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Roth 401(k) vs. Traditional 401(k)

Conventional investment wisdom says that when choosing between tax-deferred accounts [like a traditional 401(k) or IRA] or tax-free accounts [like a Roth IRA or Roth 401(k)], it’s primarily a question of how you expect your tax bracket in retirement to compare to your current tax bracket:

  • If you expect your retirement tax bracket to be higher, go for the Roth.
  • If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
  • If you have no idea, do some of both.

I recently received a related question from a reader about choosing between a regular 401(k) or a Roth 401(k):

I can contribute approximately $1,000 each month to my 401(k). The plan allows me to make either Roth or regular contributions.

I’m in the 25% tax bracket, so the $1,000 deduction I’d get every month from making regular 401(k) contributions would give me an extra $250 to contribute. Would that extra $250 monthly investment, compounded from now until I retire, be enough to overcome a higher tax bracket in retirement?

Good question. The short answer is, “No, because that’s already factored into the normal advice.”

How About an Example?

Annie invests $500 in a traditional 401(k) and $500 in a Roth 401(k). Each investment goes into the same fund. When Annie retires:

  • The Roth contributions will come out tax-free, but
  • The traditional 401(k) contributions will be taxable as ordinary income.

In other words, the $500 Annie invests in her Roth 401(k) will end up being worth more than the $500 she puts in her traditional 401(k) unless her tax rate during retirement is zero percent.

Takeaway: You have to invest more in a tax-deferred account than in a Roth account in order to have the same amount left after taxes.

For example, if you expect to be in the 25% tax bracket in retirement, you have to invest $1,333 ($1,000 ÷ 0.75) in the tax-deferred account each month for it to be as valuable as investing $1,000 in a Roth.

What Role Does an Employer Match Play?

In a follow-up email, the reader asked about how an employer match factors into the decision. For the most part, it doesn’t. Any employer contributions will be made to a “traditional” 401(k) account, regardless of whether the employee makes Roth or regular contributions.

Is Conventional Wisdom Right This Time?

When people say that the question of Roth vs. traditional is primarily about how your current tax bracket compares to your future tax bracket, they’re right. Again:

  • If you expect your retirement tax bracket to be higher, go for the Roth.
  • If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
  • If you have no idea, do some of both.

Just remember that when investing via tax-deferred accounts, you have to contribute more money.

*This is obviously not a scientific survey, but my correspondence with investors indicates that the majority of retirees are in a lower tax bracket in retirement than they were in for most of their careers.

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Comments

  1. Do you know if you are able to withdraw contributions (not earnings) from a Roth 401k tax and penalty free like with a Roth IRA? I was recently wondering about this.

    I accidentally posted this to your article from last week. Sorry for the duplicate.

  2. Hi Rob.

    My understanding is that money can only be taken out of a Roth 401(k) account for the same reasons it can be taken out of a regular 401(k) account: leaving employment with the company, disability, hardship withdrawal, etc.

    As to how much of the distribution is taxable: It’s a pro-rata share of the distribution (unless you’re 59.5 or older and have had the Roth account for 5 years, in which case none is taxable).

    For example, if you made $5,000 of Roth contributions, and earnings in the account were $1,000, then 16.67% (1,000 ÷ 6,000) of any distributions would be included in your gross income.

  3. Mike, per TFB, doesn’t a Roth 401(k) make it dangerously easy to end up having to fill your lower tax brackets in retirement with after-tax dollars even if your marginal bracket doesn’t go down? Or do you think this issue is overstated? I did a napkin calculation and it seems to me that all-Roth isn’t right for anyone unless they expect a generous pension or have a large amount of existing pretax contributions.

    Best,
    Matthew

  4. Hi Matthew.

    I’m not 100% sure what you mean by your first question. (By my understanding, distributions from after-tax accounts don’t fill tax brackets at all.)

    But I agree with your final sentence (and with TFB): All-Roth is the right decision for only a small percentage of investors.

  5. You’re right, I misstated it. I meant not having enough pretax money to fill your lower tax brackets and therefore finding yourself in a lower marginal bracket and wishing you hadn’t gone all-Roth.

  6. Oh, sorry. Then yes, that’s spot-on with my assessment as well.

  7. Mike,

    If an employer matches in the Roth is it considered income? How does that work – if I put in $500 and the employer gives me a 100% Match (real simple example)…on the way out it is tax free (b/c of it being a Roth) but what of that other $500 is that taxable on the way in?

    I don’t have access to a Roth 401(k) so I never bothered to look into it.

  8. Evan: Employer matches are made to a “traditional” 401(k) account regardless of whether the employee made Roth or regular contributions.

    In other words, the match is not taxable as income when the matching contribution is made, but it will be taxable as income when it comes out.

  9. Interesting. So you can fund a Roth 401(k) and automatically get a tax hedge benefit with your employer’s Traditional 401(k). So if taxes/income brackets are lower you pull from the traditional and if they are higher you pull from the Roth.

    Really cool – I had no idea.

  10. Mike,

    In regards to the previous post about using traditional 401k money to fill in your marginal bracket. Does social security count towards (or fill in) your bottom bracket like a pension would?

  11. Rob: Not exactly. The amount of Social Security income that’s included in taxable income depends on your income level. It can range from 0% of it being taxed, to 85% of it being taxed–at whatever your tax rate is. (See here for an explanation.)

    One way to look at it is that once you start receiving SS benefits, you essentially have a “tax hump” in the middle of your 15% tax bracket. That is, there’s a range in the middle of that tax bracket during which your effective tax rate is higher than 15% because each additional dollar of income results not only in $0.15 of income tax, but also in more of your SS benefits being taxed.

  12. Debbie M says:

    What tax bracket you will be in does not just depend on how much income you have, it also depends on what the tax rates are. I see the tax rates going nowhere but up. (Of course I thought that before the last tax cuts, too!)

  13. Mike,
    If you are in the 25% tax bracket in retirement as well as while contributing, the value of the money is exactly the same in either account.
    If I have $1000 to invest, I can put $1000 into a traditional 401K or pay the taxes and have $750 to put into the Roth. Putting $1000 into the Roth means you are, in effect, putting away more than the $1000 you had to invest. I see this used as an argument all the time but, it overlooks the fact that you have less to contribute after you pay the taxes.

  14. “If I have $1000 to invest, I can put $1000 into a traditional 401K or pay the taxes and have $750 to put into the Roth. Putting $1000 into the Roth means you are, in effect, putting away more”

    Yep, that’s exactly what I was trying to say above. It’s neither an argument for or against making Roth contributions. My intent was simply to point the difference out so that people remember to account for it when doing their planning.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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