To Roth or Not: Deciding between Traditional and Roth Contributions to 403(b) and 401(k) Plans

This post is an update of one I originally wrote in 2008 for University of Illinois Extension’s Plan Well, Retire Well blog.

My Human Resources Office just informed me that I now have the option of making some or all of my 403(b) plan contributions as Roth contributions, into what is known as a Designated Roth Account. Your employer may be offering you the same choice for your 401(k) or 403(b) plan. So how do we decide–To Roth or Not?

But before I go on, here’s my bottom line: Most of us should be putting as much as we can aside for retirement. Just making some kind of contribution, even it’s just $50 a month, to your retirement plan or IRA is the important thing. And you can do as much as $23,000 per year (2024). If you’re age 50 or older, you can make an additional $7,500 catch-up contribution each year.

Now, on to the “Roth or Not” decision.

Here’s the choice:

1. Roth: Would I rather pay taxes now on my contribution, and never owe tax on any dividends or gains?
2. Tax deferred: Would I rather reduce my taxes now, deferring the tax on my contributions until I take the money out? But then I’ll owe tax on all the money–contributions, dividends, and gains.

I also have the option of splitting my contribution – designating some as Roth, and the remainder as tax-deferred.

If my tax rate stays the same, the tax-deferred and Roth options are mathematically equivalent. That means that I would end up with the same amount of money whichever I choose. This assumes that I keep my take-home pay the same.

For example, say I’ll contribute $1000 per month if I choose tax-deferred. If I choose Roth, the equivalent would be contributing $850 per month if I’ll pay $150 more in taxes. If tax rates stay the same, my Roth balance will be the same as the value of the tax-deferred account after I pay tax on the distributions.

So what should I do? Here are the things I will consider in making my decision.

• Currently, income taxes are at historically low rates. While I don’t believe anyone can predict the future, my guess is that income tax rates will probably be higher by the time I retire and use the money in my 403(b). But my income will probably be lower too, which would put me in a lower bracket if the rates don’t change. If I think rates will increase enough that my personal rate will increase despite my lower income in retirement, that’s Advantage: Roth.
• Other taxable income in retirement could cause up to 85% of Social Security benefits to be taxed. My Social Security benefits will be very small since I don’t pay into SS as a University employee, but my husband will get a more typical Social Security benefit. Distributions from a tax-deferred plan are taxable income and could cause those SS benefits to be taxed, but Roth distributions will not. Advantage: Roth.
• Illinois does not tax distributions from tax-deferred retirement plans, so my tax-deferred contributions are completely free of Illinois income tax forever. But I will pay Illinois tax on my Roth contributions. Advantage: Tax deferred.
• What benefits could I get now by making tax-deferred contributions and having less taxable income? A lower income could let me claim the Child Tax Credit, Saver’s Credit, education tax breaks like the American Opportunity Credit or Student Loan Interest Deduction. Since I have no kids or education expenses, and my income wouldn’t be low enough to claim the Saver’s Credit, I might not get any additional benefits from reducing my income now. For me, this is a wash. But depending on your individual situation, it’s very possible that it’s Advantage: Tax-deferred.
• Will a tax-deferred contribution actually reduce my taxes? As a widow with dependents and education expenses, my sister doesn’t end up owing any income tax. She would get no tax benefit from a tax-deferred contribution and it’s clearly Advantage: Roth. But I do pay income tax each year, so for me, It’s a draw.
• Maybe I can convince myself to contribute the same amount as a Roth contribution that I’ve been making as a tax-deferred contribution. I’d have to survive on less take-home pay. I’ll end up with the same amount in my retirement account as I would with the tax-deferred contribution–but I’ll owe no income tax on Roth distributions! This would be especially appealing if I’m already contributing the maximum to my plan. I can keep contributing the maximum, pay the taxes out of my take-home pay, and essentially shelter even more of my income from taxes than if I were making tax-deferred contributions. If you have the financial wherewithall to contribute the same amount to a Roth as you have been contributing to your tax-deferred account, it’s Advantage: Roth.
• To avoid the 10% early distribution penalty in tax-deferred plan, I must be age 59-1/2 before taking distributions unless I qualify for an exception. For a Roth 403(b) or 401(k), contributions are always tax- and penalty-free when distributed. But earnings are different. I must be age 59 ½ or disabled plus have participated in the Roth option for 5 years to avoid taxes (and maybe penalties), on the part of the distribution that is coming from the growth in the account. If I were planning to retire in less than 5 years and needed to start taking distributions before the 5-year mark, I would lose some of the tax benefits. So if you’re retiring soon and you haven’t already been contributing to the Roth option in your employer plan, it might be Advantage: Tax-deferred.
• If there’s still money in my account when I die, my heirs will have to pay tax when they take money out of my tax-deferred account, but the money in a Roth is tax-free to them. If they are in a higher tax bracket than me, it’s Advantage: Roth. But if their income and tax rate is lower, or I plan to leave the account balance to a charity, it’s Advantage: Tax-deferred.

I want to point out one significant difference between Roth 401(k)/Roth403(b) plans and Roth IRAs. With Roth IRAs, distributions are deemed to come first from your contributions. The result? You can take out all your contributions whenever you choose, without any taxes or penalties. But Roth 403(b) and Roth 401(k) plans distributions are considered to be a pro-rata mix of your contributions and the earnings in the account. If you don’t meet the 5-year/age 59 ½ rule on any distribution, you may pay taxes and penalties on the portion that comes from earnings.  

If the decision between tax-deferred and Roth is not clear-cut for you, maybe you’ll do what I will probably choose. I will probably split my contributions between Roth and tax-deferred. Some financial planners describe that as “diversifying tax risk.” I’ll pay some tax now, some later. If my taxes end up being higher in retirement, I’ll be glad I used the Roth option for some of my contributions. If I’m in a lower tax bracket, I’ll be happy that I chose tax-deferred for the rest.

For a more thorough discussion of the rules around distributions from both Roth IRAs and Roth 401(k) and 402(b) plans, see my post on Distributions from Roth Accounts: Qualified Distributions, Taxes, and Penalties. The decision of whether to convert money from a tax-deferred account to a Roth has even more factors to consider. See my post, Converting to a Roth IRA: Factors to Consider, for a discussion of those.

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Copyright 2008, University of Illinois. Used with permission of University of Illinois Extension. Revised 2023 by Karen Chan, Karen Chan Financial Education & Consulting, LLC.