When thinking about starting to save for retirement, the first question most of the young investors have is “Should I invest in traditional 401k or a ROTH 401k“? There are many variation of the question – ” Should I continue investing in traditional 401k even after the company match or start a ROTH IRA”? Or “Should I invest in traditional IRA or ROTH IRA”? All of these boils down to – is pretax retirement savings more lucrative or posttax savings? Which is better for the bottom line?
Standard advice on 401k vs ROTH 401k/IRA
Most people’s blanket recommendation is to go for the ROTH because you will never be taxed again. Is ROTH always the better option? The advice inherently assumes:
- The person is not earning much and therefore is paying less in taxes now.
- The tax code is definitely going to change and it will only go up.
- Everyone will have tons and tons of money in their nest egg, so the taxes will be high when they retire.
But the tax advantage of the traditional 401k is too substantial to ignore. And no personal finance advice is one-size-fits-all, so let’s see if ROTH IRA is really the better deal for an average young investor.
My assumptions :
- Start to save for retirement when @ 25.
- Retire at 60.
- Average annual growth of 8% (Let me know where I can get this
) - Contribute $5000 after tax every year.
- I have calculated the traditional 401k contributions based on 3 marginal rates (25%, 28% & 35%). That equates to contributions of $6666,$6944,$7962 respectively pretax. Use this spreadsheet to check your own numbers based on your own tax rate.
- It is based on marginal tax. (Why? Here is a short primer on how taxes are calculated in the US)
- Post retirement life span of 20 yrs. I examine two cases for post retirement:
- Move all the savings to cash equivalent, super safe investments like a CD which doesn’t grow the principal. So the total savings is equally divided by 20 yrs to get the withdrawal amount for each year.
- Move the savings to safe, but low yield savings. I have assumed a growth rate of 3% every year.
- Inflation isn’t considered.
- Edited to add : As Joe @ Retire By 40 points out, any other income a person might have during retirement (pension, Social Security or from other sources) is not considered either. I don’t have pension benefits, I don’t have any real estate/business that might provide me with retirement income right now and I don’t include SS in my retirement calculations, if I get something it is a bonus. But certainly play with the numbers by including any other income you might have based on you own situation.
If I have missed anything, please point it out or ask me, I will add to this list.
401k vs ROTH : The tale of two portfolios
All the 4 portfolios – $5000 after tax (ROTH 401k), $6666 (traditional 401k with 25% tax bracket), $6944 (traditional 401k with 28% tax bracket, $7692 (traditional 401k with 35% tax bracket) grew at the same rate of 8%/year for 35 yrs. This is how they ended up when that person turned 60 -
ROTH 401k | Traditional 401k with 25% tax bracket | Traditional 401k with 28% tax bracket | Traditional 401k with 35% tax bracket |
$935511 | $1247348 | $1299320 | $1439347 |
The traditional 401k portfolios grew to much more than the Roth 401k portfolio because we put more money into it, thanks to the tax deduction upfront.
401k vs ROTH withdrawal (pretax vs posttax play-outs)
- (If we assume today’s conditions) The first $19000 is not taxed ($11,600 in standard deduction for married filing jointly + $7400 personal exemptions)
- The next $17,000 is taxed 10%, the next $52000 is taxed at 15%, and so on. So if the person is with drawing ~$70000, the tax rate for the entire amount would be 16.07% (based on current rate via Dinkytown calculator), where as when they contributed to the 401k they saved taxes on a 25-35% bracket.
(the withdrawal amount is per year and same for every year because there is no growth)
Scenario #2 : Money is moved from growth funds to a bond/CD fund. So it will grow at a slower, 3% rate. Every year the person withdraws an amount equivalent to [Whatever is left over in the portfolio]/# of years left in retirement.
As you can see the traditional still gives better retirement income even after taxes.
BUT, I have made a lot of assumptions about the tax rates. I have assumed it will be the same (or very similar) to today’s rate. The #1 argument for ROTH 401k/IRA is that the taxes will go up. There is no way to prove or disprove this claim, which brings us to -
Gamble with taxes
We cannot predict the future tax rates. The only thing we have is the history. Here is the historical tax rates for all the income groups -
As you can see the highest bracket has changed a LOT in the last 50 years, but the rest were relatively stable, esp. the highest earning 20% and below. So it doesn’t look like the statement that “taxes will go up a lot” is always true.
Taxes can go up, in which case people who had a ROTH heavy portfolio will do better, or it can stay the same/go down, in which case the traditional portfolio would give more retirement income.
Don’t forget state taxes. We live in CA right now and the state tax rate is up to 9.3%. During retirement, I can control where I live as I don’t have to live in a place where I could find easy employment. So if I move to Washington state or Texas, I can get a 9% savings right there.
Our approach : Hybrid
So why do I have a ROTH IRA in addition to a regular IRA?
- ROTH gives me liquidity to take my contribution out in case I need it. In fact, I opened a ROTH IRA just to keep my emergency fund in (read about it here – ROTH IRA for an emergency fund ).
- No Required Minimum Distribution.
- Pass it on without having our beneficiaries worry about taxes.
- Your employer provided 401k might not be good.
- Finally, I like diversification.
So, Should you invest in 401k or ROTH IRA/401k?
There is a problem in the ROTH is always better advice. You will have to decide what is better for you. And that decision is not set in stone either. Each year evaluate what your situation is for that year.
- If you are going to take an year off, will have very little income and travel the world, contribute to ROTH that year. You could even rollover your Traditional 401(K) to a Roth IRA that year and pay the low income tax rate.
