401(k)’s: Traditional vs Roth
401(k)’s: Traditional vs Roth
It wasn’t that long ago that traditional contributions were your only option for 401(k)’s. Bob Dylan once sang: “The times, they are a-changin.” In this case, the times have already changed, with an estimated 90% or more of 401(k) Plans in the U.S. offering a Roth option. This is fantastic news.
But that begs the question, which one should you put your money into? The answer is not cut and dry, but we can still break this down to see what likely makes the most sense for you. Let me first make this clear, the more money you put into your 401(k), whether it’s Traditional or Roth, the better off you’ll be down the line; assuming the money in those accounts are properly invested.
So, it’s important not to succumb to paralysis by analysis. Splitting the contributions 50/50 will be far better than not doing anything at all. Having said that, depending on your situation, there may be a clear-cut winner.
First, a quick revisit of the difference between Traditional and Roth. It’s quite simple, and it all has to do with taxes. Picture Uncle Sam asking you this question: “Do you want your tax break now? Or do you want it later?” Remember, a ‘retirement’ account is another way of saying a ‘tax-advantaged’ account. That is the whole point of them, to put more money in your pocket and less in the IRS’s. It’s really their way of incentivizing you to invest for retirement.
With a Traditional 401(k), you get a tax deduction the year in which you contribute, but then have to pay ordinary income taxes when you withdraw it later in retirement. The Roth 401(k) is essentially the opposite. You get no deduction now, but can withdraw tax free later.
So, if paying less in taxes is the point of these accounts, we should aim to pay as little as possible. Again, this is not only legal but encouraged by the IRS. So, let’s break this down.
A simple rule some follow is this: If your tax bracket is higher now than you expect it to be in retirement, go for the Traditional. If you expect your tax bracket in retirement to be the same or more than it is now, go for the Roth.
This is a good rule of thumb to start with, but let’s go a little deeper.
Andy & Sarah, A quick comparison:
Let’s compare Andy and Sarah to help break this down. They are both 45, single, and earn about $230k a year, putting them in the 32% tax bracket. As of this writing, the maximum contribution to a 401(k) is $23,500. Let’s assume they both are going to max it out.
Andy chooses the Traditional 401(k), which gives him a tax break now. So, when the time comes to file his taxes, his taxable income drops from $230,000 to $206,500. Being in the 32% tax bracket, this is a tax savings of about $7,500. This is $7,500 that would have gone to the IRS, but stays in his pocket instead. Next year, assuming his income and contribution level stays consistent, will be another roughly $7,500 in tax savings, and again the next year; and so on.
Sarah has chosen the Roth 401(k), which gives her no tax break now. She contributes $23,500 to her Roth 401(k), and her taxable income stays at $230,000. No tax deduction, no $7,500 back in her pocket.
Let’s assume they both do this until they are 65, and then they retire. Let’s also assume their investment portfolios are exactly the same, and they achieve a 8% annual return.
With their annual contributions and a compounding growth rate of 8%, they both wind up with a 401(k) worth around $1,075,000. Now that they are retired, they start to withdraw it to supplement their income. They each withdraw $50k a year, and along with other forms of income they have, their total income in retirement each is $100,000, putting them in the 22% tax bracket (based on where brackets are currently). Sarah pays $0 on her withdrawal, Andy pays $11,000 in taxes (22% of $50,000).
So, Andy saved $7,500 on the way in, but Sarah saves $11,000 on the way out. Sarah wins. But wait, I thought a higher tax bracket while you’re working favors the Traditional 401(k)? Remember when I said it’s not cut and dry? There is much more nuance to this. Let’s go back and find out from Andy, what did he do with that $7,500 in tax savings each year? If he simply spent it on nonsense, then the Roth is the clear winner here. It wound up being the same size as the Traditional, but can be withdrawn completely tax free, which means more money in Sarah’s pocket in retirement.
But suppose Andy was smart and actually put that $7,500 to good use, such as making an extra mortgage payment, or putting it in an investment account that also returned 8% a year. So, instead of just contributing $23,500 to the 401(k), he’s adding an additional $7,500 to an investment account. Now, he winds up with an extra $343k when he’s 65.
Now, let’s revisit their $50k annual withdrawals. To get $50k net, Sarah needs to only withdraw exactly $50,000, since it is tax free. For Andy to get $50,000 net, he needs to withdraw about $64,000. So, his 401(k) is depleting faster than Sarah’s, at a clip of $14k a year. This means his money is also earning less and less interest/return than Sarah’s. But, since he was smart and invested his $7,500 tax savings each year, he has an extra $343k to draw from. And since that is in an investment account as opposed to a retirement account, he will not pay ordinary income taxes on it, only long-term capital gains.
You can see how complicated this can get. To get to the bottom of which strategy ultimately created the most wealth over the course of Andy and Sarah’s entire lives, factoring in taxes saved, we would do a sophisticated calculation such as a Monte Carlo simulation. But the purpose of this article is not to dive into a complex calculation. Rather, we want to keep it big picture so you can have a bird’s eye view of how the strategies differ.
Now, let’s go back to our comparison and assume this time that Andy and Sarah only make $85,000 a year while they’re working, putting them in the 22% bracket. So now, Andy’s contribution provides him with a tax savings of about $5,200, instead of $7,500. Also, given he is making less money, it’s far more likely he will need to spend that tax savings on bills, rather than invest it.
So, they still wind up with the $1,075,000, but now Andy has little to no extra investment on top of that. The Roth is the clearer winner here.
To add an extra complication on top of all this, we don’t know where tax rates will be in the future. Given our growing national debt, higher tax brackets down the road may be more likely than not, making the Roth all the more attractive. Remember, the higher tax brackets are when you’re retired, the more money the Roth will keep in your pocket.
Main takeaways:
The lower your income and tax bracket is now, the less money a tax deduction will save you. Leaning towards the Roth 401(k) could make more sense
The higher your income and tax bracket is now, the more money a tax deduction will save you, making a Traditional 401(k)k contribution more attractive, given that you invest the money you save
Since future tax brackets are unknown and ultimately unknowable, it’s perhaps prudent to put money into both, so you have some flexibility when the time comes to withdraw from them
Keep in mind, Employer Match contributions always go into the Traditional bucket
Having three buckets of money to withdraw from: taxable, tax deferred and tax-free is almost always going to be ideal as it provides the most flexibility so you can optimize your withdrawals to be as tax efficient as possible
As with most financial planning topics, nuance and detail is what each decision comes down to. And the best decision one year is not always the best decision the next year. Financial strategy should always be evolving.
If you want to take a deeper dive into Traditional vs Roth contributions, as well as other financial strategies, shoot me an email or fill out the contact sheet below, and we’ll talk soon.
Ryan Page, CFP®, MBA®
Office & Text:720-826-1092
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
