If you have a decent retirement account through your employer they will give you the choice of a Traditional (pre-tax) 401(k) or a Roth (after-tax) 401(k). This decision of Roth vs Traditional 401k may intimidate you, but let’s be Wallet Engineers together!
Roth vs Traditional 401k: What’s the Difference
A traditional 401k is a tax-deferred retirement account. You pay the taxes later – after you retire.
A Roth 401k is not tax-deferred. You pay the taxes right now, but any gains or earnings are yours tax free. When retirement rolls around your tax bill is $0.
Not paying taxes sounds fantastic. That’d be great, right? Uncle Sam has to wait 20, 30 or 40 years to touch your money! Let’s investigate!
Factors to help you decide
Regardless of your choice: Traditional or Roth 401k MAX OUT YOUR COMPANY MATCH. This is imperative. It’s FREE money. If you put in 6% of your pay and they give you 3%. HOLY HELL. THAT’S A 50% RETURN. There is no other guaranteed way to get a 50% return. Do it. I do not want to belittle our readers, but if you are not doing this it is incredibly fiscally irresponsible.
If you are in the lowest income tax bracket, choose a ROTH. This choice guarantees you will pay the minimum amount of tax now rather than a variable amount of tax later. For example, if you make more money later your tax rate will increase. If the government raises taxes, you will pay more later. It is extremely unlikely that the government will lower taxes.
In the same vein as above, if your income tax rate will increase later in life it is better to choose a ROTH option now. In this way you “lock in” a lower tax rate now instead of paying a higher tax rate later.
Conversely if your marginal tax rate now is less than your estimated tax rate at retirement then you should choose a Traditional 401k. Conversely, if your marginal tax rate now is more than your estimated tax rate at retirement you should choose a Traditional 401k. I.E. If you make $425,000 per year (35% bracket) right now but you plan to only withdraw $150,000 per year in retirement (25% bracket) you could save a boatload of money! (Thanks to eagle-eyed reader Bruce for catching my mistake)
If you do not have the choice of a ROTH option now you have the option to convert your account from a Traditional to a ROTH at a later date paying the relevant tax amount. If you are barred from choosing a ROTH option because of your income level this is often referred to as a “back door” ROTH. ( “back door” ROTH has been proposed to be eliminated according to an article I read).
Wallet Engineer #1’s Choice:
Recently I ran a bunch of retirement spreadsheets which I’ll talk about in the future. My information led me to change from a ROTH 401(k) to a Traditional 401(k). This is because I expect my tax bracket to be lower in retirement (or worst case, even) than my current marginal tax rate. After adjusting for inflation I expect my required minimum distribution at age 70 1/2 to keep me in the 15% marginal tax rate (if it still exists) or at the very worst not push me from 25% up into the next 28% category.
If you remember from previous posts about my retirement strategy (which I’ll update) I’m planning to retire early – age 35-40 – by retiring on taxable stock account dividends. The amount that I plan to retire on keeps me in the 15% tax bracket – $36,000 or less per year. This is ample spending as I currently spend 40% of my gross income – approximately $24,000 per year. We’ll talk about that more in my next post. I made some sweet spreadsheets.
To coagulate everything: I switched to tradtional instead of roth because I can lower my tax basis now while getting the same, or better, result in retirement. I increased my ROTH 401(k) contribution by my marginal tax rate to contribute the same amount. Example: If I contributed 10% after 25% tax rate I now contribute 12.5% before tax .
Please leave your questions, comments, and concerns below! I am not a certified financial planner so all this gobbledegook is at your own risk!