When planning for retirement, one of the most critical decisions you’ll face is where to allocate your tax advantaged funds. The debate between contributing to a Traditional 401k or a Roth 401k continues to be a fierce one.
Executive Summary:
Key Decision: Choosing between a Traditional 401k and a Roth 401k is a crucial part of retirement planning, impacting long-term tax savings, retirement income, and wealth transfer.
Traditional 401k: Contributions are pre-tax, reducing taxable income in the present but withdrawals in retirement are taxed at ordinary income rates. Ideal for those expecting a lower tax rate in retirement or those needing immediate tax relief.
Roth 401k: Contributions are made after-tax, meaning no tax benefit now, but withdrawals in retirement are tax-free. Best for individuals expecting to be in a higher tax bracket in retirement or those seeking long-term tax-free growth.
401k Calculators: Traditional 401k vs Roth 401k calculators are tools designed to help estimate future taxes, compare pre-tax vs. after-tax contributions, and visualize investment growth, guiding users to optimize retirement income.
Case Studies: Examples show that while Roth 401k contributions may result in higher taxes today, they can often lead to greater retirement wealth and a higher probability of achieving financial goals due to tax-free withdrawals.
Employer Match: Both Traditional 401ks and Roth 401ks qualify for employer matching, which is "free money" and should be maximized, regardless of which plan you choose.
Factors to Consider: Current vs. future tax brackets, retirement age, and investment time horizon are critical factors. Younger savers, in particular, benefit more from Roth 401ks due to decades of tax-free growth.
Tax Diversification: Contributing to both types of accounts, if allowed, can provide tax flexibility in retirement. A diversified strategy can help balance taxable and tax-free income sources.
Common Myths: Myths include the idea that Roth 401ks are only for the wealthy or that Traditional 401ks always save more taxes. In reality, Roth 401ks are available to all, and Traditional 401ks may not always offer the best long-term benefits.
Try My Software: If you are ready to play around with the same high-powered calculator I use,👉 click here to get started.
There is a lot of misinformation out there
I admit I’ve struggled with this decision myself. For years, I stubbornly believed that having a higher income automatically made a Traditional 401k’s tax deduction the obvious choice.
I never truly questioned that assumption until recently. And boy, have I been wrong.
As I started experimenting with different scenarios, I’ve seen the incredible difference Roth assets can make. I hope to share some of those lessons today to help you avoid those same mistakes.
This post will break down the key differences, benefits, and drawbacks of each option. I’ll walk through a few case studies to help illustrate my point. Then, I’ll give you the steps you can take to help you choose wisely.
Importantly, nailing this calculation could be the difference between retiring on time vs. retiring later.
If you’d like to receive free access to the Traditional 401k vs Roth 401k calculator I use in this post, 👉 create an account here to get started >>
What Is a Traditional 401k?
A Traditional 401k is a workplace retirement account that allows you to contribute pre-tax dollars. These contributions reduce your taxable income for the year, providing an immediate tax benefit and additional cash flow.
However, you’ll pay taxes on withdrawals in retirement at your ordinary income tax rate. Keep this in mind for when we discuss Roth assets.
Key Features:
Pre-Tax Contributions: Contributions are made before taxes, lowering your current taxable income.
Tax-Deferred Growth: Investments grow tax free until withdrawal.
Required Minimum Distributions (RMDs): Starting at age 73, you must begin withdrawing a minimum amount annually. You can calculate future RMD estimates using this calculator.
Theoretically Ideal For:
Individuals expecting to be in a much lower tax bracket during retirement.
Those who need an immediate tax break to manage cash flow
What is a Roth 401k?
A Roth 401k is another type of employer-sponsored retirement plan, but it operates on an after-tax basis. You contribute funds that have already been taxed, meaning there’s no immediate tax benefit.
However, withdrawals in retirement are entirely tax-free.
Key Features:
After-Tax Contributions: Contributions are made with money that has already been taxed.
Tax-Free Withdrawals: Earnings and contributions can be withdrawn tax-free if conditions are met.
No Income Limits: Unlike Roth IRAs, anyone can contribute to a Roth 401k regardless of income.
Theoretically Ideal For:
Individuals expecting to be in a higher tax bracket during retirement.
Younger savers with decades of potential tax-free growth.
Tax conscious folks who want to leave their loved ones tax-free assets.
The Role of a Traditional 401k vs Roth 401k Calculator
Before deciding between a Traditional 401k and a Roth 401k, it’s wise to use a calculator that factors in your specific financial circumstances. A Traditional 401k vs. Roth 401k calculator can help you:
Estimate Future Taxes: Predict your retirement tax bracket.
Compare Contributions: See how pre-tax and after-tax contributions impact your tax future.
Analyze Growth Projections: Visualize how your investment buckets may grow under each plan.
Optimize Retirement Income: Determine which option maximizes your net retirement income and future net worth.
Let’s walk through a few examples to illustrate how a calculator can help.
Example Scenario: April’s decision
April wants to know if she should make traditional or Roth 401k contributions.
She is 35, earning $100,000 annually. Her employer offers both Traditional and Roth 401k options, and they match 4% of her salary.
April plans to retire at 65 and spend $4,166/month in today’s dollars in retirement.
She plans to contribute 15% of her salary each year until retirement.
