by Victoria 

The Grand Debate: Roth 401K vs. Traditional 401K


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written by: victoria mcgruder, cpa, cpwa®

It is a Question of When You Pay The Taxes

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.

What is the difference between the Roth 401K and the Traditional 401K?

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 Your contributions & earnings grow tax free and are withdrawn tax free in the future, after age 59 1/2.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…

  1. To a Roth 401K, you will be taxed on your gross pay of $100,000 @ 20% or $20,000.
  2. To a Traditional 401K, you will be taxed on your gross pay, less your 401K contribution. So ($100,000 – $10,000) $90,000. $90,000 income, taxed @ 20% = $18,000 of tax.

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.

Now Let’s Get To the Meat of This Debate

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…

“I Will Be In a Smaller Tax Bracket When I’m Retired. So A Traditional 401K Is Best”

Will you, though? Is it, though?

Consideration 1: Take into account future required minimum distributions

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.

Below is a required minimum distribution example:

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.

Consideration 2: You are making an assumption that there will be no significant changes to your current financial position.

You are not accounting for ANY changes in your life. What happens over that 20-40 year period when……

  1. You start a business and monetize it?
  2. Or you get a substantial pay increase that allows you to invest in more income producing assets and thus impacting and increasing your future taxable income?
  3. Significant wealth is transferred to you from an older generation?
  4. You received the benefit of tax credits that reduced your taxable income & tax rate as a result of having children & dependents on your tax return while in your 30’s and 40’s? But those tax credits won’t be there when you’re in your 70’s.
  5. You had the itemized deductions that reduced your taxable income as a result of owning a home. Like mortgage interest, real estate taxes, etc. but later on in life you don’t own a home and are now using the standard deduction?

The takeaway: Do not nonchalantly make the assumption that your income tax rate will be less in retirement.

When To Consider Investing in the Traditional 401K vs the Roth 401K

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.

  1. You are willing, able and committed to using those tax savings and investing them into a Roth IRA annually. Let’s use the same scenario above where you make $100,000, are in the 20% tax bracket and you save $2,000 per year by contributing to the Traditional 401K vs the Roth 401K. IF you are eligible to contribute to a Roth IRA (See below) and are committed and disciplined in taking that $2,000 and putting it into a Roth IRA account every year, then the Traditional 401K Option may be best for you.
  2. In order to follow through with this scenario, you also need to ensure that you are eligible to contribute to a Roth IRA. There are no income limitations with a Roth 401K, but there are with a Roth IRA. Review my blog post on Roth IRA Eligibility and Limitations by clicking here.
  3. Your future income tax rate when you begin taking withdrawals is either equal to or less than your current income tax rate.

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

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.

My Personal Reasons for Opting for the Roth 401K

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:

  1. Tax free growth and withdrawals to be used at my discretion during retirement. Stress free, no impact on tax rates, cash in my pocket to be used as I see fit.
  2. Having the flexibility to convert the Roth 401K to a Roth IRA in the future so I would not be required to take out distributions if I didn’t need them.
  3. If I had a goal of passing wealth on to my children, this is going to be one of the most tax efficient ways to do so. Converting my Roth 401K into a Roth IRA, allowing it to continue to grow tax free for the remainder of my life and passing on to my children tax free (assuming my estate is below the estate tax threshold).

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!!

Tune in to new blog posts every Tuesday and Thursday!

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Thank you for being here - I'm Victoria!

I'm a financial advocate, coach, and blogger on a mission to help you build wealth with confidence! 

Having worked closely with countless clients over my 14 year career, I've gained a very deep understanding of money management and effective planning strategies in guiding individuals and families towards financial success. Now, I want to share that wealth of knowledge and insight to empower YOU to take control of their finances, make well-informed decisions, and create a life of abundance without the stress of finances looming over you. I'm so glad you're here! 

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