In last Friday’s post I talked about how you could save $100,000 in tax savings by retirement with a Traditional 401(k). As I mentioned, there are two 401(k) account options, the Traditional 401(k) and the Roth 401(k). Your employer may only offer the Traditional, but it’s more common to offer both. So which account do you ultimately choose when it comes to your 401(k) investing? As a DIY investor, the decision is ultimately yours to make.
While $100,000 is a good chunk of change that you can save with the Traditional 401(k), because of the immediate tax savings you get with contributing pre-tax dollars, there are reasons why selecting the Roth 401(k) would be a more advantageous option. Let’s take a look.
What are the reasons for investing in a Roth 401(k)?
- You are in a lower tax bracket today than you expect to be in retirement. Let’s say, for example, you make $47,000 today, which would place you in the 25% tax bracket. And let’s assume you are a diligent saver, starting at age 22 and investing 7% of your salary, with a 4% employer match, until age 67. You’d end up with approximately $2.3M by the time you retire (assuming an 8% investment return). Let’s say you take out 4% each year as income, which is roughly $92,000 (=.04 *$2.3M). That now puts you in the 28% tax bracket. If you had selected a Traditional, you would have saved $822.50 (=.25 * $3,290) while working, but with a Roth you save ~$18,800 (see tax liability calculator here)! The tax benefit you get in retirement when you are in a higher tax bracket with a Roth is truly outstanding.
- You want the certainty of knowing exactly what you will have saved by retirement. If knowing that you won’t have to figure out how much you’ll actually have each year after taking into account income taxes, and instead you’ll get to live off your withdrawals tax free, then a Roth is a good idea. Even better, you won’t have to be concerned about the fluctuation in tax rates and its impact on your bottom line because you’ve already paid Uncle Sam. (Keep in mind, however, if you do get an employer match and you contribute to a Roth, in fact your employer dollars are pre-taxed and you will pay tax on these withdrawals in retirement.)
- You have the option to rollover your Roth 401(k) into a Roth IRA. I won’t go into too much detail here, but with a Roth 401(k) when you leave your employer you can rollover your account into a Roth IRA. There is benefit to doing this because with a Roth 401(k) you will be required to start taking out required minimum distributions at age 70 1/2, but with a Roth IRA there are no required minimum distributions – ever! For the sake of argument, let’s say you have a successful side business when you “retire” before age 70 1/2 and you make more than enough income from your side business each year to sustain you. In that case, why would you even need the withdrawals from your Roth 401(k)? To keep your money growing tax free in that case, you can roll it over into a Roth IRA. Even better, you can leave this Roth IRA untouched for the rest of your life, and then leave it to your beneficiaries, which they themselves too will enjoy tax-free! (IMPORTANT NOTE: If you find yourself needing to rollover your 401(k), make sure to solicit the assistance of a professional tax and/or financial advisor.)
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Thanks Matt. I’ve been reading your blog for a month or so. Its great.
About the Roth IRA- what if I’d rather save money for a down payment on a condo?
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Hey Adam! That is a great question and one I have recently begun to think of as well. To save for a down payment on a condo depends on your time frame. If you are planning on the next year or more, I’d recommend putting your money into a certificate of deposit where you can get a higher investment return compared to a traditional savings account. You could put the money in a brokerage account but you’ll end up paying capital gains taxes on any appreciation, and the rates are even higher if your assets are held for less than a year. So therefore I wouldn’t recommend this route at this time. If you want to buy one in the next couple of months or so, then I would recommend saving your money in a traditional savings account that pays at least 1.00% or higher APY. You can check out bankrate.com to compare savings accounts. – Matthew
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Hey Matt,
I disagree with your third point. It’s not really a reason to pick a Roth 401k because you have the same option with a traditional 401k.
You can roll over a traditional 401k into a traditional IRA when you leave your company. Afterwords, you can then do a traditional to Roth conversion on your IRA, accomplishing exactly what you stated in point 3, except starting with a traditional 401k.
Other than that, awesome points. Roth is most certainly better numerically if you’ll have more taxes later than now, and its always nice to know your post tax savings!
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Hey Akash! What you mention is not the same. On the contrary, with your approach, you will have to pay ordinary income taxes during the year of your conversion to the Roth IRA. Depending on the size of your account and tax rate you are in, you could be faced with a very high tax bill that you will have to pay out of pocket. So if you don’t have the cash on hand to pay those taxes you won’t really be able to execute that approach. It’s easiest to start with a Roth 401(k) and go straight into a Roth IRA when you leave a job or retire. In that case, you won’t have the concern of needing to plan out an intricate tax strategy or needing cash on hand to pay an extraordinary amount of taxes on the conversion. My advice is it’s easiest to keep like things together. Hope that helps! – Matthew
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Hey Matt,
I thought about the issue some more and realized there’s another good reason to be careful of your traditional to roth conversions – a progressive income tax code.
Basically, since you get taxed “harder” the more money you make, converting a traditional account into a roth may push you into a higher tax bracket than you may otherwise be in.
In that sense, I agree that its best to keep like things together – and avoid the tax headaches!
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Hi Akash! You are correct! Because of our progressives tax system, the tax burden gets bigger and bigger if you have a high account balance and from getting pushed into a higher tax bracket when you execute the conversion. So best to keep like things together to minimize the expense! – Matthew
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