Traditional vs. Roth 401k – Which is truly better?
This week Matt Robison and I put the Traditional 401k and the Roth 401k in a head-to-head battle of the retirement accounts. If you’ve been following this podcast for a while, you are well aware of what a 401k account is a tax-advantaged way to help fund your retirement. Just in case you need a refresher, a 401k, or 401(k), is a retirement savings plan offered by many employers in the United States. It’s a valuable tool that allows you to save for your retirement while enjoying potential tax benefits. There are two types of these accounts, a Traditional and a Roth. Which is right for you? Follow the fight to find out.
🥊 Round One:Traditional vs. Roth – The Taxes
First up in the ring, the two accounts swap jabs with regard to taxes. One of the primary distinctions between these two types of 401(k) accounts is the timing of tax payments.
- Traditional: Contributions are made with pre-tax dollars, which means you don’t pay taxes on the money you invest until you withdraw it in retirement.
- Roth: Contributions are made with after-tax dollars, so you pay taxes upfront, but your withdrawals in retirement are tax-free.
So what’s the score? At first glance, it might seem like a wash when it comes to Traditional vs. Roth 401(k) accounts. The math appears to work out the same if your tax rate remains constant throughout your life. If you pay 24% on your contributions now or in 20 years, there is no difference. Math nerd alert – it’s the commutative property: tax x $dollars x compounding = $dollars x compounding x tax.
However, there’s an important factor to consider: tax drag.
🥊 Round Two: The Sucker Punch – Tax Drag
Unfortunately the simple math above doesn’t work in the real world. Why? Tax Drag! Let’s see how. Warning: The following section might explode your brain. 🤯
Let’s say that you contribute $22,500 to a Traditional 401(k) in 2023. On top of that, you save an additional $10k from your paycheck. Awesome!
If instead, you contribute $22,500 to a Roth 401(k) in 2023, you owe more in taxes (this year). Recall that you pay tax in 2023 on that $22,500 of income to enjoy tax-free withdrawals in retirement. This tax, taken out of your paycheck, is 24% x $22,500 = $5,400. Since your paycheck is lower, you can only save $4,600 ($10k – $5,400)
So now let’s compare those two examples:
- Traditional: Contribute $22,500 and have $10k of savings in your brokerage account
- Roth: Contribute $22,500 and have $4,600 of savings in your brokerage account
- All the money grows at 8% (6% increase + 2% dividends) each year.
- In the Traditional and Roth accounts, it grows tax-free!
- In your brokerage account, the 2% dividends are taxed each year plus the gain is taxed (capital gains tax) when you sell.
- After 20 years, you withdraw all the money from the Roth (tax free) or Traditional (pay taxes on the account balance at 24% tax rate)
As you can see, you’ll end up with $6,263 more in a Roth 401(k) after 20 years, even at the same tax rate (24%). This is because the “extra” savings in your brokerage account has a tax drag. Note: This is why it’s generally preferable to save in either the Roth or Traditional accounts versus a taxable brokerage account.
The point? Even with the exact same tax bracket (start and end), the Roth 401(k) wins.
🥊 Round Three: Down for the Count – Roth Wins…Or Does It?
While the Roth 401k might seem like the clear winner, it gets more complicated when you ask the crucial question: Will your tax rate be higher or lower in the future?
Many people assume their tax rate will be lower in retirement because they won’t be earning a salary. However, you’ll still need income in retirement to cover living expenses. Distributions and Social Security are still included as income. Moreover, we’re currently in historically low tax rates, which may not continue.
One other factor to take into consideration is inheritance. If you leave behind a Roth 401k for your heirs, they can enjoy tax-free withdrawals, even if they’re in higher tax brackets due to their own income.
🥊 The Final Punch Count
Feeling confused about which account to choose? Ask yourself the following:
- Are you young and expect higher income in the future? A Roth 401k may be your best bet. You have more to save now, you’re in a lower tax bracket, and tax-free withdrawals in the future can be a significant advantage.
- Are you in your high-income, peak-earning years? A Traditional 401k might make sense to lower your current tax burden.
- Are you in a lower tax bracket (e.g., 10%-24%)? Roth could be a wise choice. Paying 24 cents on the dollar now to never pay taxes again is a good deal. If you are in a higher bracket (e.g., 32% tax rate), you might hope to be in a lower bracket during retirement making the Traditional 401k a better option for right now.
- Do you already have most of your savings in amTraditional 401k? Boost your Roth savings to diversify your tax options.
This decision involves making assumptions about your future financial situation. Consider working with a financial advisor who can use sophisticated software to handle multiple variables and create a tailored plan that aligns with your specific goals and circumstances.
In the world of retirement planning, the choice between a Traditional and Roth 401k isn’t always straightforward. It depends on your unique financial situation, goals, and assumptions about the future. By understanding the key differences and seeking professional guidance when needed, you can take charge of your retirement savings and make choices that set you on the path to financial security in your golden years. Remember, the decisions you make today can shape your future for decades to come.