The grand debate around investing in a Roth 401K and a Traditional 401K all comes down to this one simple question. Will I be in a higher tax bracket today or in the future? Or another way to pose the question, do I want to pay tax on my contributions today or later on in life?
I have ALWAYS been a Roth lover. Tax free growth, tax free withdrawals – a complete no brainer in my opinion. But over the years I continue to become more skeptical of its “no brainer” nature. Well, I love numbers, enjoy geeking out in excel and have a passion for identifying what financial choice yields the best results. So I had to do an analysis for myself to figure it out.
So let’s break it down in a way that I hope makes sense for you as you begin to navigate your own decision to invest in the Roth 401K vs. the Traditional 401K and determine which option is best for you.
The Roth 401K – you are taxed on your contributions today. Your contributions & earnings grow tax free and are withdrawn tax free in the future, after age 59 1/2. (Refer to my The Roth IRA & Why I Love It blog post for more of the rules related to a Roth). You pay taxes upfront for the benefit of tax free growth in the future.
The Traditional 401K – your money is contributed into the 401K pre-tax. Your contributions & earnings grow tax deferred, to be taxed later on in life when you take withdrawals out from the account. You benefit by saving on taxes today but defer the tax payment for your future self to pay.
So for example (let’s use a very simple scenario, excluding the standard deductions and using hypothetical tax rates to focus on the concept and not the math):
You have an income of $100,000 and you are in the 20% tax bracket. If you contribute $10,000…
You saved and cut your current income tax bill by $2,000. $2,000 extra dollars that you get to use today to spend, invest, save however you see fit. This “extra” $2,000 and how you choose to use it will be one of the determining factors of whether or not the Roth or the Traditional 401K makes sense for you.
The most common response related to this debate is that “I will be in a smaller tax bracket in the future than I am in today.”
So in other words, why would I choose a Roth 401K and pay tax on my contributions today while in a higher tax bracket then I will be during retirement? Instead, I could put pre-tax dollars into the Traditional 401K, save money on taxes and pay the tax later on in life when I’m in a lower tax bracket. It’s certainly a reasonable thought process…of course there is a but to that…
Will you, though? Is it, though?
If you are actively contributing and investing into a 401K and consistently will continue to do so, one could strongly argue that your 401K will be a substantial account 25, 35, 40 years down the road. When you have a 401K – Roth or Traditional – you are REQUIRED to take out the minimum distribution as determined by the IRS using the distribution rate table starting at age 72.
You need to consider the amount you will be required to take out. The distribution, if in a Traditional 401K account, is taxed at ordinary income tax rates and will have a meaningful impact on your taxable income and tax rate. (Remember in the Roth 401K, your contributions and earnings withdrawals are tax free).
This required minimum distribution is based on your age and value of your 401K account. The larger the account, the larger the minimum withdrawal. The larger the withdrawal, the higher the tax bracket.
Let’s say you are a single tax filer, you save $5,000 per year into a 401K starting at age 25 to when you retire at 65. If the account grew at a rate of 7%, at age 72 your 401K will have grown to approximately $1.8 Million.
If in a Traditional 401K, using the IRS distribution rate table linked above, your required minimum distribution at age 72 would be approximately $70,000. That $70,000 will be reduced by your standard tax deduction of $12,550 making your taxable income about $57,450. You have now made it into the 22% tax bracket.
You are not accounting for ANY changes in your life. What happens over that 20-40 year period when……
The takeaway: Do not nonchalantly make the assumption that your income tax rate will be less in retirement.
Scenario A: Where are you living today? And where will you be living during retirement?
If you are currently living in California, New York City, Washington DC, New Jersey, or another state where the highest income tax rate is greater than 8%. And you are making a considerable income of $200,000+. Your current income tax rate between Federal and State could be anywhere between 40% – 50%.
If that is the case, and you one day plan to move to a state with lower income taxes or a state where there are no income taxes like Florida, this would be a scenario where I would strongly consider the Traditional 401K Option.
Scenario B: You Invest the Tax Savings Into A Roth IRA:
As we discussed above, the benefit of the Traditional 401K is that you save on taxes today because your contribution to your 401K will reduce your taxable income and thus reduce your tax due. Now IFFFFF the following applies to you….then I again would strongly consider The Traditional 401K Option.
High Net Worth Scenario C: You have significant wealth and plan to give the majority if not all of the IRA to a charity.
If you are charitably inclined and have an understanding that you will be coming in to significant wealth in the future, or your income is on track to provide for your future lifestyle and then some, perhaps you won’t need this 401K after all. (I will go into this in greater depth in another blog post). With that said, you are able to select a charitable organization as the beneficiary of your retirement fund. This will have accomplished two things – 1. You never paid taxed on your contributions. 2. By selecting a charitable organization to receive the funds, they will not be paying tax on the earnings or the withdrawals. Yay! No tax.
The bottom line is that there is not a one size fits all approach to this or personal finance for that matter. You have to get an understanding of your options, your risks, the benefits to each and make a decision that makes the most sense for you.
There are numerous variables that have an impact on the debate between the Roth 401K vs. the Traditional 401K. Age, location, current income, assumed future income, marriage status, etc. There is no telling what your total income will be 40 years from now, what income tax bracket you will be in or what your 401K balance has grown to.
But if I were to come up with a general overview of the multiple different what-if scenarios I created, the Roth 401K appeared to be the best option vs The Traditional 401K for many of the scenarios in the event that the annual tax savings between the Traditional 401K and Roth 401K (that $2,000 noted above) was not reinvested.
HOWEVER, if you took your tax savings from the Traditional 401K contribution and invested it annually into a separate Roth IRA, and your income tax was the same or less in the future – then that appeared to be the clear winner.
But as a general way of thinking for myself, my assumption is going to be that I will either be in a similar or higher tax bracket in the future than I am in today.
We don’t know what tax rates will be in the future, we don’t know what our retirement/health needs will be in the future, we don’t know exactly how the market will perform. But for me, I would rather opt for the Roth 401K, learn to live on a little less today and benefit from the following:
That’s all folks!
Woowee…..if you made it all the way to the end of this, I am sending you a giant air hug!!
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