Traditional 401(k) versus Roth 401(k)
- Tim Owens
- Mar 23, 2023
- 4 min read
Updated: May 8, 2023
When it comes to 401(k)s, most people have a Traditional 401(k). With more and more companies offering the Roth 401(k) option, a question comes to mind. Which of the two is actually better? The implications of choosing one over the other can be large, so make sure you think through your decision prior to checking one box over the other. This blog shows an example comparing the two alternatives, while also providing you the key factors that will determine the outcome of your 401(k).
Deciding whether to have a Traditional 401(k) versus a Roth 401(k) can be a complicated and confusing decision. Which of the two alternatives will leave one with more money for retirement? Unfortunately, we cannot know this for certain. This is because we don’t know what the future tax rate will be. Also, we do not know what tax bracket one will be in when they take distributions. However, we can do a general analysis of a couple situations and hopefully make a more educated decision when it comes to choosing between a Traditional 401(k) versus a Roth 401(k).
Example 1 of Traditional versus Roth Analysis:
Name: Lisa
Age: 25
Income: $100,000
Current Income Tax Bracket: 30%
Income Tax Bracket at Age 60: 30%
Contributions: 5% ($5,000) annual
Assumed Interest Rate: 8%
Let’s run the numbers on Lisa if the current assumption above holds true for her situation.
With the Traditional 401(k), Lisa is able to allocate $5,000 straight into her 401(k) each year. This will grow tax deferred until retirement. With the 8% assumed interest rate over the 36 years, Lisa’s Traditional 401(k) will have grown to $935,510. Now, Lisa is eligible to take the full amount out since she has surpassed 59 ½ which is the requirement age to start taking distributions from a 401(k). However, if she were to take the full amount, she is likely to have to pay higher taxes than if she were to spread out her distributions over time as distributions are taxed as ordinary income. However, let’s for the sake of argument say she takes out the full amount and that it is taxed at a very modest 30%. A total tax bill of $280,653 would be due, and would leave Lisa with $654,857 to use for her retirement.
Now let’s look at the Roth 401(k) alternative. 30% of the $5,000 contribution gets taxed up front.
That allows $3,500 each year to be allocated towards the Roth 401(k). Again, assuming an 8% interest rate, Lisa’s Roth 401(k) would grow to $654,857 by the end of year 36. Since no taxes are due, Lisa is free to do whatever she wants with the money.
Would you look at that? The same income tax bracket for the Traditional and Roth 401(k)’s returned the exact same dollar amount. Obviously, these assumptions are not likely to hold, but we hope that it gives you a better idea of tradeoffs. Here are some additional caveats to think about.
Caveat #1: The larger the lump sum you withdraw from a Traditional 401(k), the larger your tax bill is likely to be. From the above example, a 30% tax from a reported $935,510 income is what we would like to call, unlikely.
Caveat #2: Most 401(k)’s includes management fees that are paid to brokers and the companies who manage the funds (Vanguard, American Funds, etc.) These fees are based off the funds you have allocated towards a specific fund. If Management Fund A has a fee of 1%, then 1% of the money that you have in that fund will be charged as a management fee each year. In year 20 of Lisa’s Traditional 401(k), she has $228,809. In the Roth 401(k), she has $160,166. If she were to have all her money allocated in Management Fund A, she would be charged $2,288 in the Traditional 401(k) and $1,601 in the Roth 401(k). Over 36 years, the fees in this example would be a little more than $31,000 more in the Traditional 401(k) versus the Roth 401(k).
Example 2 of Traditional versus Roth Analysis:
Name: Lisa
Age: 25
Income: $100,000
Current Income Tax Bracket: 30%
Income Tax Bracket at Age 60: 40%
Contributions: 5% ($5,000) annual
Assumed Interest Rate: 8%
With an increased tax rate at Age 60, Lisa’s Traditional 401(k) would only produce $561,306. The Roth 401(k)’s numbers stay the same, at $654,857. Almost $100,000 more than the Traditional 401(k) option.
We wish we had a crystal ball that told us what future tax brackets were going to be. They are the largest factor in determining whether a Traditional or Roth 401(k) is the better option for you. Your own tax bracket is another important factor to keep in mind.
We hope this article gave you a good understanding of what factors to consider when choosing between a Traditional 401(k) and Roth 401(k). The future is yet to come, but proper planning could save you many thousands of dollars down the road.
Contact us today to discuss your business’s 401(k) needs!
(559) 322-2230
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