Anyone who says that a Roth 401k or a Regular 401k is absolutely a better deal for you is either misguided, not telling you the truth or a blockhead. There are too many unknowns that are unknowable. You can’t really know which is a better deal with foresight.
Worse, the most important variable in this decision is almost always overlooked by the brainiacs who argue one way or the other.
Don’t worry, we’re going to focus on what is truly important so you can make a smart choice and understand why even the best decision is still a guess. But before we do, let’s review.
The Differences Between The 401k and Roth 401k
If you contribute to a 401k, you’ll get an immediate tax break. The money grows tax deferred and you only pay taxes when you start withdrawing your money. Me Gusta.
With a Roth 401k you get no immediate tax deduction when you make your contributions but your investment earnings and your withdrawals are both tax free. Profit-a-licious.
They both seem attractive. But which is a better deal? The truth is, it’s impossible to know as I said.
You Have To Decide – So Which Is Better?
All things being equal, the younger you are, the better the Roth 401k is. That’s because the younger you are the lower your tax bracket (probably) is. That means the immediate deductions offered by a 401k aren’t that juicy. And if you assume that you’ll be in a much higher tax bracket when you retire, the tax free withdrawal feature of the Roth 401k really starts looking swanky.
But to really know, you have to push your own numbers and make some very big assumptions. Let me show you what I mean.
Let’s assume the following:
- You have $15,000 before tax that you can save.
- You have 30 years before you retire.
- You can earn 5% on average on your money both before and after you retire.
- You are in the 20% Federal and State tax bracket when you begin your career.
- Your tax bracket will change over the years.
- You want to use your accumulated capital to create income once you retire.
Let’s see what happens to your money if you contribute that $15,000 to a 401k each year.
After 30 years, your annual $15,000 contribution grew at 5% to a shade less than $1,000,000 in the original recipe 401k. Not only that, when you made your contribution, you received a tax deduction and that put dollars in your purse cousin.
If you were in the 20% tax bracket for example, and you reduce your taxable income by $15,000, that saves you $3000. If you invest that tax savings each year at 5%, net of taxes, that money grows too. In fact, at the end of 30 years, you’ll have a little over $200,000 saved up in after-tax dollars as a result of those tax savings accumulating.
Now, when you retire, you’ll earn about $60k a year if you can invest all that money at 5%. After taxes, that comes to a shade over $48k if you retire in the 20% tax bracket.
But (and this is important) if you retire in the 50% tax bracket, that $60k is whittled down to about $30,000 a year.
Now, let’s compare this to the Roth 401k.
Remember, you have $15,000 available to save but you don’t get a tax deduction for contributions to a Roth retirement account. That means your $15,000 gets sliced down each year by your tax bracket before it gets deposited into the 401k Roth.
The nice thing is, your contributions grow without any tax burden and your withdrawals are tax-free also. So, given the same scenario, the Roth 401k provides annual income of only $39k. That is less than the regular 401k if you retire in the 20% marginal tax bracket. But it is more than the regular 401k if you retire in the 50% MTB.
The Take Away
When it comes to deciding between the Roth 401k and the regular 401k the most important consideration is your retirement tax bracket. But you can’t possibly know what you bracket is going to be that far into the future. Therefore, it’s impossible for anyone, no matter how smart they tell you they are, to know what the best decision is for you.
What You Should Do Now
The younger you are the more important this decision is. But you’ll only know the best way to go long after you’ve made your choice. That being the case, the best course of action is to:
a. Consult with your tax advisor.
b. Make some assumptions about your retirement tax bracket and run the numbers yourself.
c. Hope for the best.
d. Consult with your tax advisor and then split the difference between both types of 401ks.
To be frank, I like option D but it’s a matter of style. Personally, I’d rather be a little bit right or wrong than way off base. Given there is so much information that is simply impossible to know, it probably makes most sense to hedge your bets. At least that’s how I see it.
Where do you stand on the Roth vs Regular 401k?