Should I Split My 401(k) and Roth Contributions?

Employer-sponsored 401(k) plans are a key part of retirement planning, offering a structured way to save with tax advantages. Within the 401(k) framework, two primary options exist: the traditional 401(k) and the Roth 401(k). Understanding their distinctions and how to strategically allocate contributions can significantly influence one’s financial well-being in retirement. This article clarifies these differences and provides a framework for informed decisions.

Traditional 401(k) and Roth 401(k) Fundamentals

A traditional 401(k) operates on a pre-tax contribution model. Money contributed is deducted from your paycheck before federal income taxes, reducing your current taxable income and providing an immediate tax benefit. Investments grow on a tax-deferred basis, meaning you do not pay taxes on any investment gains until you withdraw the funds in retirement. When withdrawals are made, both original contributions and accumulated earnings are taxed as ordinary income at your then-current rate.

In contrast, a Roth 401(k) is funded with after-tax dollars. Contributions are made from your paycheck after taxes have been withheld, offering no immediate tax deduction. The significant advantage comes in retirement: qualified withdrawals, including both contributions and earnings, are entirely tax-free. For a withdrawal to be qualified, you generally must be at least 59½ years old and have held the account for at least five years. This tax-free growth and withdrawal feature can be particularly appealing.

Both traditional and Roth 401(k) plans are subject to annual contribution limits set by the IRS. These limits apply to the total amount an employee can contribute across both types. For 2025, the employee contribution limit is $23,500. Individuals aged 50 and over are eligible for additional “catch-up” contributions.

Employer contributions, such as matching funds, are typically pre-tax, even with a Roth 401(k). This means employer contributions and their earnings are taxed upon withdrawal. The overall limit for combined employee and employer contributions is separate from the employee deferral limit.

Key Considerations for Your Allocation Decision

Deciding whether to contribute to a traditional 401(k), a Roth 401(k), or a combination depends on your current financial situation and future expectations. A primary factor is comparing your current income tax rate to your anticipated rate in retirement.

If you expect a lower tax bracket in retirement, a traditional 401(k) may be advantageous. The immediate tax deduction reduces current taxable income, and withdrawals are taxed later at a lower rate.

Conversely, if you anticipate a higher tax bracket in retirement, or if tax rates increase, a Roth 401(k) might be better. Paying taxes on contributions now allows for tax-free withdrawals in retirement. This strategy benefits younger individuals expecting higher income and tax brackets over their careers.

Your time horizon, the length of time until retirement, is another consideration. A longer time horizon generally favors the Roth 401(k) due to a greater period of tax-free growth, maximizing tax-free withdrawals. The power of compounding returns on tax-free earnings can be substantial over several decades. Even with a shorter time horizon, tax-free growth benefits can still be significant.

Tax diversification is a common strategy, involving assets in accounts with different tax treatments. Contributing to both traditional and Roth accounts creates flexibility to manage taxable income in retirement. You can withdraw from tax-free Roth accounts in years with higher income, and from traditional accounts when your taxable income is lower.

Current income level also influences the decision. Unlike Roth IRAs, Roth 401(k) contributions have no income limitations, making them an option for high-income earners. A Roth 401(k) provides a pathway to tax-free retirement income for those phased out of Roth IRAs. Employee contribution limits still apply across both traditional and Roth 401(k)s.

Strategies for Optimizing Your Retirement Savings

Optimizing retirement savings involves tax diversification, spreading investments across accounts with varied tax rules. This provides flexibility to choose which accounts to draw from based on your tax situation. For example, in a year with higher expenses, you could draw from your tax-free Roth account to avoid increasing taxable income. In years with lower income, you might withdraw from your traditional 401(k) to utilize lower tax brackets.

Individuals can adjust their allocation between traditional and Roth 401(k) contributions throughout their careers. Early in a career, with lower income and tax brackets, contributing to a Roth 401(k) can be beneficial, as taxes are paid at a lower rate on contributions, allowing tax-free growth for many years. As income increases and an individual moves into higher tax brackets, shifting some contributions to a traditional 401(k) could offer a valuable immediate tax deduction. This allows for proactive tax planning based on changing income levels and evolving tax laws.

It is important to periodically review your financial situation and retirement goals to ensure your contribution strategy remains aligned with your objectives. Tax laws can change, and personal circumstances such as income, marital status, or anticipated retirement lifestyle can evolve. Regularly assessing your allocation helps you adapt to these changes and maintain an optimized retirement savings plan.