Contributing to a 401k account to save for retirement is an easy decision, especially when a company match is involved. However, how would you choose between contributing to a traditional 401k vs a Roth 401k? The obvious differences are:
- Traditional 401k: Income taxes are paid when the money is taken out during retirement. Contributions reduce current taxable income.
- Roth 401k: No income taxes are due when the money is taken out during retirement. Contributions have no effect on current taxable income.
Actually, there is one other major difference–the contribution limit. The 401k limit is the same dollar amount for both traditional and Roth versions, therefore the contribution limit for a Roth 401k is effectively higher since it is funded with after-tax money. One other benefit of the traditional 401k is that it can be converted into a Roth IRA later on, with some restrictions. The key benefit of both 401k’s over a regular taxable account is that they do not incur annual taxes on dividends and capital gains, allowing earnings to compound freely.
In order to compare the 3 types of accounts (traditional 401k, Roth 401k, taxable), we need to make a few assumptions:
- Current tax rate (federal and state)
- Tax rate during retirement (federal and state)
- 401k contribution limit
- Amount to invest
- Years to retirement
- Investment return
- Annual tax cost for taxable accounts
Although no estimate will be perfect, making these assumptions is a necessary step in evaluating your options. The spreadsheet below compares the two 401k options using the assumptions above. Go ahead and change the assumptions to fit your situation.
There are two scenarios when the decision is relatively easy:
- If you expect your future tax rates to be lower and you plan on contributing less than the traditional 401k limit, then you should probably go with a traditional 401k.
- If you expect your future tax rates to be higher, then you should probably go with a Roth 401k.
Most of you are probably not in either scenario, so you would have to weigh the Roth’s advantage of a higher limit vs the traditional’s advantages of a lower future tax rate. Another thing to consider is that a traditional 401k can be converted into a Roth IRA at a later date, with some restrictions. So if you expect your tax rates to drop significantly in the near future, choosing to go Roth then may be beneficial.
Some relevant links: