One of my good buddies came over this weekend and he recently got a new job. He is contributing to his company’s 401(k) plan – which is excellent! He met with a few folks from HR to figure out whether a traditional 401(k) or Roth 401(k) would be best. The folks that he met with recommended the Roth 401(k) because he is making less money now and he has the potential to make more money in the future.
Therefore, he can contribute now with post-tax dollars while his taxes are low and save money on his taxes in the future by getting the write off from the traditional 401(k). The first thought that popped into my mind as we discussed this topic was: this will make an awesome blog post.
In this post, I’ll discuss:
- What is the main difference between a Roth 401(k) and a Traditional 401(k)?
- Is the recommendation provided by my buddy’s HR department the best advice to follow?
- Of course, some math to break down the analysis
- My recommendation and wrap up
The difference between a Roth 401(k) and Traditional 401(k)
Contributions with post-tax dollars versus pre-tax dollars. With a Traditional 401(k), the money you contribute is not taxed and reduces your taxable income. With a Roth 401(k), the contributions you make are with post-tax dollars. Think of it as money you contribute after you receive the money from your paycheck.
Let’s say that you make $50,000/year and you contribute $1,000/month into your Roth 401(k). At the end of the year, you will have contributed $12,000. Because you didn’t receive a tax-deduction, you will pay taxes on all $50,000 of your income. This equates to a little over $8,200 just in federal taxes.
Using the same example, but now you contribute into a traditional 401(k). At the end of the year, you will have contributed $12,000. Instead of being taxed for making $50,000, you reduced your taxable income to $38,000.
So what does this mean? It means you only paid about $5,200 in federal income tax, and it means that you saved yourself $3,000 in taxes – that is $3,000 in your pocket that Uncle Sam can’t take away. Let’s dig in a little further…
Unpacking the “traditional” recommendation
I honestly still struggle with what the best decision is – traditional 401(k) or Roth 401(k).
When I was first out of school, I contributed to a Roth 401(k) because I followed the “traditional” recommendation. Most people argue that you should contribute to a Roth 401(k) when you are young because your income, and hence your tax rate, is lower.
Once you begin to make more money and pay more in taxes because of a higher effective tax rate, you can start to contribute to a traditional 401(k). This will reduce your taxable income. Additionally, in retirement, your tax rate will likely be lower because you will live off of less. Therefore, it makes sense to delay paying the taxes until your tax rate is lower.
Predicting the future…
Trying to predict what your tax rate will be in retirement is risky. First, you have no idea what your situation in retirement will be like. If all of your money is in a traditional 401(k) and you need to tap it for a big expense, you could lose a great deal of money to taxes. Second, you have zero control over what the government will do regarding tax law changes.
If you can guess what your tax rate will be, you can make the decision now whether it makes more sense to pay taxes now or in the future. But no one can predict the future 🙂
Now the folks on the early retirement journey know that traditional 401(k) is the way to go because they are all about tax efficiency. They are probably saving into a taxable account, in addition to their traditional 401(k) and traditional or Roth IRA. They will live off of their taxable account while slowly converting their traditional IRA into their Roth IRA.
Here are some great articles to check out if you have more interest in this concept:
- Top hit on Google is Justin’s article over at Root of Good.
- Fellow Engineer, The Mad Fientist has a nice article titled: How to Access Retirement Funds Early
- Another fellow engineer, Joe over at Retire by 40, has an article named: Build a Roth IRA Conversion Ladder to Minimize Taxes in Early Retirement
Next, onto the math!!
The math is pretty straightforward. Here are three examples that display the tax differences for someone making $50k and contributing to a Roth 401(k) and a Traditional 401(k). The first example uses a contribution of $6k per year, the second example uses $12k/year, and the final example has a person maxing out their 401(k) – $18k/year!
You can see how much money you can save yourself on taxes if you contribute into a traditional 401(k). What is even better is if you take that money you saved in taxes and put that money into another retirement/investment account. Using the last example, take the $7k you saved in taxes and throw it into a Roth IRA (yes I know the current yearly max is $5,500). In 20 years, you will have over $1 million between your traditional 401(k) and your Roth IRA!
If you want a copy of the spread sheet to play around with, you can download the Excel spread sheet here: Traditional 401k or Roth 401k.
My recommendation and wrap up
The best advice I can give, which was given to me early in my career, is to have multiple buckets. I would save more into accounts that can reduce your taxable income so you have more of the money you work so hard to earn. If you can, take that extra money you are saving and invest it.
Maybe invest in a Roth IRA or a taxable account so you have money if you need it in a tax-free bucket (because you already paid the taxes on the contributions!)
If you have a solid plan to retire early, I highly recommend checking out the links I provided earlier in my post.
You saw from my last example how saving the money you save on taxes can really add a nice cushion to your retirement fund. The example also gives your two different buckets to dip into in retirement – one tax-free and one taxed account. I encourage you to download the spreadsheet and take a look at your situation.
Do you save into a Traditional 401(k) or Roth 401(k)?