You asked for it, and here it is. After last week’s post on Traditional IRAs vs. Roth IRAs, I received some questions on Traditional 401(k) vs. Roth 401(k) Accounts.
The comparison is very similar to Traditional IRAs vs. Roth IRAs. With Traditional 401(k) accounts you contribute pre-tax dollars (or sometimes after-tax dollars, but for sake of comparison and the most common application I’m talking about pre-tax 401(k) contributions in this post). You contribute some dollars, your employer (hopefully) contributes some dollars, and you sit back and watch the money grow until you retire (and not before age 59 1/2). Assuming you contribute pre-tax dollars, you won’t pay taxes on this money until you take it out.
With a Roth 401(k), you contribute post-tax dollars and are not taxed on your contributions OR the gains again. The big benefit here is that while there are income limits to be eligible to contribute to a Roth IRA, there are not income limits when it comes to contributing to a Roth 401(k). This gives someone who makes sufficient money the option to contribute “Roth dollars” now and never pay taxes on the gains, even if they are not eligible to contribute to a Roth IRA. (Note that the employer match on a Roth 401(k) is still going to be with pre-tax dollars.) Also keep in mind that your employer must sponsor a Roth 401(k) for this option to apply to you to begin with. And you might have to check! You may have access to a Roth 401(k) but not realize it.
401(k) and Roth 401(k) accounts have the same contribution limits (that’s the $18k for 2016 we talked about here) and both require minimum distributions at age 70 1/2. (Traditional IRAs also require minimum distributions. Roth IRAs do not.)
With all of these options – 401(k), Roth 401(k), Traditional IRA, Roth IRA – which should you contribute to?
Well, this is where it can become more of an art than a science. In short, it depends – on your tax bracket now, your projected tax bracket in retirement, your expectations for how your earnings will vary throughout your working lifetime, how the tax brackets may change, how vehicles to save for retirement may change, etc. etc. etc.
So, let me see if I can simplify this for you.
The value to saving via pre-tax dollars is that less of your income is taxed. I’m going to give you a simplified (yet reasonable, and hopefully illustrative) example. Say you make $100,000 in 2016 and your average tax rate is 25%. That means your net take-home pay is $75,000 – after $25k goes to the IRS. If instead you contribute $18k to your 401(k) plan with pre-tax dollars you are then taxed on what’s left, the $82k. If we’re conservative here and assume a 25% tax rate on the entire $82k, you owe $20.5k in taxes. You just saved $4,500 in taxes!
From another perspective, let’s imagine you are getting ready to take a vacation IN retirement and need $10,000. If you want to take money out of the 401(k) you saved into while you were working, you now have to pay taxes. Let’s assume, again, that your average tax rate is 25%. You now need to take out $13,333 from your retirement savings – $3,333 goes to the IRS and $10k goes to you for your trip.
If you make a lot of money now, contributing pre-tax dollars can be a huge tax saver.
If you think you’ll be in a lower tax bracket in retirement, it probably makes sense to defer the taxes until then (meaning, you contribute pre-tax dollars now).
If you have a long time horizon, maybe 30-40 years until you retire and plan to use these savings, a Roth (IRA or 401(k)) with tax-free growth may be the way to go.
I could go on and on with scenarios. My point is, there are definitely A LOT of things you could consider. BUT, my other point is that a lot of these things are unknown. And life shouldn’t be about complicated scenarios and what-ifs. Who knows what life – and the tax code – will be by then anyway? And so, I say focus on what you can control. Here are a few of those things:
- Live within your means.
- Keep an emergency fund in cash.
- Contribute enough to your 401(k) – if you have one – to at least benefit from the maximum employer match you can get.
- Save for near-term (think less than 3-year, maybe 5-year) goals such as buying a house.
- Diversify how you save, if possible (see below).
- And remember, any savings is better than no savings!
My personal preference, with all the unknowns, is to save among these three broad buckets:
1. Pre-tax 401(k) Dollars
- Pro: Fewer tax dollars spent now = more dollars saved now
- Con: Taxed at ordinary income rates when this money is taken out in retirement
2. Post-tax Roth Dollars (IRAs and 401(k)s)
- Con: More tax dollars spent now
- Pro: These dollars, including the gains, are never taxed again
3. Taxable Investment Account, Post-tax Dollars
- Pro: Taxed at capital gains tax rates, which are lower than ordinary income tax rates AND you have more flexibility with this money (no age 59 1/2 requirements to take the money out)
- Con: This money does not benefit from the tax-deferred or tax-free growth options of 1. and 2.
And let me be clear: There are really NO cons to having money and being able to save money!
You may not be able to do all of this right now. In fact, most people probably can’t do all of this right now. That’s okay. Focus on what you can do, while maintaining a clearer picture of what you can do additionally down the road.
This is a lot, so please let me know if you have questions. Thanks again for the questions and follow-up from past posts. Keep ’em coming!