Investing, Retirement 
8
comments

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

Email  Print Print  

401KIt’s been several years since the Roth 401(k) was introduced to the American retirement scene. As this retirement planning option has become more well-known, and as more employers offer the Roth version of the venerable 401(k), more workers are faced with making a decision about which is more likely to help them reach their retirement goals.

If your employer offers access to a Roth 401(k), it makes sense to rethink your retirement contribution plan. Here’s how to decide which type of 401(k) to use for your retirement investment.

Cash Flow Now vs. Tax Savings Later

The Roth 401(k) is a great addition to the retirement savings landscape because it combines the higher contribution of a 401(k) with the tax-free growth seen with the Roth IRA. Plus, a Roth 401(k) doesn’t come with the pesky income limitations attached to the Roth IRA. Your Roth 401(k) is just like the “regular” 401(k), except instead of getting a tax deduction now, you contribute with after-tax dollars and you don’t have to pay taxes on your withdrawals during retirement.

For many employees, the decision comes down to this: Do you need the cash flow now? Or do you prefer to enjoy tax savings later?

With a traditional 401(k), you make your contributions with pre-tax dollars. This decreases your taxable income, and reduces your current tax bill. If you are going to make a retirement contribution automatically from your paycheck, you are going to see a bigger pay day with the traditional 401(k). This is because the money is taken out of your paycheck before taxes are assessed. Your employer withholds your taxes based on this lower income, so less tax is taken out.

On the other hand, your Roth 401(k) contribution is taken only after taxes have been assessed. After your higher taxes have been withheld, your Roth 401(k) contribution is deducted from your paycheck. The result is a smaller payday with a Roth 401(k).

If you are counting every dollar and struggling with your cash flow needs, a regular 401(k) might make more sense. But for those who are more concerned about the future, a Roth 401(k) provides a nice opportunity to improve tax efficiency. It’s true that you pay taxes on your income right now, but if you think that taxes will rise in the future, you save in the long run by paying now.

That’s because, with a traditional 401(k), when you eventually withdraw your money from your account, it is taxed as ordinary income; you don’t even get the advantage of long-term capital gains rates. Your Roth 401(k), however, sees no taxes. All of the money in the Roth version grows tax-free, shielding you from higher taxes down the road.

Your decision should be based on your current situation. It’s also worth noting that you can change things up later. While you might need the tax deduction from a traditional 401(k) right now, in a few years, after your income increases, you can switch to a Roth 401(k). Pay attention to your individual needs, and consider consulting a professional to help you make the best decision.

(Photo: Tax Credits)

{ 8 comments, please add your thoughts now! }

Related Posts


RSS Subscribe Like this article? Get all the latest articles sent to your email for free every day. Enter your email address and click "Subscribe." Your email will only be used for this daily subscription and you can unsubscribe anytime.

8 Responses to “How to choose between a traditional 401(k) and a Roth 401(k)”

  1. md says:

    You also need to consider that you most likely will be in a lower tax bracket at retirement. So even though you may anticipate tax rates rising, a Roth 401K may not save you money if you end up in a lower tax bracket.

  2. Anthony says:

    Perhaps, I don’t understand the tax advantages/disadvantages here.

    Suppose, I dump $16,500 into either a Roth 401(k) or traditional 401(k) today. In 40 years, that single contribution may grow to $800,000.

    Here’s how I understand it:

    In a traditional 401(k), I save on taxes today on the $16,500, but I will have to pay taxes on the $800,000 later.

    In the Roth, I go ahead and pay taxes on $16,500 today. But I save on taxes later on the $800,000.

    So, how much do tax rates need to change for it make sense to pay taxes on $800,000 rather than on $16,500? Also, unless the tax brackets become extremely disproportionate, wouldn’t it make more sense to pay taxes on the $16,500 today? (That is, isn’t the Roth better?)

    Or am I misunderstanding something here…?

  3. Claes says:

    md, that’s a good point, but the research I’ve seen seems to suggest most people don’t really end up with income needs in retirement much lower than their needs prior to retirement. So they’re going to be taking money out at the rate they are earning it at retirement to maintain their standard of living, and aren’t likely to fall much lower in terms of tax bracket, I think.

    Anthony, it would be if you were contributing identical amounts. The thing is, though, if you’re using a regular 401(k), you can probably afford to contribute more with the same cost out of pocket, because it’s being taken out of your paycheck pretax. That larger amount is going to grow tax free for the next 40 years and end up being substantially bigger than it would have been in a Roth that started with a smaller amount. So mathematically, if tax rates stay the same, owners would end up paying the same amount of tax whether they use a Roth 401(k) and regular 401(k)… this paper from TIAA-CREF has a good chart explaining it: http://www.tntech.edu/files/hr/benefits/Roth_Info_tr030106.pdf

    • Texas Wahoo says:

      This is only true if you are not maxing out your 401(k) contributions.

      If you are contributing 16.5k and just deciding between Roth 401(k) and 401(k), you will be putting more money in the Roth, because it is already taxed money.

  4. JoeTaxpayer says:

    Anthony – If the rate is exactly the same, there’s no difference. $1000 grows to $10000 and 25% tax leaves $7500. $750 would grow to $7500, then no tax. But – taxes don’t work this way. Deposits come off the top. By definition, your 401(k) or IRA money is taken from the top marginal rate you pay. Withdrawals, on the other hand, start at zero (for a single, the first $10K of income covers your standard deduction and exemption). Then some taxed at 10%, then 15%.

    The issue is complex, and it’s tough for any rule of thumb to be useful for all people. The best advice I can offer the younger worker is this – “Go with Roth for any money that would be marginally taxed at 15%, then shift to Pretax as you slip into the 25% bracket.” For those already in the 25% bracket, a mix of the two accounts may be the right choice depending on how much they save.

    Last – keep in mind, the company match is always pre-tax.

  5. Sadie says:

    Hindsight is always so good! But if today I had opportunity to make the decision “Traditional” vs “Roth”, I would immediately select “ROTH” because those taxes have been PAID and now…HISTORY! Best to ‘pay the piper’ upfront.

    As to “401K” I would invest up the “company match” & then place other monies into “Roth”.

    Considering the taxable Estate & Inheritance possibilities with “Roth”, I view investing in the Roth account far more advantageous.

    And if I have misunderstood, then do let me know!

    • JoeTaxpayer says:

      Sadie – as long as you acknowledge the lower brackets to fill during retirement, you’re good. Investing to the company match means you are depositing some pretax money. Retiring with 100% in Roth is a missed opportunity to use those low brackets. Hindsight is right. There’s an ideal mix that can be navigated along the way.

  6. Mike says:

    Got to go with Joe on these comments. 401k Roth contributions will cost you your marginal tax bracket of today vs your effective tax rate in the future. We should be teaching this material in our schools. Chances for most of us are that we will be paying less tax in retirement as an overall percentage, regardless of the possible rise in rates.


Please Leave a Reply
Bargaineering Comment Policy


Previous Article: «
Next Article: »
Advertising Disclosure: Bargaineering may be compensated in exchange for featured placement of certain sponsored products and services, or your clicking on links posted on this website.
About | Contact Me | Privacy Policy/Your California Privacy Rights | Terms of Use | Press
Copyright © 2014 by www.Bargaineering.com. All rights reserved.