If my 401k has a Roth option, should I do that or Traditional 401k contributions?

The short answer is… a Roth account can help you effectively save more if you already saving at the IRS limits using a “traditional” retirement account.

As background, regular or “traditional” 401k contributions go into your account pre-tax, i.e. you are not taxed at the time of the contribution to your account, but you are taxed later in retirement when you use the money as income. Roth contributions are taxed before they go into your account and are not taxed in retirement, assuming tax laws don’t change (however there is a rule that your first Roth balance must exist for at least 5 years before you can access the money without paying taxes again). In other words, they both have beneficial tax treatment.

There are several interesting nuances regarding Roth vs. traditional contributions, but for most people, the key factors to consider are:

• If tax rates stay the same, there is no tax benefit difference. However, given that tax rates could change, using a combination of Roth and regular contributions (which can be contributed to and held simultaneously, they are not mutually exclusive) can be a tax-hedge, and you can choose which “bucket” you’d like to pull from first in retirement, based on your view of taxes or other factors.
• Because Roth and regular contributions are subject to the same contribution limits, making a Roth contribution is effectively a way to save more, and is therefore especially helpful for people who are already at the IRS savings limits using “traditional” contributions but would like to increase savings. For example, if you save $1,000 into Roth, you will have $1000 (plus any earnings) to use in retirement, since the tax happens at the time of the contribution, not in retirement. That same $1,000 in a “traditional” retirement account was not taxed when you contributed it into your account, for example, if your tax rate is 30% in retirement, you would have $700 to spend (i.e. $1000 less 30%), instead of the $1,000 that you would have in the case of a Roth contribution (plus any market growth in both cases). So, Roth effectively allows you to save 30% more (or whatever % your effective income tax rate is).

If your budget is very tight currently, using regular/traditional contributions can be helpful option since it has a smaller impact on your paycheck (since contributions aren’t taxed now, it costs you less than $1 to save $1). When or if you have more budget flexibility, or are maxing out traditional contributions but would like or need to save more, Roth might be the better vehicle (somewhat depending on future tax rates).

Also, note that if you have both Roth and regular accounts in retirement, it generally makes sense to withdraw Roth money first, so the regular tax-deferred money grows longer while tax-deferred. However, if tax rates rise, it may be advantageous to draw from your Roth assets. Consult your tax attorney or financial planner for exceptions for your situation… for example, Pulling from Roth first may also be advantageous for those with higher-wealth, given/depending on inheritance tax laws and exemptions and related goals, or other dynamics specific to your situation.

Also, it is possible to convert some or all of your traditional balances to Roth balances (within an IRA, or within a 401k, if your 401k offers Roth and allows conversions), but you must pay the tax to conduct the conversion, since the IRS treats the conversion amount as income. If you choose to do a conversion, remember these tips: You may benefit from staging the conversion over multiple years, if doing the conversion in 1 year causes you to shift into a different income tax bracket (i.e. to avoid paying extra taxes).  It is impossible to know when investment markets will be up or down, but if you’ve been planning to do a Roth conversion and the market happens to drop significantly, that can be an advantageous time for a Roth conversion because your balance is temporarily lower, which means that your tax would be calculated on a smaller conversion balance. Also, it is difficult to know when tax rates will change, but doing the conversion when tax rates are lower will also decrease the tax impact.