Using the Calculator:
Traditional 401k:
Her taxable income decreases to $85,000 this year, saving her approximately $4,650 in taxes (assuming a 22% federal tax rate and 9% CA rate).
By retirement, her balance grows to $1,785,761 in qualified 401k assets.
Her financial plan succeeds 620 times out of 1000 trials (62%)*.
Roth 401k:
Her taxable income remains $100,000, and she pays the additional $4,650 in taxes this year.
By retirement, her 401k balance is the same: $1,785,761. But this time, it’s all tax-free money.
At age 90, she is $905,222 wealthier.
She pays $219,000 fewer total taxes in the lifetime.
Her financial plan succeeds 830 times of out 1000 trials (83%)*.
*For reference: I rarely plan for 100% success rates with the calculator. 80% is often cited as a standard benchmark for a reasonable probability of success.
Example Scenario: The Knope’s Decision
Ben and Leslie are 45 years old, earning $100,000 and $200,000/yr respectfully. They plan to retire at 67 and are considering whether to allocate their contributions to a Traditional or Roth account.
Both receive a 4% employer match and will take Social Security at 67. They plan to spend $11,000/month (today’s dollars) in retirement.
Ben and Leslie plan to max out their contributions each year until retirement.
Using the Calculator:
Traditional 401k:
Their taxable income decreases to $254,000, saving them approximately $15,180 in taxes this year (assuming a 24% federal tax rate and 9% CA rate).
By retirement, their balance grows to $2,727,361 in combined traditional 401k assets.
Their financial plan succeeds 290 times out of 1000 trials (29%).
Roth 401k:
They retire with the same amount as above: $2,727,361.
The Knope’s end their lives with an additional $1,229,129 in net worth.
They pay $151,715 less in total taxes.
Their financial plan succeeds 930 times out of 1000 trails (93%). 🙌
Outcome and Conclusion
Both April and the Knopes can strengthen their chances of retirement success, pay fewer taxes, and pass along a higher net worth. They can do this by choosing Roth 401k contributions vs Traditional 401k contributions.
That said, each will have less today to spend on lifestyle needs each year. April’s $4k/year and the Knope’s $15k/year could be needed for their expenses today.
But, if they were my clients, I’d strongly encourage them to commit to spending less today so they have a better chance of retiring on time!
Watch me walk through the Knope’s Traditional 401k vs. Roth 401k calculator >>
Factors to Consider When Choosing
1. Current vs. Future Tax Bracket
If you believe your tax rate will be significantly lower in retirement, a Traditional 401k may save you money. This is the traditional way of looking at it (no pun intended).
Conversely, if you expect your tax rate to rise or stay similar, the Roth 401k can be advantageous.
2. Employer Matching
Both Traditional and Roth 401k contributions qualify for employer matching, which is essentially free money. Prioritize maxing out your contributions to capture the full match, regardless of plan type.
3. Flexibility in Retirement
Roth 401ks offer greater flexibility by providing a source of tax-free income. This can be especially beneficial if you desire to retire before age 59.5.
4. Age and Time Horizon
The younger you are, the more helpful a Roth 401k can be. Decades of tax-free growth compound significantly.
As you get closer to retirement, Roth contributions don’t have as much as an impact.
5. Diversification of Tax Strategies
Consider contributing to both plans if your employer allows it. This strategy provides a mix of taxable and tax-free income sources in retirement.
While I’m a huge advocate for Roth assets, it’s not a bad idea to have some tax diversification. Examples of other tax buckets are traditional 401k or IRA assets, a standard brokerage account, or real estate.
Common Myths About 401k Plans
Myth 1: Roth 401ks Are Only for the Wealthy
Roth 401ks are accessible to anyone, regardless of income. The absence of income limits sets them apart from Roth IRAs.
Myth 2: Traditional 401ks Always Save You More Taxes
While Traditional 401ks offer immediate tax savings, they may not always be the best long-term choice, especially if tax rates increase.
We can clearly see the long-term tax and net worth consequences in the Knope’s scenario.
Myth 3: You Can’t Switch Later
Many employers allow you to split contributions between a Traditional 401k and a Roth 401k, enabling you to adjust your strategy as circumstances change.
Myth 4: I Missed the Boat, it’s Too Late for Roth Assets
While it’s true that Roth contributions are especially beneficial for younger savers, a Roth conversion strategy can be smart for people of all ages.
I spent years contributing only to a Traditional 401k, thinking it was the best route for me. However, I’ve recently started “catching up” by leveraging a Roth conversion strategy to build tax-free retirement income.
Curious if this approach might work for you? Download my eBook, "The Most Useful Guide to Roth Conversions", to explore how you can make the most of this powerful tool.
Next Steps
The Traditional 401k vs. Roth 401k decision doesn’t have to be overwhelming. Start by using a reliable calculator to model different scenarios that consider your income, tax rate, and retirement goals.
With professional guidance, these calculators can stress test your current plan. Helping you be prepared for any future possibilities.
If you’d like free access to the calculator I use start by creating an account here.
While everyone’s situation is unique, proactive attention to this could result in substantial financial gains—don't miss out!
If you’d like an alternative, the best DIY calculator I’ve come across is New Retirement (now Boldin). The last I checked, it costs $120/year for retail access.
Have you explored both Traditional 401k vs. Roth 401k options? How’d you decide which one to do?
Disclosure:
This is a hypothetical situation based on real life examples. Names and circumstances have been changed. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing
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