- For someone who is looking to max out their 401(k), they essentially can put away more money in a tax efficient account by investing in a Roth 401(k). Even though the limit is the same, doesn’t mean the value is the same because Roth 401(k) contributions are made with after-tax dollars.
- If you are just little over to fall into a lower tax bracket, you can contribute enough in traditional to let you fall in the lower bracket and then contribute to a ROTH IRA.
- If your income is a over the limit for some deductions, contribute to traditional IRA/401k to bring it down to the level where you can take the deduction.
The worst thing you can do is nothing. So don’t let this question stop you from investing. Even if you picked one randomly, you will do better than not saving for retirement. Both the ROTH and the traditional 401k/IRA are great investment vehicles. Use my spreadsheet, do the math, pick what works for you best.
What do you currently do? Do you maximize the pre-tax potential or want to be tax free during retire, so go all the way with posttax retirement plans or a mix of both?
{ 20 comments… read them below or add one }
I use a combination approach with my retirement funds split between pre- and post-tax dollars. I figure I will then end up hedging the potential tax risk but still maintain the benefits of contributing pre-tax dollars as well. It is like diversifying against future tax policy.
I am similar to CFM. I have a 401k at work – 100% match up to 4%. Also have a Roth IRA. I started both at the same time – age 23. I’m going to continue contributing into each because who knows what taxes will be like in the future. Could be the same – could be 50%.
I like Roth IRA because you never have to pay tax again. Also, you can use it as a savings account because you can always withdraw any amount up to the total contributed amount (not earnings). So there’s more flexibility with Roth vs Traditional.
I think it’s a good move on the Roth IRA/Traditional 401(k). I would still lean towards the traditional at this point in your career, but for pure tax diversification purposes it’ll be nice the have the Roth IRA in certain years of retirement.
On inflation – you’d probably be better off knocking down the return from 8% if you assume no inflation. It will leave your tax brackets comparable, but with 8% returns there is usually some component of inflation juicing the returns. I think 8% may be attainable, but I like to assume the worst (despite my sunny disposition!).
I didn’t take inflation into account and honestly I am not getting an 8% return. That is what is generally assumed so, I took it. I should try different ROI and see if it makes a difference.
Great post and thanks for making your spreadsheet available, Suba! My husband and I are in the 15% tax bracket now and it looks like the Roths are barely the better choice based on these numbers. I really thought it would be a bigger difference!
Pondering this right now. With C having been out of work for 2.5 years now, we haven’t been contributing anything to retirement for him. I’ve continued contributing to my 403(b) and increase what I’m contributing every year, but will it be enough for 2 people to retire on?
We are unexpectedly getting a tax return this year, and I’m considering- pay down debt, save for home improvement, or open an IRA or RothIRA for C.
We have ROTH IRA esp. for the liquidity purposes. We cannot afford to contribute to 401k AND IRA at this time for just retirement. May be one day…
I like the hybrid approach as this is what I am already doing. So many people are quick to point to the Roth. To be honest I dont know what tax bracket I will be in when I retire so I figure I would just hedge my bets. I like the liquidity that ROTHS provide.
Great information! I personally like the Roth option, but a Roth 401(k) can certainly be a winner as well.
Personally, I am leaning more toward the Hybrid approach. I am found of the ROTH due to it’s liquidity.
*fawned
I go for the hybrid approach as well. It will give more flexibility when I withdraw.
Your assumption about 401k withdrawal is a bit sketchy. What if I have social security income or pension or other income? If the tax rate is the same, traditional 401k doesn’t have any advantage over Roth. It all depends on the tax rate.
Agreed, I didn’t take any other income into account. I should add that in my assumptions. Pension didn’t even cross my mind
People who have those would be very lucky. Right now I am not counting for SS either, but I should state that nonetheless. And the other income as well.
I’m going to encourage my children to start with a Roth right out of high school when their tax rates will probably be zero. I think the best course of actual regardless of 401k or IRA would be to start the clock as early as possible.
Hey Suba, fantastic analysis. I’ve actually taken the same approach as you (the hybrid model) so that I can hedge if factors change. The only difference is that I do a Roth + SEP (instead of 401k since I’m self-employed). I actually like maximizing both my wife and my own Roth’s for purposes of college savings too before funding a 529 since the 529 will affect financial aid options down the line and the Roth does not.
Car Negotiation Coach,
You aren’t limited to a SEP if you’re self employed…you could open a 401K with Vanguard, for instance, and this would allow you to put more money away because you can then be contributing from both the employer AND employee side. with Vanguard managing the account for you, the so-called “more administration” of the 401K goes away.
Of course, if you don’t have the extra money to put away, it doesn’t really matter.
Good luck either way.
One more issue to be considered in these calculations: movement between tax brackets. Right now, I’m in the 15% bracket. Probably will be for a few more years. When I opened my IRA, and deposited most of my contributions to date, I was 10%. In the future, I should see the 25% bracket and possibly even the 28%. 33% is highly unlikely.
I’m starting to question how much I should do in our 401K. We’ve always maxed it, but we are now trying to build our retirement lifestyle plan and some of that includes homes in certain locations. I’m starting to wonder in this market, should I invest in a retirement property now when prices and interest rates are low? I do a bit of blindly doing the 401K thing myself and I really should reassess my allocation.
Nice post. I split my contribution between roth and traditional. I always debate this with friends or clients. Anything to do with taxes is a gamble.
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