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    How to choose between a traditional and Roth 401(k)

    by Live Free MD December 31, 2017

    In my post, “Use it Or Lose It,” I talked about the awesome benefits of the Roth IRA.  You do have to pay taxes on the money now, but it grows tax-free, and you can withdraw the money after age 59.5 without owing any taxes.  It’s the only way to win the tax game.  It is 100% your money, forever!

    In comparison, money in a traditional IRA, traditional 401k, or  taxable account is not 100% your money, because you will owe taxes on some or all of it in retirement.

    Most people are only able to contribute $5,500 per year ($11,000 for a couple) towards a Roth account.  However, if you are an employee, you may have access to a Roth version of the 401k, called the Roth 401k. Talk to your human resources department to determine if you are able to contribute to a Roth 401k.

    The Roth 401k

    The Roth 401k acts much like a Roth IRA, but with higher contribution limits.  You can contribute up to 18,000 of after-tax money to a Roth 401k in 2017 and never pay taxes on it ever again.

    The catch is that you can contribute to a Traditional 401k OR a Roth 401k, but not both.  So, you need to decide which one is better for your situation.

    How to choose between a traditional 401k and a Roth 401k

    There are three points to consider:

    Your current tax bracket Your projected tax bracket in retirement How much value you place on owning 100% of your money

    The lower your current tax bracket, the lower the tax rate on your Roth 401k contributions and thus the more the Roth 401k makes sense.  Conversely, the higher your current tax bracket, the more you will save in taxes by contributing to a traditional 401k, and the more the traditional 401k makes sense.

    The higher your projected tax bracket in retirement, the more you will value having tax-free money in the future and thus the more the Roth IRA makes sense. Conversely, if you expect to be in a lower tax bracket in retirement compared to your current tax bracket, then the traditional 401k makes more sense.

    From a philosophical perspective, the more you value owning 100% of your money, the more you will value Roth money over traditional 401k money (which you will owe taxes on in retirement). No one really knows what will happen to tax rates in the future,  but if I was a betting man, I would bet that they will go UP.  All the more reason to own 100% of your money!

    A simplified rule of thumb

    If you are a low to middle-income earner in the 10-25% marginal tax bracket, then the Roth 401k is a slam dunk.  You are paying a relatively low tax rate on your current income and will likely be in a similar or higher tax bracket in retirement.

    If you are a very high-income earner in the highest tax bracket (39.6%), then the Traditional IRA is the way to go.  You will save a large amount on current taxes, be able to invest more earlier, and will likely be in a lower tax bracket in retirement (after all, to get into the highest tax bracket in retirement would require a portfolio over $10 million).

    If you are somewhere in the middle, then you can choose based on how much you value owning 100% of your money, or you can try to run some numbers.  Let’s look at a simplified case for someone in the 33% marginal tax bracket.

    A case study

    For this case, let’s assume a married filing jointly couple making $300,000 per year.  They are in the 33% marginal tax bracket (see table above).

    If they contribute $18,000 towards a traditional 401k,  this will reduce their taxable income by $18,000, so they will save 6,000 on their taxes (33% of $18,000).  That means that they will have $6,000 more to invest every year compared to if they had invested in a Roth 401k.

    If $6,000 per year is invested over 30 years assuming a 6% rate of return, this will amount to around $500,000.

    Since this couple is contributing 18,000 to a traditional 401k for 30 years, they will have around $1.6 million in their traditional 401k account at retirement, assuming a 6% rate of return.

    They will owe taxes on all this traditional 401k money. If they are in a 25% tax bracket in retirement, they would owe $400,000 on this money.  This is less than the $500,000 they have by investing $6,000 more per year, so they come out ahead by investing in the traditional 401k.

    On the other hand, if their tax rate in retirement is 33%, then they would owe $528,000 in taxes in retirement (33% of $1.6 million), which is more than the $500,000.  In that case, the Roth 401k would have won.

    One additional complicating factor

    As you can see, in the upper middle-income tax brackets, it can be challenging to determine whether the traditional 401k or Roth 401k is better. The situation is further complicated by the possibility of performing late career “Roth Conversions,“ which means transferring traditional 401k money  from a prior employer into your Roth IRA.  You will pay taxes on this conversion, but if you cut down on work later in your career, you may be in a lower tax bracket so the tax hit will be more manageable.   This can be a good way to beef up your Roth accounts in the years leading up to retirement.

    Conclusion

    If you have access to a Roth 401k at work, you should generally take advantage of this option unless you are in a very high tax bracket.  Accumulating as much Roth money as possible is the only way to win the tax game.  You want to win the game, right?

    Read the article here

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    How to choose between a traditional and Roth 401(k) was last modified: January 4th, 2018 by Live Free MD

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