What’s Better – a Traditional 401(k) or a Roth 401(k)?

What’s Better – a Traditional 401(k) or a Roth 401(k)?

Both a Traditional and Roth 401(k) definitely have their own place in your retirement savings and the decision to choose one over the other isn’t always straightforward. Given the uncertainty around future tax rates, let’s look at which one of the two options works out the best for your situation. In this analysis, we are going to make a few assumptions and run an analysis on both the type of accounts and see which one comes ahead.

Difference Between A Traditional 401(k) and A Roth 401(k)

When you contribute part of your income to these accounts, you benefit from special tax advantages that you wouldn’t receive from investing in just a taxable account. These employer plans include features such as allowing employers to match your contributions up to a certain amount, and giving employees the ability to make either pre-tax (Traditional) or after-tax (Roth) contributions. The distinction between a Traditional and Roth 401(k) is similar to that of Traditional and Roth IRAs.

Traditional 401(k)

Contributions to a traditional 401(k) are made with pre-tax dollars and after tax. They are not counted as taxable income and will reduce your MAGI. When you contribute pre-tax dollars, you are allowing your assets to grow tax-deferred, meaning you will not have to pay taxes on the money you contribute to the account, but you will owe taxes when you withdraw.

When you retire and begin to receive distributions from your traditional 401(k) account, your money will be taxed (including the growth) as ordinary income.

Roth 401(k)

Roth 401(k) contributions are the opposite of their pre-tax counterpart. Contributions made to this account are from after-tax dollars. According to an article from CNBC, seven in 10 companies offer a Roth 401(k) option.

Unlike a Roth IRA, a Roth 401(k) does not have any income limits, so all employees can choose this account type regardless of their income level. When you contribute to these accounts, you won’t receive a tax break, but all growth and qualified future withdrawals are tax-free.

Since you won’t be taxed on the money you withdraw, it can be a great option if you think taxes are going to increase in the future.

How Much Can You Contribute To A 401(k)?

The IRS encourages participation in 401(k) retirement savings plans for employees of all compensation levels. However, it imposes limits on the total amount that can be contributed in any given year, regardless of income.

Contribution Limits Age <50 years Age >50 years
Employee Only 19,000 25,000
Total Contributions (including employer match) 56,000 (100% of your compensation, whichever is less)62,000 (100% of your compensation, whichever is less)

What’s Better – a Traditional 401(k) or a Roth 401(k)?

In order to answer which option is the better one among the two, let analyze how both of these accounts perform with a sample scenario. We will run some numbers on a different combination of contributions made to each of these accounts and see which one fairs better.

Case#1 – When You Are In Same Tax Bracket

Assumptions

Annual retirement plan contribution
$10,000
Years to invest until retirement plan withdrawals begin40
Hypothetical annual return before retirement8%
Current federal income tax rate25%
Number of annual withdrawals in retirment25
Hypothetical annual return in retirement6%
Estimated federal income tax rate in retirement25%
Related:  How To Evaluate A 401(k) Plan

1. Account Values In Retirement

After 40 years of contributions and growth, the traditional and Roth accounts would both be worth $2,928,567 at retirement.

Without considering taxes, each account could provide annual withdrawals of $219,235 in retirement.

Hypothetical annual withdrawals in retirement before taxes
Hypothetical annual withdrawals in retirement before taxes

2. Tax Liability

With traditional accounts, taxes are paid on withdrawals. So annual withdrawals from a traditional account would be reduced to $164,426 after taxes of $54,809 are paid.

Contributions to Roth accounts are made with money that’s already been taxed, so qualified withdrawals are not taxed again. Therefore, the Roth account could provide the full $219,235 each year.

Hypothetical annual withdrawals in retirement after taxes
Hypothetical annual withdrawals in retirement after taxes

3. Investment Tax Savings From Traditional 401(k)

With a traditional account, the tax benefit comes at the time money is invested. In other words, contributions are not taxed. To allow for a fair comparison, the potential value of these tax savings with a traditional account needs to be measured.

If the annual tax savings of $2,500 were invested in a taxable account with the same returns as for the retirement plans, the investment of your tax savings could provide an additional annual income of $27,226.

Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings
Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings

Winner – Roth 401(k)

Based on the assumptions we have made, the additional income would not make up for the taxes paid on withdrawals. Therefore, a Roth 401(k) Account might be better than a Traditional 401(k) Account in this situation.


Case#2 – When You Are In A Lower Tax Bracket in Retirement

Assumptions

Annual retirement plan contribution
$10,000
Years to invest until retirement plan withdrawals begin40
Hypothetical annual return before retirement8%
Current federal income tax rate25%
Number of annual withdrawals in retirment25
Hypothetical annual return in retirement6%
Estimated federal income tax rate in retirement12%

1. Account Values In Retirement

After 40 years of contributions and growth, the traditional and Roth accounts would both be worth $2,928,567 at retirement.

Without considering taxes, each account could provide annual withdrawals of $219,235 in retirement.

