Roth or Traditional 401(k), Which Is Better?

Last Updated Mar 19, 2010 2:38 PM EDT

While much attention has been focused on the opportunities for Roth IRAs, the more important choice for many investors is whether they should use a Roth or traditional 401(k) account for their future retirement plan contributions. With decades to go before you retire, the 401(k) offers important tax planning choices.

Background. 401(k) plans can now offer participants the ability to put money into either a traditional 401(k) account or a Roth 401(k) account. Many plans have been adding the Roth feature, and if you don't have one, you may want to ask your HR department to consider adding one.
  • First, a Roth 401(k) allows you to contribute up to $16,500 if you're under age 50, and $22,000 if age 50 or over. That's much higher than the $5,000 (under age 50) and $6,000 (age 50 or older) limits for Roth IRAs. Thus, you can shovel a lot more money into a Roth 401(k) than you can a Roth IRA.
  • Moreover, with a Roth 401(k) there's no income limit for contributions. Compare that to a Roth IRA, where your ability to contribute is phased-out once you reach certain income thresholds. Essentially, if you're married, the phase out starts at 167,000, and if you're single, it starts at $105,000. But if you have a Roth 401(k), you can contribute regardless of how much you make.
Tax Summary. With the traditional 401(k) account, you receive an income tax deduction for the amount contributed to the plan; the money grows tax deferred until retirement, and then you pay income tax on the funds as they are withdrawn each year.

With a Roth 401(k), you don't get a current income tax deduction for your contribution, but the money grows tax free. That means you don't pay any tax on the gains between the time you contribute the money and your retirement, and you don't pay any income taxes once you take the money out in retirement.

Which to Use. So should you use a traditional or Roth 401(k) account? Here's something that might surprise you. If your tax rate before and after retirement is the same, it doesn't matter which one you use; you'll end up with the same amount of after tax money. Here is an example:
  • Assume that you're in the 25% tax bracket, you have $10,000 of your income available to save in a 401(k), the money will grow at 7.5% per year for 20 years, and then you'll take it all out at age 65 to spend on your retirement.
  • If you use a traditional 401(k), the full $10,000 goes into the plan because you don't owe any income tax on it. After 20 years growing at 7.5%, the $10,000 would be worth $42,479. If you take it all out and pay 25% in taxes, you are left with $31,859.
  • If you use the Roth 401(k), you don't get a tax deduction today. Thus if you had $10,000 to contribute, after paying the 25% in taxes, you would only end up with $7,500 in the plan. If that grows at 7.5% per year for 20 years, it's worth $31,859, which is all tax free and the exact same after-tax amount you would have if you used the traditional 401(k).
Now the analysis changes significantly if you think you'll be in a different tax bracket in retirement. Essentially, if you think you'll be in a higher bracket once retired, you would use the Roth feature. You forgo the income tax deduction today, but avoid higher taxes later.

If you think you'll be in a lower tax bracket in retirement, you would use the Traditional 401(k). You get a big tax deduction today, and when you pull the money out, you pay a lower tax on the increased value.

The hard part is determining if you'll be in a lower or higher bracket. Because we have a graduated income tax system, meaning we are subject to multiple income tax brackets, you don't just have one tax bracket.

Multiple Tax Rates. Here's how it works. Assume you're married and earn $100,000. The income you earn between $0 and $16,750 is only taxed at 10%, the income you earn between $16,750 and $68,000 is taxed at 15%, and then the money you earn between $68,000 and $100,000 is taxed at 25%. So you actually have three tax brackets.

It's likely that when you retire we will still have a graduated income tax system. Thus, the money you take out of your IRA may be subject to different tax rates.

So follow this example. Assume you make $100,000 and contribute $10,000 to your 401(k) this year. If you use a traditional 401(k), you get a tax deduction and save 25% in taxes. But now assume you are retired. When you take some of that money out of the plan, a portion of it might be taxed at only 10%, 15% or 20%depending on the tax brackets at the time you retire. Then as you draw out more each year, some of the money might be taxed at 25%, 28% or higher.

Just as when you're working, each year you're likely to have multiple tax brackets. That makes it hard to determine if the money you're contributing today will be subject to a higher or lower tax bracket in retirement. The truth is that for most people, it's simply a guess. So what do you do?

You might consider splitting your 401(k) contributions between the traditional plan and the Roth plan. You don't have to pick one or the other; you can do a little of both. That way you get a deduction on some of your money today, and may well pay a lower tax on some of that when it comes out in retirement. At the same time you're also adding to the Roth, which gives you a hedge against the possibility that you'll be in a higher bracket for some of your money in retirement.

Then once you retire, you have two sources of funds to utilize to manage your tax exposure each year.

Bottom line. Both the traditional and the Roth 401(k) accounts offer important tax planning opportunities for retirement. You may want to use a bit of both.

Other Tax Tips:
Lower Your Taxes In Retirement
Get Money From Your IRA Early
Don't Miss These Two Tax Forms
Consult your individual tax advisor prior to making any tax decisions.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.
  • Charlie Farrell

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