Friends, this title is a common question!
Let’s begin with the basics. With a Roth 401(k), you pay taxes upfront — then save. With a traditional 401(k), you avoid paying taxes upfront, but instead, you have to pay taxes during retirement when you withdraw the money.
If your tax rates remain the same (and that’s a big “if”), there isn’t a big difference in the outcomes between these two retirement savings options. For example, I ran some hypothetical numbers in Dinkytown.net comparing the Roth versus traditional 401(k). If a person saves $12,000 per year from age 25 to 45, earns a 7 percent rate of return, and is always in a 22 percent tax bracket, the Roth would be worth $17,939 more than the traditional. (Note: The Dinkytown calculator assumes you invest the tax savings in the traditional, so you would actually be contributing more than $12,000 into the plan. See the fifth bullet below).
But for most people, tax rates do not stay the same, and that’s what can sometimes make deciding how much to save in the Roth versus the traditional a little tricky.
Here are a few suggestions, which should help you make a financially sound decision.
- If you’re in a high tax bracket and getting close to retirement, you should consider contributing mostly, if not all, to the traditional 401(k) instead of the Roth. The traditional may be better in this situation because you’re avoiding taxes while in a high tax bracket, and when you retire and start paying taxes on those investments, you’ll likely be in a lower tax bracket.
- When you’re young (i.e., less than 35 years old) and in a low tax bracket (i.e., 12 or even 22 percent tax bracket), it is a good time to save in Roth, for the opposite reason as above.
- Even if the Roth option is better for you today, that does not mean you should always assume it will be in the future. Remember, when your age and tax bracket change, so do the calculations.
- Speaking of calculations, Dinkytown.net offers a nifty online calculator to run comparisons: Roth 401(k) vs. Traditional 401(k) Calculator. The site offers other helpful calculators, as well. But keep in mind: Even if the Roth or the traditional option shows better results, it’s probably still a good idea to save some money in both types of retirement savings accounts.
- A very important detail with regards to the calculations is that with the traditional: If you don’t invest the savings from not having to pay taxes on the amount you contribute, then you’re better off saving in a Roth. For example, let’s say you save $10,000 per year into a traditional 401(k). Doing so reduces your income by $10,000, and therefore if your effective tax rate is 12 percent, then you save $1,200 in taxes per year. These hypothetical calculations I’m presenting assume you invest that $1,200. If you don’t invest it, then your traditional plan will have that much less than the Roth plan.
- Regardless of your tax bracket, saving some money in a Roth account is probably wise, because during retirement, you’ll probably want money you can withdraw without paying taxes. What can be frustrating is having your entire next egg in a traditional 401(k), and every dollar you withdraw, you have to pay taxes on. Furthermore, if this happens, you could be forced into a higher tax bracket. Not good!
- If your employer 401(k) plan doesn’t offer a Roth option, and if you qualify, you can easily open a Roth individual retirement account (IRA) at Schwab, Fidelity, or another custodial firm and save money in that Roth on your own. The personal Roth IRA offers some advantages over your employer-sponsored 401(k). For example, you will have more investments from which to choose. Furthermore, if/when you switch jobs, you don’t have to roll it over.
- If your employer matches your 401(k) contributions, save up to the maximum amount of the match, no matter if it’s a traditional or a Roth account. A match is almost always the best deal since it is essentially free money from your employer.
- Don’t forget that there are rules for participating in a Roth. For example, pay close attention to the income limits on the IRS website.
There you go. I hope this helps clarify a few things. If you’re still confused about the Roth versus the traditional 401(k) plan, you can always ask Tilly!