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Roth 401ks vs. Traditional 401ks


Last week, we asked: 401k or IRA? So the obvious follow-up is: Roth or traditional?

If you read that and say, “huh?” Don’t feel bad. Despite hundreds of articles I’ve read on the topic, I have yet to find one that explains the differences between Roth and traditional accounts in a way that non financial nerds can understand it.

Today I’ll do my best.

Note: Not everybody has the option to do a Roth 401k. Only some employers offer this, although it’s becoming more common. In this series we’re discussing 401ks, but the differences between Roth and traditional accounts we discuss today apply to individual retirement accounts (IRAs) as well.

Traditional vs. Roth

Very quickly, retirement accounts come in two flavors—traditional and Roth.

  • With traditional accounts, you don’t have to pay taxes on the money you put in now, but you have to pay taxes on the money when you withdraw it later.
  • With Roth accounts, you can only put money in after you’ve paid taxes on it, but when you withdraw it in retirement, you don’t have to pay taxes on the money.
Traditional Accounts Roth Accounts
Contributions made with pre-tax dollars Contributions made with after-tax dollars
Withdrawals (principle & interest) are taxed Withdrawals (principle & interest) are tax-free
10% early withdrawal penalty applies to entire balance 10% early withdrawal penalty only applies to gains, not deposits

For quick trivia: the Roth accounts are named for this guy, the Delaware Senator who created the Roth IRA in 1997.

Roth 401ks vs Roth IRAs

We’re focusing on comparing Roth 401ks and traditional 401ks, but how does the Roth 401k differ from the Roth IRA, every blogger’s favorite retirement account? The big points are highlighted on the chart below—contribution limits, income limits, and mandatory retirement age.

But if you have a Roth 401k at work, is there any reason to still contribute to a Roth IRA?

Yes.

The main reason is Roth IRAs can double as emergency funds. With a Roth IRA, you can withdraw your deposits tax- and penalty-free at any time. (You just can’t touch the gains.) Not that you should do this, but if you ever had a big emergency and needed money, tapping a Roth IRA is better than tapping a 401k or traditional IRA and paying a 10% penalty. It’s probably better than taking a 401k loan, too.

Roth 401k Roth IRA Trad. 401k Trad. IRA
Tax Deductible No No Yes Yes
Taxed at Withdrawal No No Yes Yes
Early Withdrawal Penalty On earnings only* On earnings only* Yes, before 59 1/2 Yes, before 59 1/2
Mandatory Withdrawal Age 70 1/2 No 70 1/2 70 1/2
2015 Contribution Limit** $18,000 $5,500 $18,000 $5,500
Loans Allowed Yes No Yes No
Income Limits No Yes Yes On deductions***

*Penalty applies to earnings withdrawn before age 59 1/2 or within five years of contribution. You may withdraw deposits at any time penalty-free.
**Investors over 59 1/2 may make additional catch-up contributions.
***Anybody may contribute to a traditional IRA and earnings will not be taxed until retirement. Depending on how much you earn and whether you have a retiremetn plan at work, you may not be able to deduct all of your contributions, however.

Other Differences

As you can see, there are a lot of subtle differences between these account types, and all the acronyms and contingencies start to make your head ache like a bad hangover. Just a couple more things to mention:

Rollovers: When you leave a job, you can rollover your 401k into an IRA at the broker of your choosing. If you have a traditional 401k it becomes a traditional IRA; a Roth 401k becomes a Roth IRA.

Roth Conversions: You can convert a traditional IRA into a Roth IRA by doing a Roth conversion. You pay taxes this year on the balance of the IRA so you won’t have to pay them in retirement. This can be a way to diversify the tax basis of your retirement savings or for high earners to get around the income limits on Roth IRA contributions.

Choosing Between a Roth 401k and a Traditional 401k

Here’s the thing about this decision: If the tax rate you pay stays exactly the same between now and when you retire, there will be NO DIFFERENCE in your returns between a Roth and Traditional account invested in the same stocks. So:

  • Roth 401ks are better if you believe you will be paying a higher tax rate in retirement than you pay now.
  • Traditional 401ks are better if you believe you will pay a lower tax rate in retirement than you pay now.

Here’s how this looks. The table on top compares a traditional 401k with a Roth 401k if tax rates stay the same; the bottom table compares the accounts if the investor’s tax rate goes up 50%.

Roth 401k vs Traditional 401k returns.

Of course, no one knows for sure what taxes will be in the future, but most people assume taxes won’t go down.

If you’re young and professionally ambitious, it’s a good assumption that you’ll be in a higher tax bracket as a successful retiree than you are now on an entry-level salary.

This is why most advice geared towards young investors heavily favors Roth accounts.

That said, some people hedge by using both traditional and Roth accounts so they get some benefits whether taxes go up or down. Before Roth 401ks became available, many investors had a traditional 401k at work and a Roth IRA too. If you can’t do a Roth 401k at work, this is what I recommend.

Here Are The Takeaways:

  • Roth 401ks are good because if your tax rate goes up, your savings will be worth more in retirement.
  • But because nobody knows what tax rates will do, it’s not a bad thing to have both Roth and traditional accounts.
  • The less you earn now, the better it is to contribute to a Roth.
  • The more you earn, the more you want to transition to traditional accounts.

