RSSWhich is better – Roth or 401K?
Oct 24
kosmo - See all 763 of my articles
First, the disclaimer. The Soap Boxers (SB) is not a tax professional. While SB makes every effort to provide accurate information, SB is not liable for damages that occur from use of the information. This information is only intended as a “jumping off point”. You should perform your own research or consult your tax professional before deciding on a strategy.
Many people are convinced that one of the two strategies is THE BEST, and that the other is a lesser strategy. Is this true? In a word, no.
First, I’ll explain the basic differences. With a Roth, you pay tax on the money, then invest it. When you withdraw the money at retirement, you owe no taxes. With a traditional IRA or 401(k), you take pre-tax money and invest in. When you withdraw the money at retirement, you do owe taxes. There are other differences, but I’ll focus on this. For the sake of simplicity, I will use 401(k) to refer to 401(k)s and traditional IRAs.
If your tax rate is the same now as it is at retirement, there is no difference in the amount of money you are eventually able to keep. Let’s assume that you have $10 to invest for retirement, you are in a 10% tax bracket now and at retirement, you can invest in a fund that will give you fivefold your money at retirement, and that you can withdraw 100% of funds at retirement. Obviously, this is a dramatic oversimplification for the sake of illustration.
Roth: You take the $10, pay $1 in taxes, then invest $9 in the fund. You are able to withdraw $45 at retirement.
401(k): You invest the entire $10. At retirement, the fund is worth $50. You pay tax of $5 and are able to withdraw $45.
As you can see, the end result is the same. The values only differ if your tax rate today differs from your tax rate at retirement.
What would happen if a drastic change were made to the tax brackets? Let’s say that suddenly, the tax rates were doubled – the 25% bracket became a 50% bracket. The Roth investors would be huge winners, as they have already paid taxes on their retirement funds – at the old rate.
On the flip side – what would happen if the rates were slashed in half – the 25% bracket became a 12.5% bracket? The 401(k) folks would be the big winners – they get to pay the future rate of 12.5% instead of the 25% that the Roth investors paid on their past investments.
Imagine the worst case scenario for Roth – a federal sales tax that completely replaces income tax. Roth investors would not have to pay income tax when they withdraw their money, but they would suddenly be taxed again with the consumption based sales tax.
OK, let’s take a step back. None of these drastic scenarios is likely to occur (if the sales tax ever occurs, there will surely be a Roth fix as part of the plan). However, relatively minor changes to the tax brackets could change your results. It is possible that the 25% bracket would become a 22% bracket or a 28% bracket. While you can’t base investment decisions completely on possible future changes, neither should you completely dismiss the possibility.
If your company matches a contribution, take advantage of it. For example, your company matches the first $1000 in a 401(k), dollar for dollar. You might be in a situation where a Roth typically makes more sense for you. However, you should still invest $1000 in the 401(k) in order to obtain the matching funds. You have just doubled your money. Even if you pay a higher tax rate on this money at retirement, you will come out ahead.
OK, let’s shift gears to the assumption that the brackets will remain pretty much the same, aside from being indexed for inflation.
When you are young and in the lower tax brackets – 10% and 15% – a Roth makes much more sense than a 401(k). It is pretty unlikely that you are going to end up in a bracket lower than 15% when you reach retirement age.
Big retirement next egg
OK, shift to age 50. You have invested very well, and you expect your post-retirement taxable income to be 150% of your current taxable income. Great – the Roth still makes the most sense for you.
Small nest egg
You haven’t invested as well as the last guy, and you expect your retirement taxable income to be 60% of your current taxable income. In this case, the 401(k) makes sense. Reduce your taxable income today with the 401(k) contributions, and pay the lower rate when you retire.
Big salary
Once again, you’re age 50. You have been promoted 4 times in the last 3 years and are making money hand over fist. You have invested pretty well over the years, but you only expect your retirement taxable income to be 60% of your current taxable income – simply because your income level has exploded. Again, the 401(k) makes the most sense.
Note that I have referred to taxable income, rather than gross income. Many factors can impact taxable income and shift the Roth/401(k) decision. An example would be mortgage interest. Perhaps you are currently deducting a large amount of mortgage interest and plan to have the house paid off at retirement. This will push your future taxable income higher (making Roth more attractive than it might have otherwise been)
Another example would be some sort of windfall income. Perhaps you earn a substantial amount of money from a sideline in a given year (book royalties, game show winnings, etc). This might cause a one year spike in taxable income and make 401(k) more attractive than it might be in other years. On the flip side, you might get laid off (or take unpaid time off) and experience a lower than usual taxable income that year – making Roth more attractive that year.
Remember to revisit your retirement options. Do not feel that once you pick an option, you must only invest in that type of retirement plan. When circumstances change, you may want to change the way you save for retirement. A Roth might make sense for you at age 25, but a 401(k) might make more sense at age 45.