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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