Q: My employer has added a Roth 401(k) option to our retirement plan. What is the difference between the Roth 401(k) and a traditional 401(k)? How do I know which one is right for me?
A: In a 401(k), employees contribute money to their retirement savings using pre-tax income. With a Roth 401(k) deduction are taxed at the time of contribution. This means that you will have to pay taxes on the traditional 401(k) money when you withdraw it for retirement. However the Roth 401(k) withdrawals are tax free just like a Roth IRA.
So the simple answer is that a 401(k) contribution is made pretax and Roth 401(k) contribution is made after taxes have been taken out. This means that the withdrawals on the traditional 401(k) are taxable where withdrawals from Roth 401(k) are not.
Now the choice of plans requires some educated guessing on your part. Are you going to make more or less when you retire? What will the tax structure be like when you retire? How are you supposed to know?
The fact is that you can’t know what the tax rates will be like when you retire. You also won’t be able to judge what your retirement income will be at 59 ½ when you are 29. Life just doesn’t work like that. The best you can do is run some numbers and judge for yourself with some advice from a tax advisor like a CPA.
So what if we keep our contributions pretax with the traditional 401(k)? Say we are in the 25% tax bracket and we are contributing $10,000 per year to our 401(k) plan. We will assume a 10 percent return on all of our investments. Let’s assume we are married and filing jointly. Let’s also assume that the tax structure is exactly the same in 30 years. Will we end up with more money with the Roth or the traditional IRA?
Traditional 401(k)
With the traditional IRA, all of our money is working for us until retirement, so let’s calculate the future value of $10,000 in 30 years. Assuming an annual return of 10%, it’s about $174,494. Not bad, however, when we go to withdraw this money we have to pay taxes. If we assume that withdrawing $174,494 puts us into the 28% tax bracket then we will have about $143,635.49 after taxes. The calculation for taxes is simply the amount withdrawn minus the taxes owed which is:
$174,494 – ($24,972.50 + (($174,494 – $128,500) * .28)) = $143,635.49.
Roth 401(k)
The Roth is easier to calculate. Assuming the money we contribute is at the 25% marginal rate we lose $2,500 right away to taxes. So that leaves us $7,500 to invest over 30 years. Again assuming a 10% annual return over 30 years we end up with $130,870. With everything else remaining equal we will end up with less money
The above example is a very simple estimation assuming the only income you will have in retirement is the money you withdraw from your IRA. I also assumed we would withdraw the whole earnings on our initial $10,000. You probably wouldn’t do that unless you needed all the money.
I can’t predict the future and I’m betting you probably can’t either. Events that are out of you immediate control will have a huge impact on your financial future. Consider the retirement plans themselves. Will congress continue to allow these types of tax sheltered investments? After all we have a huge national debt that should be paid at some point. What if future congresses aren’t as favorable in there tax policy? What if they are more favorable?
How in the world can you know what the world will be like when you retire in thirty years? Think about what happened in the last thirty; the end of Communism, the rise of personal computers and the internet. In the 1970’s income in the top bracket was taxed at 70 percent. In the 50’s it was 90 percent. Tax policies can and do change.
We don’t know what the future holds so how can we plan accordingly? At some point you must accept that there is a large amount of risk in the future. You have to make the best educated guess. We started by running the numbers and making some basic predictions about the future based on the past and present.
My opinion is to avoid the Roth 401(k) unless you and your CPA decide otherwise. I’m against guaranteed losses and you are locking in an instant loss by choosing the Roth option. I would rather have my money grow tax free and deal with the tax consequences at retirement. As stated before, there is no way I can know that the tax landscape will be like when I retire. There are some hints from the past that can help me plan, however.
Watching congress and the president over the past years, we’ve seen up and downs in tax rates. Knowing that these will fluctuate depending on the party in power we can choose to withdraw our money at a time when tax laws are more favorable. Considering that we can begin withdrawing the money at 59 ½, we have a large window of opportunity, considering that you have until the year after you turn 70 to begin distributions of your 401(k). So we have a ten year window of opportunity to withdraw our money when tax policy appears most favorable.
Remember, you should understand the consequences of any investment decision. Doing your own research is a good start. If you have any questions you should consult a qualified professional.
Resources:
Wikipedia Entry on Traditional 401(k)
Wikipedia Entry on Roth 401(k)
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Comments
3 Comments so far
You make some nice points. However, many believe a smarter approach for most will be to hedge. That is you can put a % in tax deferred (traditional) and a % into Roth — perhaps 50% of your target savings percentage (or dollar amount) in each.
If taxes increase over time or you graduate to higher tax levels, you will be in better position come retirement — have more options. For example, you may be able to avoid being taxed at a higher levels or amounts as some of your income won't be taxable from the Roth come retirement age.
Also note that all employer matching contributions must be made tax deferred as you decide how much to put into your Roth.
Lastly, Roth 401k does not have any income restrictions like the Roth IRA which may make it a more appealing option for high earners.
Best,
Stuart
Stuart,
I have seen the hedging strategy and I don't think it's a terrible idea. However, I value simplicity at this point and having yet another investment "bucket" doesn't appeal to me at the moment. I already take advantage of the original Roth for after tax investments. However a regular Roth does phase out as your income climbs.
Hopefully I've illustrated that you should at least run the numbers and understand the implications on the growth of investment dollars before and after tax. In my experience many people don't even begin to understand how to do the calculations. Also the material that came with our Roth 401(k) was unhelpful at best.
Again, investors should seek qualified council, like a CPA, if they don't understand the implications of their retirement planning choices.
Thanks for the comment Stuart!
I agree with much of the article, but feel your comparison of Traditional 401K v. Roth 401K is a bit misleading.
In your example, the difference in the amount of your 401K after 30 years is solely due to the percentage of tax you pay, as you are paying a lower effective tax rate on the Traditional 401K (17.68%) compared to the Roth 401K (25%). If you increased the effective tax rate of the Traditional 401K to 25% you would end up with the same amount of money after tax in 30 years regardless of whether you selected a Roth or Traditional 401K.
Thus, your decision to select between a Roth or Traditional 401K (or IRA) boils down to what you predict your effective tax rate will be in 30 years compared to your present effective tax rate (along with additional estate planning benefits provided by the Roth). In other words, the future value of your investment is only affected by the effective tax rate that you pay, not whether you are taxed at that rate now (Roth) or in the future(Traditional).