Hypothetical annual withdrawals in retirement before taxes
Hypothetical annual withdrawals in retirement before taxes

2. Tax Liability

With traditional accounts, taxes are paid on withdrawals. So annual withdrawals from a traditional account would be reduced to $192,927 after taxes of $26,308 are paid.

Contributions to Roth accounts are made with money that’s already been taxed, so qualified withdrawals are not taxed again. Therefore, the Roth account could provide the full $219,235 each year.

Hypothetical annual withdrawals in retirement after taxes
Hypothetical annual withdrawals in retirement after taxes

3. Investment Tax Savings From Traditional 401(k)

With a traditional account, the tax benefit comes at the time money is invested. In other words, contributions are not taxed. To allow for a fair comparison, the potential value of these tax savings with a traditional account needs to be measured.

If the annual tax savings of $2,500 were invested in a taxable account with the same returns as for the retirement plans, the investment of your tax savings could provide an additional annual income of $29,277.

Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings
Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings

Winner – Traditional 401(k)

Based on the assumptions we have made, the additional income would be more than the taxes paid on withdrawals. Therefore, a Traditional 401(k) account might be better than a Roth 401(k) account in this situation.


Case #3 – When You Are In A Higher Tax Bracket in Retirement

Assumptions

Annual retirement plan contribution
$10,000
Years to invest until retirement plan withdrawals begin40
Hypothetical annual return before retirement8%
Current federal income tax rate12%
Number of annual withdrawals in retirment25
Hypothetical annual return in retirement6%
Estimated federal income tax rate in retirement25%
Related:  How To Save For Retirement Without A 401(k)

1. Account Values In Retirement

After 40 years of contributions and growth, the traditional and Roth accounts would both be worth $2,928,567 at retirement.

Without considering taxes, each account could provide annual withdrawals of $219,235 in retirement.

Hypothetical annual withdrawals in retirement before taxes
Hypothetical annual withdrawals in retirement before taxes

2. Tax Liability

With traditional accounts, taxes are paid on withdrawals. So annual withdrawals from a traditional account would be reduced to $164,426 after taxes of $54,809 are paid.

Contributions to Roth accounts are made with money that’s already been taxed, so qualified withdrawals are not taxed again. Therefore, the Roth account could provide the full $219,235 each year.

Hypothetical annual withdrawals in retirement after taxes
Hypothetical annual withdrawals in retirement after taxes

3. Investment Tax Savings From Traditional 401(k)

With a traditional account, the tax benefit comes at the time money is invested. In other words, contributions are not taxed. To allow for a fair comparison, the potential value of these tax savings with a traditional account needs to be measured.

If the annual tax savings of $1,200 were invested in a taxable account with the same returns as for the retirement plans, the investment of your tax savings could provide an additional annual income of $17,434.

Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings
Hypothetical annual withdrawals in retirement after taxes with annual withdrawals from invested tax savings

Winner – Roth 401(k)

Based on the assumptions we have made, the additional income not make up for the taxes paid on withdrawals. Therefore, a Roth 401(k) account might be better than a Traditional 401(k) account in this situation.

Which One Should You Choose?

Based on the above scenarios, it appears that we can draw the following conclusion.

1. If you are anticipating to be in a lower income (which is the case with the majority of the people in the US), you can safely stick with a Traditional 401(k).

2. If you are anticipating to be in a same or higher tax bracket in retirement, then Roth 401(k) might be the route to go.

Consider running the numbers with changing the tax brackets and see which of the 2 options makes sense. Does a hybrid option work better? Run your numbers.

Disclaimer: Whenever you are looking at a question like this, always remember to check the underlying assumptions the author has made in doling out a suggestion. In my case, I have quite a few variables assumed for calculation. Always do your due diligence before making any move.

References:
https://www.americanfunds.com/individual/planning/tools/traditional-vs-roth-401k-403b-analyzer.htm

4 thoughts on “What’s Better – a Traditional 401(k) or a Roth 401(k)?”

  1. What’s tricky about these numbers is that putting in $10k into a traditional 401k is not the same as putting in $10k into a roth 401k, since you are using pre-tax vs after-tax money. If you want to have the equal impact on your paycheck, you would actually be putting in $10k – ($10k * your tax rate) for the roth 401k. To make the comparison accurate, you would want your roth 401k contribution to reflect that calculation with taxes.

    I do agree that for most people, the traditional route is probably going to be the best option. But I like to have some tax diversification by maxing out my traditional 401k (which I will do this year) and then maxing out both of our roth IRA accounts. So in either scenario, we should be alright.

  2. Hi Chris,

    That’s exactly the route we are taking. One thing with Roth 401k though is that it’s a great option for people who have money in a rolled over IRA and can’t afford to to do a backdoor Roth. This is a great option.

    I agree with you on tax liability diversification by having money invested into different accounts. Things can get very tricky once you have social security income also factored in during retirement.

  3. Totally relevant to my husband’s situation. He’s doing Roth right now, but we’re starting to think about it a lot harder and a little closer. Thanks for sharing.

    • @SavvyHistory,

      This one is definitely tricky. I would run the numbers and see which way I would come out ahead. But for the most part a Traditional 401k and Roth 401k mix should give a good diversity.

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