Retirement plans can be confusing. They sound like an alphabet soup – 401(k), 403(b), SEP, SIMPLE, 457, and more.
Let’s take a look at two of them today – the Roth 401(k) and the Traditional 401(k).
One of the more common questions is, “Which is better?” As with most financial questions, the answer is: it depends!
The truth is that no one can say definitively which is better. There are too many variables and, more importantly, nobody knows what tax rates will be in the future, which is a huge factor in the analysis.
I’ll give you the knowledge and tools to evaluate the decision for yourself. This way you can make the best-informed decision instead of randomly signing up for a Roth 401(k) or Traditional 401(k) without knowing how it will impact your future.
What is a Roth 401(k)?
A Roth 401(k) is a type of retirement savings plan where you contribute after-tax money, and withdrawals are tax-free after age 59 ½.
The keyword is “after-tax”, meaning you are paying tax on the dollars you contribute today. Said another way, you are voluntarily paying more in taxes today to avoid paying taxes in the future.
Special Note: If your employer offers a company match and you are contributing to the Roth 401(k), your company match will be contributed to the Traditional 401(k) portion. This means money is being contributed pre-tax and, in retirement, you will pay tax on the withdrawals from the employer match portion.
For example, if you contributed the maximum to your Roth 401(k) ($19,500 in 2021) and your employer match worked out to $3,000, you would have $19,500 growing tax-free and $3,000 growing tax-deferred.
What is a Traditional 401(k)?
A Traditional 401(k) is also a type of retirement savings plan, but instead of contributing after-tax money, you are contributing pre-tax money, and withdrawals in the future are taxed.
The keyword is “pre-tax”, which means you are not paying tax on the dollars you contribute. This means you are lowering your taxable income and the amount of tax you pay today. The downside is future withdrawals are taxed.
I’ll cover whether it is better to pay tax today or in the future down below.
Does Your Employer Offer Both Options?
Now that you know more about both options, you need to ask your employer if they offer a Roth 401(k) and Traditional 401(k). Some employers offer no retirement plans. Others only offer a Traditional 401(k) because the Roth 401(k) is a relatively new savings vehicle. It was introduced in 2006.
This in contrast to the Traditional 401(k), which was created in 1978. It wasn’t until 1981 that the IRS issued rules to allow employees to contribute through payroll deductions.
If your employer offers a Traditional 401(k) and Roth 401(k), you have a critical decision to make. Should you contribute 100% to the Traditional 401(k), Roth 401(k), or split the contribution between both?
Pay Taxes Now or Pay Later
As you may have guessed by now, the decision has everything to do with taxes. Do you want to pay the taxes now or later?
Most people would say pay the taxes later. In fact, many CPAs often do everything possible to reduce income in the current year. The problem with this approach is sometimes you voluntarily want to pay more taxes today to avoid paying more taxes in the future.
Stick with me for a moment. It will start to make more sense.
Let’s say you began investing early into the Roth 401(k) and never contributed to the Traditional 401(k). Let’s assume at retirement you have $1,000,000 all in a Roth 401(k). In this scenario, the $1,000,000 is truly yours. When you take withdrawals, not a penny of it will be taxed. What you see is actually what you can receive.
Instead, if you contributed to the Traditional 401(k) your entire career and never contributed to the Roth 401(k), your money has never been taxed. Let’s also assume in this scenario that you have $1,000,000 at retirement. The difference is that $1,000,000 is not all yours. Uncle Sam has been investing alongside you. Any money you take out will be taxed.
For example, if you distributed the entire account, you would be taxed at 37% at today’s tax rates for a large portion of it. Let’s say your effective tax rate is 30%. In that scenario, your $1,000,000 is only $700,000. If you tried to withdraw the entire account for living purposes, your dream house, or vacations, you would not receive the full amount.
This can be tough to conceptualize because when you look at your retirement account, you look at it as all yours, but that isn’t the case. If you see $10,000 in it, you really only have $7,000-$9,000, assuming an effective tax rate of 10%-30%, of your own money after taxes.
Very few people pay attention to their future tax rate. This is a mistake.
Most people think they will be in a lower tax bracket in retirement, but this isn’t always the case. If you do a phenomenal job saving and/or have other income sources, it’s entirely possible you could end up in a higher tax bracket in the future once you are collecting Social Security, taking IRA withdrawals, and receiving rental income.
Even if you don’t have other income sources, tax rates could go up. If you receive a tax deduction today at 12%, but your future tax rate is 22%, you are paying ten percentage points more of tax and a Roth 401(k) would have been a better option.
Let’s use another example to highlight this point. At the same time, I’ll answer another common question, “What about the opportunity cost of paying the taxes today? Shouldn’t we analyze more than just the tax rate today versus the future?”
Spoiler alert: no.
You “simply” need to determine if you will be at a higher tax rate today or in the future to decide whether a Traditional 401(k) or Roth 401(k) is a better deal.
For example, if you contribute $10,000 to a Traditional 401(k) and are in the 12% tax bracket today, this means your tax savings is $1,200 in the current year ($10,000 x 12%). The total cost of making the contribution is $8,800 to you today. If you make no contributions and allow it to compound at 7% annually for 35 years, it will be worth approximately $106,765.