If you make a lot of money, you cannot contribute to a Roth IRA because of income limits. You can still do a Roth 401k if you have one at work, but that doesn’t mean you should. Unfortunately, there’s no clear dividing line because nobody knows how their tax rate in retirement will compare to their tax rate now. If you want to make sure you get it right, regular visits with a financial planner or tax expert are a must.

To make it simple as possible, however, know that saving for retirement is more important than whether you use a Roth or traditional account. But as a rule, follow this automatic investing flowchart: Start with your 401k—traditional or Roth—and contribute enough to get your employer’s match (if there is one). Then contribute up to $5,500 a year to a Roth IRA. Then go back an max out your 401k.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. I think it is important to look at marginal vs. effective tax rates. The number crunching is more complex, but the traditional usually wins out, because rarely is your effective tax rate in retirement going to be greater than your current marginal tax rate.

  2. I am 26 years old and I have a Roth IRA and a traditional 401k. I invest up to the match on the 401k, and unfortunately don’t have any left for the Roth at the moment. I would like the option of being able to withdraw as much money as I want in retirement tax-free, so a Roth is a great idea for me.

  3. If your company offers a Roth 401k, in addition to regular 401k (and lets assume you have a good choice of funds), wouldn’t it make more sense if put money in the Roth 401k vs Roth IRA?

    With the Roth 401k, doesn’t the company match your contributions (to a certain limit) just like regular 401k? A Roth IRA doesn’t give you that free money.

    Am I missing something here?

    • My company has both a Roth and Traditional 401(k), but the matching funds only go into the traditional 401k, so no matter what I will be paying taxes on some of my withdrawals. If the matching funds went into the Roth you would never pay taxes on it. That would be too good to be true.

      • I’m not sure if it varies by plan, but it appears that the Roth 401k plan I’m contributing to has my employer’s matching contributions going into the Roth plan rather than the traditional 401k that I was contributing to before the Roth option was offered.

        I guess my one concern is this though…for the first 7 years of my employment I was contributing into a traditional 401k plan. My employer started offering a Roth 401k plan starting 1/1/12 that I started contributing to. When I go into my brokerage account, it does not distinguish the contributions & earnings from pre-Roth contributions and those from my current Roth contributions, so I’m not sure how I’ll be taxed when these assets appear to be intermingled between traditional & Roth $s (though I have been recording all my bi-weekly fund purchases from my Roth contributions, so I do know the # of shares I own from Roth $s)

        • Jessica says:

          They should be holding the 2 pots of money separate for you…it will probably show up on your end-of-year statement. My company also offers both plans, and I switched to the Roth once they began offering it. My annual statement is much more detailed than the monthly balance I can access online!

  4. Sometime in 2012 I will have the option to start a Roth option with my Thrift Savings Plan (federal government 401k). I am contributing the full amount to my TSP, and I have a Roth IRA fully funded as well. So I am already tax diversified. I like the idea of being tax diversified when I retire, but at the same time I have no idea what my tax situation will be when I retire. I think for now I am going to stick with the traditional tax deferred TSP, because for some reason I don’t think I will be paying higher taxes in retirement, and here’s why…

    I think something to seriously consider is how much of your income you are currently spending. I live on less than half my income, and I just can’t imagine my taxes being higher in retirement than they are now. I will be able to fully control my income in retirement, choosing when I want to pay myself a paycheck, so I will have control over my tax bill. Right now I can’t control my income, it is what it is, and so are my taxes.

  5. What is the best way to guess at which tax bracket I will be in during retirement? Is this based on my expected 401k withdrawals?

  6. David Weliver says:

    For Mark and others who have asked about predicting tax rates in retirement, it’s somewhat a guessing game…especially when retirement is 30-40 years off. We have no idea what the government do, but we may be able to figure out what our income might look like by combining social security benefits with what income we hope to get from our own savings.

    Here are a couple articles that go into more detail:

    https://news.fidelity.com/news/article.jhtml?guid=/FidelityNewsPage/pages/question-roth-future-tax-rates&topic=saving-for-retirement

    http://www.savingadvice.com/articles/2007/06/11/101530_why-youre-likely-to-be-in-a-higher-tax-bracket-when-you-retire.html

  7. The issue I’ve had with Roth IRA in recent years is that politicians know that lowering income tax rates is popular. I wouldn’t be surprised if income tax was a thing of the past by the time I retire.

  8. I really like how well you explained such a complex topic. Roths are a great choice if you have that option, and are proven to be beneficial to almost all participants (haven’t met anyone yet who’s complained about it!). I cosign on your point about it being an emergency fund cushion because the withdrawals are penalty free (not including gains). It is definitely better than taking out a 401k loan because if you leave your job the loan has to be paid in full, usually within a couple of months.

    Good information, thanks for sharing!!

  9. Hey guys. I am 22 and just started working full time. My original plan was to invest in my 401k up to the match of 6% (in this case $3900), and then put an additional $5000 into a Roth IRA. However, I just found out about the option of a Roth 401k, which I had never knew existed. So now I am wondering if I should still continue with the Roth IRA, or if I should instead invest that $5000 in my Roth 401k instead? OR should I just take the entire $8900 I planned on investing and put it all in a Roth 401k (and forget about the traditional 401k)?

    Basically I have a set amount of money that I am looking to put away for retirement, and I am just wondering what the best way to allocate that money would be (among traditional 401k, Roth 401k, or Roth IRA). Any advice would be much appreciated!