Should I Contribute to a Traditional 401(k) or a Roth 401(k)?
Client Question: Should I contribute to a Traditional 401(k) or a Roth 401(k)?
Advisor Answer: As with many financial decisions, there are a host of variables to consider when making this decision. The general advice is to invest in the Traditional 401(k) if you believe your tax rate is higher now than it will be during retirement when you presumably need to withdraw the funds (and vice versa for the Roth). Although this general advice can make sense, it overlooks the benefit of contributing to both the Traditional and the Roth when it comes to taking portfolio distributions. Also, many people do not actually end up investing the initial tax savings from the Traditional 401(k), which can make the Roth 401(k) the better option in practice.
What’s The Difference Between a Traditional and a Roth?
Contributions made to a Traditional 401(k) are tax-deductible and grow tax-deferred whereas contributions made to a Roth 401(k) are made with after-tax dollars and grow tax-free. So what does that mean? If you are in the 24% federal marginal income tax bracket and contribute the maximum of $19,000 to your Traditional 401(k), you will save $4,560 ($19,000 X 0.24) in taxes for the tax year in which you make the contributions. This is because $19,000 is deducted from the amount of income you are actually taxed on. This all sounds great, but the downside is all distributions from a Traditional 401(k) will be taxed at your ordinary income tax rate during retirement.
Let’s say you chose to contribute $19,000 to a Roth 401(k) instead of a Traditional 401(k). In this case, you would not receive a tax deduction for making the contribution, and you would not get the initial tax benefit like you would have with the Traditional 401(k). The key benefit of a Roth 401(k) is tax-free growth as opposed to tax-deferred growth. This is best illustrated in an example: Assuming a 7% investment rate of return, $19,000 would grow to $144,632 after 30 years. If the $144,632 was inside a Traditional 401(k), all distributions would be fully taxable at one’s ordinary income tax rate. In contrast, none of the funds would be taxable when withdrawn from a Roth 401(k). Assuming a 20% effective income tax rate during retirement, the assets inside the Roth 401(k) would be worth 20% more (or $28,926.40 since $144,632 X 0.20 = $28,926.40) than the assets inside the Traditional 401(k).
It is Important to Invest the Tax Savings from the Traditional 401(k)
In the example above, it seems clear the Roth 401(k) would have been the better option since $28,926.40 is more than $4,560. As Lee Corso from the ESPN show College GameDay says, “Not so fast, my friend!” If the original $4,560 of tax savings had been invested and earned an investment rate of return of 7% over 30 years, it would have grown to $34,711, which is larger than the $28,926.40 of tax savings associated with the Roth 401(k). Here, we can see that having a lower tax rate when the contribution was made as compared to when the funds were withdrawn resulted in a situation where the Traditional 401(k) was more beneficial. The benefit would have been equal in both cases if the tax rates had been the same. More specifically $19,000 X 0.20 = $3,800, and $3,800 would grow to $28,926.40 after 30 years assuming a 7% investment rate of return; this is the same exact amount as the tax benefit from the Roth 401(k) in the previous example.
Many people don’t realize the tax savings from a Traditional 401(k) come in the form of a larger tax refund and/or or a smaller tax payment to the IRS at the end of the tax year. In practice, it is rare for people to actually invest their tax refunds/savings. Instead, people spend the tax savings or stash them in their bank accounts. The result is that the true tax benefit of the Traditional 401(k) is often not realized. This is why I initially mentioned the Roth 401(k) often ends up being the better choice in practice.
Why Not Both?
Often times, it is actually most beneficial for people to contribute to both a Traditional and Roth 401(k). If you have a Roth 401(k) option available, you should have the ability to contribute to both a Traditional 401(k) and a Roth 401(k). Many employees only have a Traditional 401(k) option available.
A major benefit of having both Traditional and Roth 401(k) assets is you may be able to take advantage of the marginal income tax rate system during your retirement years, which I detailed in my newsletter titled, “How Much am I Paying in Taxes?” In order to avoid re-explaining, I will give a relatively easy example to illustrate the benefit of having both Traditional and Roth assets.
Let’s assume you are retired, have no source of income besides your 401(k) assets, and need $70,000 per year to live on. As an individual taxpayer, you can take the standard deduction of $12,000. This means the first $12,000 of your income is not taxed at all. To take advantage of this, you could withdraw $12,000 from your Traditional 401(k), which is taxed at your ordinary income tax rate, without being taxed on any of it. You could then take the remaining $58,000 ($70,000 – $12,000) from your Roth 401(k), which would not be taxed because Roth assets are distributed tax free. If you would have taken the $58,000 from your Traditional 401(k), it would have been taxed.
In this case, you received an initial tax deduction for contributing to the Traditional 401(k) (see example above with $4,560 of tax savings), and you were not taxed on the $12,000 distribution from the Traditional 401(k) during retirement. Basically, we are creating a situation that ensures the tax rate during your working years was higher than tax rate actually applied to your distributions.
In this article, I mentioned a couple things to think about when making the decision to utilize a Traditional 401(k) and/or Roth 401(k). In reality, there are many other factors to consider that I would be happy to discuss with you as part of my One-Time Financial Plan.
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