If you distribute the account at a 12% tax rate in retirement, the after-tax amount you receive is $93,953.20 ($106,765 x 12%).
Instead, let’s say you want to contribute to a Roth 401(k) while you are in the 12% tax bracket, but because you are contributing after-tax money, you can only contribute $8,800 (not the full $10,000 like before). If you allow the $8,800 to compound at 7% for 30 years, it will be worth approximately $93,953 – the same exact amount as the after-tax amount of the Traditional 401(k).
I wanted to provide real numbers for you to see that the opportunity cost of paying taxes today does not matter. You only need to estimate your tax rate today versus the future.
If you want to analyze the numbers yourself, use this calculator. You’ll see that if you make the current tax rate 22% and the retirement tax rate 22%, your after-tax values of the Traditional 401(k) and Roth 401(k) are equal.
Again, the IRS is investing alongside you with the Traditional 401(k). If you make $800,000 on your money, the full $800,000 is not yours. The IRS is likely receiving 10% – 30% of it when you distribute the money, resulting in only $560,000 – $720,000 after taxes. This is really important because if you look at your 401(k) balance, that is not actually the amount of money you can spend. It’s very different than when you look at your bank account. With your bank account, you can spend the full amount.
If you estimate your tax rate today to be lower than in the future, the Roth 401(k) is the better option.
If you estimate your tax rate today to be higher than in the future, the Traditional 401(k) is the better option.
Hedging Tax Rates
Can you say confidently what tax rates will be in 7 years, let alone 20+ years? I can’t.
One way to hedge your bet is to split the contribution between a Roth 401(k) and a Traditional 401(k). You don’t have to split it 50/50 either. You could split it 70/30, 20/80, or any other combination.
This is where you need to carefully think about your own situation and decide what is best for you.
With that said, my personal thoughts are below:
- If you are in the 12% tax bracket, you likely should not be contributing to a Traditional 401(k).
- If you are in the 35% or 37% tax bracket, you likely should be contributing to a Traditional 401(k).
- Everything else in between is a grey area.
While a tax deduction in the 22% and 24% tax brackets are appealing, we are in a historically low tax rate environment. If you contribute $10,000, you are saving $2,200 – $2,400 in taxes, meaning your contribution is really only costing you $7,600 – $7,800; however, remember to think about your future tax rate.
For many people, they could be in the same tax bracket in retirement or an even higher tax bracket. The tax brackets today are not permanent. They are due to sunset at the end of 2025 and in 2026, we would be in a higher tax rate environment because we would go back to 2017 tax rates. For most people, this means roughly that the 12% tax rate will go to 15%, 22% to 25%, and 24% to 28%.
This is the default trajectory. It’s entirely possible we see higher tax rates in our lifetimes.
If you are in the 22% or 24% tax bracket, it’s not a bad idea to split your contributions between the Traditional 401(k) and Roth 401(k). The 32% tax bracket is a tough decision. In most scenarios, you are likely better off contributing to the Traditional 401(k), but there plenty of possibilities where a Roth 401(k) makes sense.
Personally, I like hedging my bets. Plus, I am personally betting tax rates go up at some point in the future.
More than anything, I like locking in my taxes today. It’s nice knowing I have prepaid my taxes and the money growing tax-free for 30+ years is 100% mine. Uncle Sam is not investing alongside me for most of it. I won’t be subject to the whims of politicians wanting to change taxes. I like the certainty of it, which is why most of my retirement savings have been to a Roth 401(k).
Will I come out ahead? I don’t know. But then again, not every decision has to optimize your economic wealth. It can optimize your emotional wealth.
How Much to Save?
While we are on the topic of retirement plans, the next natural question is, “How much should I save?”
While that is a very personal question and depends on a wide variety of factors, I believe people should aim to save 15-20% of their income; however, I would not do it all in your 401(k).
The 401(k) is for retirement purposes and while it’s great to save for retirement, there are plenty of goals before retirement – buying a home, starting a business, taking a sabbatical, having a child, and more. A 401(k) plan is not going to be easily accessible for those dreams.
Please keep that in mind as you save. There are significant benefits to having an account you can use before retirement.
If you are easily saving the maximum to your 401(k) plan and can save additional money into a brokerage account, then, by all means, contribute the maximum. If you are unable to save the maximum, consider using a portion of your savings to invest in a brokerage account and then make small adjustments to your 401(k) savings each pay period until you start to feel it. Even $20 here and there can make a big difference over your lifetime.
Final Thoughts – Summary
While most people try to defer taxes as long as possible, a Roth 401(k) option can be an attractive alternative to a Traditional 401(k), particularly for people in the 12% tax bracket and even the 22% and 24% tax bracket.
With a Roth 401(k), you are locking in the taxes you pay today and have a lifetime to compound tax-free. With the traditional 401(k), it’s the opposite. You receive a tax deduction today, but you’ll owe taxes on future withdrawals. Remember, with the 401(k), your account balance is not all yours.
If you have not looked at your retirement plans recently, I encourage you to see if your employer offers a Roth 401(k) option. If they do, I recommend you make an active decision about whether to contribute to the Roth 401(k), Traditional 401(k), or split your contributions.
Taking it a step further, talk with a friend about it. Share what you are doing and ask them how they made the decision.
Good luck deciding and talking to a friend about it!