here’s the reality: there’s no guarantee. So, here are a few key things to consider:

Required Minimum Distributions (RMDs)

At age 73, the IRS requires you to take RMDs from Traditional 401Ks and Traditional IRAs. The bigger your account, the bigger the required withdrawals, the bigger your taxable income and, yes you guessed it, the bigger your tax bill. 

For Example: If your Traditional 401K grows to $1.8M by age 73, your first RMD could be ~$70,000. That may push you into a higher tax bracket than you were expecting years ago when you made your plans. 

Future Life Changes

• You may earn more in your career and accumulate more wealth.
  
• You could sell a business or inherit assets that increase taxable income.
  
• Tax credits (kids, mortgage deductions) may go away by the time you retire.
  
• Tax laws themselves may change. (Spoiler: they usually do.)

The point? You simply can’t assume your taxes will always be lower later.

When a Traditional 401K Might Make Sense For You

For example, let’s say you retire at 60 and you don’t plan on drawing Social Security until 67, and you aren’t living off of your Traditional 401K or IRA accounts, instead you’re living off of your taxable brokerage account. 

During that seven year gap, your taxable income could be significantly lower than when you were working which means you might fall into a significantly lower tax bracket. That window gives you the opportunity to convert some of your Traditional 401K funds into a Roth, pay the taxes at that lower rate, and then enjoy tax free growth and withdrawals down the road. 

Roth 401K vs Traditional 401K: The Bottom Line

There’s no one size fits all answer. You have to get an understanding of your options, your risks, the benefits to each and make a decision that makes the most sense for you given the information you know today (that could easily change in the future). 

There are numerous variables that have an impact on the debate between the There are a few scenarios though that I want to address with you where the Traditional 401K can still win over the Roth 401K and tax free growth: 

Scenario A: High Income Tax State Now, Low Income Tax State Later

If you live in a high tax state like California, Oregon, New Jersey or New York and plan to retire somewhere like Florida or Texas (no state income tax), then contributing pre tax now and paying lower taxes later can absolutely make sense. But, for most people, no one can guarantee where they’re going to be 20+ years from now. 

Scenario B: You Invest the Current Tax Savings in a Roth IRA

If you’re disciplined enough to take the tax savings from your Traditional 401K contributions and invest it in a Roth IRA, you can create the best of both worlds. This strategy absolutely requires discipline but it can be really powerful for long term growth and tax savings.

Scenario C: Charitable Giving

If your long term plan is to leave your 401K to a charity, then Traditional contributions can be a smart move. Why? Because neither you nor the charity will ever pay taxes on those funds. Of course, this strategy assumes you’re in a financial position where you won’t need to rely on those future distributions to cover your own lifestyle. But if giving is part of your legacy plan, choosing Traditional contributions today can make a lot of sense.

Scenario D: Roth Conversions in Early Retirement

One strategy worth mentioning is the idea of Roth conversions in early retirement. This can be a smart move if you stop working before Social Security kicks in and before you start taking income from your retirement accounts so now your income is temporarily lower. 

Roth 401K vs. the Traditional 401K. Age, location, current income, assumed future income, marriage status, etc. all play into the decision. 

There is no telling what your total income will be 40 years from now, what income tax bracket you will be in or what your 401K balance has grown to.

But with that said, I don’t believe the Roth 401K is always the “best” option, despite how often it gets marketed that way. 

As you can see from all the scenarios above, there are a lot of factors that play into which account type makes the most sense for you. 

Personally, I tend to lean toward the Traditional 401K for most people because it offers immediate tax savings and greater flexibility. 

Yes, there are some unknowns around future tax rates, but that’s part of the planning process. From a purely numbers standpoint, there are plenty of smart strategies we can use to optimize cash flow and make your money work harder for you both now and in the future.

That said, if you’re the type of person who values simplicity, wanting the clear cut option where you pay taxes now and then never have to think about it again, the Roth might feel more aligned for you. 

Neither choice is inherently wrong, but the “best” decision really depends on your income now, your income later, the state you live in and your long term goals.

Either way, you’re making a great decision by investing in your retirement at all.

Learn More + Next Steps

Want a deeper dive? Check out my blog post: The Roth IRA.

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