# When A Roth 401(k) Trumps A Traditional 401(k)

The New Year’s Day tax deal (also known as the fiscal cliff legislation) made headlines in the retirement world because it included new rules to make it easier for employees to convert existing traditional 401(k) plans to Roth 401(k) plans. Over the past six years, an increasing number of companies have begun to roll out Roth 401(k) options for their employees.

Many people now have the simple question: **“When does it make sense to choose a Roth 401(k)?”**

Before we answer that question, you should understand the key difference between a Roth 401(k) and a traditional 401(k). With a Roth, you’ll pay taxes on the money you invest now, but no taxes when you withdraw the money at retirement.

In other words, contributions to a Roth 401(k) are not tax deductible, unlike contributions to a traditional 401(k). Distributions from a Roth 401(k) are not taxable, unlike the distributions from a traditional 401(k). The combined contribution limit is $17,500.

A Roth 401(k) enables you to pay a small tax bill upfront in exchange for what is almost undoubtedly a larger tax bill later. Thus, most discussion of Roth accounts tends to devolve into a debate on how much higher (or lower) tax rates will be in the future.

However, for most people, the issue is more basic. If you are a disciplined saver, you can get the same effect *and* the current tax deduction. You can save in a regular 401(k) now, take the deduction, and then save an additional sum in a taxable account to pay your tax bill on retirement.

So the question boils down to: **Do you have the self-control and spending discipline to save money now to pay off taxes later?** Or do you need the crutch of the Roth account?

Like everything tax related, specific situations and details matter. So let’s walk through the factors that can help you decide whether a Roth 401(k) will make sense in your situation. (By the way, you should maximize your retirement savings in general only after you have enough liquidity. That’s a topic for another post, one we want to write soon).

## Why not just choose a Roth IRA?

- You can achieve some of the same goals with a Roth IRA. But the Roth 401(k) has no income limit. In 2013, you can only contribute to a Roth IRA if your annual income is below $127,000 (single) or $188,000 (married).
- The limit for annual contributions to a Roth 401(k) is $17,500 in 2013, while the limit for annual contribution to a Roth IRA is $5,500 in 2013. You can contribute to both.

## Real Money Example: Traditional vs. Roth

If you do the financial analysis on the benefits of the Roth 401(k), you can see the way the tax benefits and the psychology of saving come into play.

**Let’s look at two sample employees, Joe Facebook & Jane Google.**

Joe Facebook contributes $17,500 to his traditional 401(k) in 2013. Jane Google contributes $17,500 to her Roth 401(k) in 2013.

Joe ends up with the bigger after-tax paycheck in 2013. When Joe contributes $17,500 to his traditional 401(k), he gets a tax deduction this year. Assuming his combined marginal federal and state tax rate is 45%, he will save $7,875 dollars of his 2013 taxes.

However, Joe hasn’t really saved on his tax bill permanently. He’s just deferred that payment to the future. If Joe’s contributions grow at 7% until he retires in 20 years, that $17,500 will have grown to over $67,719. But assuming his combined tax rate is still 45%, he now will owe over $30,473 in taxes when he takes his distribution, for a net of $37,246.

Jane, on the other hand, will see $17,500 come out of her income for the year of 2013, after tax. But assuming the same investment returns, tax rates and time frame, when she retires she can withdraw the full $67,719. No tax bill is due.

From a cash flow perspective, Jane will have much higher after-tax income than Joe, because while they both invested the same amount of money, Jane gets to keep her full retirement distribution, while Joe has to pay taxes on his.

## Why does investing the tax savings matter?

On the surface, it seems like trading a small tax bill today for a large tax bill in the future makes sense. The idea of a $30,000 tax bill looming in the future certainly doesn’t feel fantastic.

But what if Joe Facebook saved the $7,875 in 2013? If he saved it instead of spending it on his daily cappuccinos, he could use the proceeds to pay off the tax liability on his 401(k) when he eventually retires, matching the benefit of the Roth 401(k).

If Joe decided instead to open an investment account with that $7,875, then in 20 years with a 7% return he would potentially have $30,473 to pay that tax bill upon retirement. (To estimate the actual tax bill in 20 years is difficult – it requires making assumptions about your total taxable income, your state of residence, and future tax rates.)

In short, to match the benefit of the Roth 4o1(k), you need to invest the tax savings from the traditional 401(k) to cover that growing income tax liability.

## So Should I Choose a Roth 401(k) or Not?

If one of the following three situations fits you, you should seriously consider taking advantage of a Roth 401(k) offering:

- If you do not currently have access to Roth protected retirement accounts, a Roth 401(k) can help you hedge your future tax exposure. The high contribution limits mean you can potentially build up Roth assets much more quickly than through a Roth IRA.
- You earn high enough income to be disqualified from opening a Roth IRA, and you’d like to add additional Roth-protected assets.
- You have the income and/or expense discipline to handle the hit to take-home pay this year, but you don’t believe you’ll be among the minority of people capable of diligently saving for a future tax bill.

## The Bottom Line

Effectively, any kind of a Roth account can act like a “forced savings” of money you’ll need to pay taxes on your retirement savings. Most people need that kind of forced savings, which behavioral experts call a “precommitment strategy” – a way to overcome your own lack of self-control. From a behavioral finance point of view, people who invest in Roth accounts are likely to end up with more after-tax income when they retire.

**More details on Roth 401(k)s**

*Company matching contributions, when available, are not made into the Roth 401(k), but go into a separate traditional 401(k) account.**You can have both a Roth 401(k) and a traditional 401(k) as long as you stay within the total annual contribution limit.**When you leave a company, you have the option to roll over your Roth 401(k) into a Roth IRA, not a traditional IRA. And yes, you can do this at Wealthfront.**The Roth 401(k) is a benefit offered through your employer, similar to other 401(k) plans. As a result, the investment options and provider are limited by your employer’s specific plan.*

For more on your traditional 401(k), read our recent article discussing 401(k) administration fees.

