your 401(k) #6: roth vs. traditional
Should I choose traditional or Roth?
What is the difference between the two?
Which one is best for me?
If you’re confused by the whole Roth vs Traditional debate, have no fear, you are not alone. “Should I choose traditional or Roth?” is one of the most common questions I get from friends and family alike, so this video and post should provide some clarification.
First things first, why is this even a question? Why are there two options? In a nutshell, the debate centers around everyone’s favorite topic: TAXES. More specifically, it revolves around when you pay taxes and how much you end up paying.
Until relatively recently, there was only one option: traditional. When the 401(k) and other defined contribution accounts were created, they were done so under the Revenue Act of 1978. That piece of legislation included a provision that granted special tax treatment to money set aside for retirement. In traditional accounts, the money you contribute gets deposited pre-tax or tax-deferred. “Pre” means before, so that means your contributions go into your account before taxes have been taken out. You also get to deduct the amount you contribute from that year’s tax bill, providing a small tax break.
Here’s a (very simplified) schematic of the money flow from your paycheck with a traditional account:
Not paying taxes on that money today and getting a small tax break when you file your return sounds like a pretty sweet deal. That is, until you retire and realize that not all of your account balance is yours to keep! In order to get the tax break today, you’re agreeing to pay taxes on both the money you contribute AND your investment earnings when you retire.
Roth accounts, which came about in 1997, are essentially the opposite. In a Roth, you contribute money post-tax. “Post” means after, so your money goes into your account after federal and state taxes have been taken out. Here’s another (very simplified) schematic illustrating the money flow from your paycheck with a Roth:
Because you’ve already paid Uncle Sam his share, your money is allowed to grow completely tax-free. That means you won’t owe any more tax on the money you put in or on your investment earnings. The power of compound interest would be all yours to keep!
As we learned in the Compound Interest video, if you start early enough, your investment earnings will make up the majority of your nest egg. Let’s circle back to the example in that video:
- If you contribute $5k per year from ages 25 to 65, you’ll have contributed $200k total.
- If your money grows at an average rate of 8% per year, your $200k will be worth over $1.5 million when you retire.
- Now let’s assume you withdraw the recommended 4% per year in retirement ($60k/year or $5k/month).
- If you have a traditional account, you’ll have to pay taxes on that money as if it were ordinary income. So, depending on your other sources of income (Social Security, investments, etc), you could end up paying 25% ($15k) or more in taxes, leaving you with $45k (or less) of the $60k you withdraw.
- If you have a Roth account, you’ll get to keep the full $60k for yourself because you paid Uncle Sam his share years ago.
So how do you choose? Long story short, it boils down to the tax bracket you’re in today and the bracket you expect to be in when you retire. Loaded question, right? In all honesty, I have no idea what bracket I’ll fall into 40 years from now. But, there are two common schools of thought:
If you’re young and just starting your career, you’re likely in the lowest income tax bracket of your life (assuming your pay increases with age/experience). In this case, you may benefit from a Roth because the amount you’d pay in taxes on your contributions today would, in theory, be significantly less than what you’d pay on your contributions + earnings in retirement.
If you’re older or earning a high salary right now, a traditional account could be the way to go. Due to our marginal tax rate system, you’d benefit most from tax-deductible contributions today. Assuming you stop working when you retire, or the amount you withdraw from your 401(k) is less than your pre-retirement income, you’ll likely fall into a lower tax bracket.
If you’re still unsure, here are some questions you can ask yourself to gauge which option is best for you:
- Do I expect to make more or less money as I get older?
- Do I think tax rates are likely to go up or come down over time?
- Another way to ask this question: Do I think the financial needs of the government will increase or decrease over time?
- Remember, our taxes go to pay for infrastructure and social programs, among other things. Will the government need to take more or less money from each person to pay for these programs?
- Will I have greater or fewer tax breaks in retirement?
- There are a number of things that can lower your tax bill during your working years - children/dependents and interest paid on your mortgage, for example.
- If your kids are no longer dependent on you financially, you won’t be able to claim that deduction anymore. Same goes if your house is paid off by the time you retire.
- Will I live in a high or low tax state? Or even a no-tax state like Texas or Florida?
- Moving to a lower tax state in retirement could automatically lower your overall tax rate by anywhere from 2-9%, depending on your state. This could be a supporting factor for a traditional account.
- How do I want my retirement money handled after I pass away?
- Because you've already paid taxes in a Roth, any money left over when you pass will be inherited by your beneficiaries tax-free. That means they won't have to pay taxes on the money they inherit, which is a powerful estate planning tool.
To try your hand at calculating which bracket you’ll fall into in retirement, you can check out the current tax rates here. A financial planner would also be able to help you determine where you’ll fall.
Two last points I want to make:
Any employer match funds you receive will be treated as traditional contributions, so you’ll owe taxes on that money and its growth in retirement no matter what. If you don’t know what an employer match is, click here to check out last week’s video.
In most cases, you don’t have to choose! Some 401(k) plans and IRAs today allow you to split your contributions, say 50/50, between traditional and Roth. Or, if you have a traditional 401(k) through your employer, you could open a Roth IRA on your own to benefit from Roth treatment. Just be aware of potential double fees for technically having “two” accounts (one Roth, one traditional).
MY PERSONAL PERSPECTIVE
Now, I can’t give you advice, but I can share my personal perspective.
I’m currently 27 years old and married. My husband and I are both ambitious and hope to be very successful financially. We also plan to invest in real estate and other ventures to make sure we have income from multiple sources. So we expect to generate significantly higher income in the future than we’re making now. I also believe that tax rates will creep up over time, and I hope to spend my golden years in California, which has a higher state tax rate than what I currently pay.
Therefore, I would choose Roth over traditional because I would rather pay lower taxes today and let my money grow tax-free.
Furthermore, from a psychological perspective, I prefer to look at my account balance and know that all of the money there and in the future is mine to keep. Finally, from an estate planning perspective, I want my future children to inherit any leftover money tax-free as well.
TONY ROBBINS' MONEY: MASTER THE GAME
Last summer while laying the groundwork for ReisUP, I read Tony Robbins' book Money: Master the Game. I highly recommend it if you want to learn more about the 401(k) industry and get even more jazzed up about taking control of your financial future.
To end this post, here’s a great snippet from the book about the Roth vs Traditional debate:
“A Roth IRA - and more recently the addition of the Roth 401(k) - is often overlooked, but it is one of the best and yet legal “tax havens” in the face of rising future tax rates. And we owe a big tip of the cap to Senator William Roth for their introduction back in 1997. Let’s look at how they work.
If you were a farmer, would you rather pay tax on the seed of your crop or on the entire harvest once you have grown it? Most people seem to get this question wrong. We are conditioned to not want to pay tax today (and thus defer into the future). They think it’s best to pay tax on the harvest. But in reality, if we first pay tax on the seed, that’s when the value of what’s being taxed is smallest. A big harvest means a big tax! If we pay our taxes now on the seed, then whatever we have come harvest time is ours to keep! A Roth account works in this way. We pay our tax today, deposit the after-tax amount, and then never have to pay tax again! Not on the growth and not on the withdrawals. This arrangement protects your pie from the government’s insatiable appetite for more tax revenues and, most importantly, allows you to plan with certainty how much you actually have to spend when you take withdrawals.”
Robbins (2014). Money: Master the Game (1st ed.). New York, NY: Simon & Schuster.