The Three Types of 401(k)’s: Traditional, Roth, & After-Tax 401(k)’s Explained

By: Scott Sturgeon, JD, MBA, CFP®

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While having access to a 401(k) through work certainly isn’t a bad thing, it does come with a multitude of challenges and decisions to make to ensure you’re approaching it to fit your personal financial situation. How much should I contribute? Which type of 401(k) is a good fit for me? How should I invest each type of 401(k) account?

In this article, we will explore the three main types of 401(k) plans: Traditional 401(k), Roth 401(k), and After-Tax 401(k)’s. By delving into their unique features, advantages, and considerations, you’ll be better equipped to choose the plan that aligns with your financial planning retirement goals. Remember, employers may vary in which of these types of plans are available as part of your employee benefits package, so confirming what’s available to you might be a good first step.

With that out of the way, on to the three types of 401(k) plans…

Traditional 401(k) Plan

The Traditional or Pre-Tax 401(k) plan is the most common type offered by employers. It allows employees to contribute a portion of their pre-tax income to their retirement account, usually as a percentage of their pay, throughout the year. The key features of the Traditional 401(k) plan include:

1. Pre-tax Contributions: Contributions made to a Traditional 401(k) plan are deducted from the employee’s gross income, reducing their taxable income for the current year. This provides an immediate tax advantage, especially for higher income earners. If your income is currently higher than you anticipate it will be in retirement or future years, there’s a decent chance putting more money into a Traditional 401(k) might make sense.

2. Tax-Deferred Growth: The earnings generated on investments within the Traditional 401(k) account are not subject to taxes until withdrawals are made, ideally during retirement. That means unlike a taxable brokerage account, you won’t pay any income taxes on interest, dividends, or capital gains generated within a Traditional 401(k) account. This tax deferral allows the account to grow at a potentially faster rate as funds that would normally go towards taxes can instead be reinvested into the account.

The catch though, is that when you go to make withdrawals from your 401(k) in retirement (sometimes after it’s been rolled over to an Individual Retirement Account (IRA)), you pay income tax on any amounts distributed from the account. Tax planning becomes vitally important during this process as there may be approaches you can take to reduce the amount you pay in taxes as a result over time.

3. Required Minimum Distributions (RMDs): Starting at age 72 (soon to be 75), individuals are required to withdraw a minimum amount from their Traditional 401(k) accounts annually. These required withdrawals are subject to income tax and the percentage of the account that must be withdrawn increases as you get older.

For some retirees, RMD’s amounts may end up being more than they actually need to live on, requiring them to pay taxes on income they don’t really need! With some advanced planning, this kind of scenario can be reduced or eliminated via Roth IRA Conversions, but it requires careful analysis to determine whether this strategy makes sense or not.

Roth 401(k) Plan

The Roth 401(k) plan is an increasingly popular addition to retirement savings options through work. It combines features of a Roth IRA with a Traditional 401(k) plan. Key aspects of the Roth 401(k) plan include:

1. After-tax Contributions: Unlike the Traditional 401(k), contributions to a Roth 401(k) are made with after-tax dollars. This means that contributions do not provide immediate tax benefits, typically making it less attractive for high income earners.

2. Tax-Free Withdrawals: Qualified withdrawals from a Roth 401(k) account (sometimes rolled over to a Roth IRA in retirement), including both contributions and earnings, are tax-free, provided the account has been open for at least five years and the individual has reached age 59½. This is arguably one of the strongest benefits of having a Roth 401(k) or resulting Roth IRA since retirees can use those tax free withdrawals to offset other taxable income streams and ideally keep themselves in lower tax brackets as a result.

3. No RMDs: Unlike the Traditional 401(k), starting in 2024 Roth 401(k) accounts are not subject to RMDs during the account owner’s lifetime. This makes it an attractive option for those who do not need to access their retirement funds immediately. Additionally, when the account owner passes away, a Roth 401(k) can be transferred to a surviving spouse or non-spouse beneficiaries carrying with it the same benefit of tax-free withdrawals. That’s different and arguably more beneficial than a Traditional 401(k) left to non-spouse beneficiaries who often must begin taking distributions from the account within 10 years.

After-Tax 401(k) Plan

In addition to the Traditional & Roth 401(k), there is another type called the After-Tax 401(k). While probably the rarest of all three types of 401(k)’s, it’s most similar to the Roth 401(k) in some respects, but the After-Tax 401(k) plan also has its own unique characteristics:

1. After-Tax Contributions: With an After-Tax 401(k) plan, employees contribute funds with after-tax dollars, just like in a Roth 401(k). For high income earners, this feature is attractive for a couple different reasons. First, as described below, it provides an avenue by which those who earn too much money to make indirect Roth IRA contributions. Secondly, the amount that can be contributed is higher than the annual cap on Traditional & Roth 401(k) contributions, allowing for increased retirement savings in general.

2. Mega Backdoor Roth IRA: One significant advantage of After-Tax 401(k) plans is the opportunity for a conversion or what’s also called a Mega Backdoor Roth IRA. Employees can choose to convert their After-Tax 401(k) contributions into a Roth IRA or a Roth 401(k) through a process called an in-plan Roth conversion. By doing so, they can enjoy tax-free growth and tax-free withdrawals in retirement as those funds are eventually being moved to a Roth IRA. Since contribution amounts to After-Tax 401(k)’s are higher than Traditional or Roth 401(k)’s, this can be a great strategy to implement for those with excess cashflow.

3. Considerations: While After-Tax 401(k) plans offer conversion options and by extension tax-deferred growth and, it’s crucial to assess your specific financial situation to determine if this strategy makes sense to implement. Factors such as your income level, expenses, retirement goals, and tax strategy should be considered. Consulting with a wealth advisor or tax professional is recommended to determine the optimal strategy for your individual circumstances.

By familiarizing yourself with the different types of 401(k) plans—Traditional, Roth, and After-Tax—you make contributions and invest in a way that fits your current financial situation. Perhaps more importantly, you can determine which of these plan types to contribute your earnings to and at what point in your career to do that, in order to create tax efficiencies over time. As always, it’s essential to evaluate your financial goals, tax situation, and long-term retirement objectives before making any decisions. Seeking guidance from a fiduciary wealth advisor or tax professional can provide personalized insights and help you determine how to implement various 401(k) strategies custom to your individual situation.

Curious to learn how working with a seasoned CFP® professional at Oread Wealth Partners can bring value to your unique financial situation? Let’s talk.

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