And what if we believe the 2043 tax rate is going to be 55%, then what should we do?

Well, you definitely want to go with Roth then, as with traditional you would have to pay 55% at the time of retirement. Generally speaking, if you expect your income over the years forcing you into a higher tax bracket, or if you foresee an increase in tax rates for whatever reason, then Roth is the answer. If you expect your income or the tax rate to decrease, traditional is the better option as you would pay at a lower rate at retirement.

Any taxpayer can make contributions to a Roth IRA. You first make non-deductible contributions to a traditional IRA, then immediately roll them over to a Roth. This technique is called a “backdoor IRA”; it is completely legal, and very common among people who make more than the income limit for direct Roth contributions.

Also, your numbers demonstrate an interesting point that I’m surprised you didn’t call out explicitly: the post-tax contribution limit to a Roth is the same as the pre-tax contribution limit to a traditional plan. This means that a Roth effectively lets you shelter more money. If you followed Joe Facebook’s strategy, taking the money you’ll need for taxes and investing it in a retirement account, you’ll always end up with less than you need, because of the taxes you’ll pay on the tax money.

I might be missing something, but is there a reason why you used 20 years instead of 30 years in

“If Joe decided instead to open an investment account with that $7,875, then in 20 years …”?

Since you are comparing Joe’s returns against Jane’s, I would calculate ($7,875 * (1.07^30-1)) ≈ $52K. Even with 25% tax, he still keeps $39K, which is more than his tax burden from the traditional 401(k).

Hi Jim,

Two great catches, which is a nice way of saying, thank you for catching two mistakes in the post. The “30 years” reference was a typo – all the numbers in the post are 20 year calculations. In terms of the tax rates, using 25% is a mistake on multiple levels. In 2013, the long term rate can be as high as 23.8% now, and in California, you can add potentially another 13.3%. Of course, you may be in a different tax bracket when you retire or move to a different state. For the purpose of the post, the message is really that you need to invest at least some of (if not all) the tax savings from the traditional 401(k) to match the economics of the Roth 401(k).

Thanks for flagging the issues. I’ve fixed the post accordingly.

Adam

Of course, you’re also assuming that Joe stays in the same tax bracket upon retirement that he’s in today. For most people, that’s unlikely, and that’s the attraction of a 401(k) – the chance to play tax rate arbitrage. If Joe is in the 31% bracket now, but the 25% bracket upon retirement, he’ll save 6% in taxes simply by deferring the income tax 20 years.

Likewise, if Jane is in the 31% bracket now and the 25% bracket upon retirement, she’ll have overspent on taxes by 6%. To add insult to injury, her $67,000 in 2033 won’t buy as much as $67,000 will today, further increasing her loss (albeit in a more obtuse way).

As you said, you can game this in any number of ways, depending upon what assumption you make.

As I mentioned in the post, guessing someone’s tax rates in the future makes assumptions about at least three different unknowns: what will your income be in retirement, what state will you live in during retirement, what will the tax laws be in retirement. Comparing the tax code of 1953 to 1983, or 1983 to 2013 you quickly see the issue.

The point of the analysis in this blog post is that, at any rate, the Roth 401(k) eliminates a tax liability today that the traditional 401(k) carries. You have to save externally to the 401(k) to cover that liability to match the economics of the Roth long term.

Adam

Is it not true that there is another benefit to the Roth 401k, i.e., that increases in the value of the Roth account are not taxable when one withdraws but that those increases are taxable from a traditional 401k?

E.g., I thought that if one put $1000 into a pre-tax, traditional 401k, then the investment would compound tax-free, but when one drew down the account after retirement, by which time it might have grown to $2300, one would have to pay taxes on the entire $2300. However, if one put $1000 into a post-tax, Roth 401k, the investment also would compound tax-free, but when one withdrew the money after retirement, none of it would taxable. This means that in my example, the Roth 401k would protect one from paying taxes on the $1300 increase in the value of the account.

This is correct, but the advantage of the traditional 401k is that you don’t pay taxes initially on the $1000 you contribute. When you contribute $1000 to the Roth 401k, you would pay income taxes on that money (assuming you earned in that year).

If you calculate the amount you’d see in your paycheck the year you make the contribution, you’ll see that both offer tax-deferred growth. When you pay the taxes is key.

I think I’m missing something: When you put $17,500 into the Traditional 401k, you are saving taxes … 45% in your assumptions… whereas in Roth 401k, you get no tax savings. So your Trad. vs. Roth comparison should either 1) include analysis on the effect of the $7875 savings further invested in another account, for the Traditional 401k, or 2) change the Roth 401k contribution amount to $17,500 times (100%-45%), or $9,625. Isn’t that right? Or what am I missing.

If you re-read the introductory section, and the conclusion, you’ll see that I do include that analysis. If you go traditional, it assumes you will set that money aside, and you will invest it over the same time period. Assuming identical tax rates, and accounting for external savings, it will come out neutral. However, the question is whether or not you really will put your tax savings to work for the long term, or spend them in the year.

“Most people need that kind of forced savings, which behavioral experts call a “precommitment strategy” – a way to overcome your own lack of self-control.”

Adam

Adam:

Good post. You need to be a bit clearer with your “investment of tax savings” when participating in a 401(k). Sure, hypothetically with all else equal, you’d be in the same position with “pre-tax contribution and save the difference” that you’d be in with simply post-tax/ROTH savings. However, you are assuming that you can invest all of the “tax savings” in an account that has no tax on the growth each year. This is not possible in a brokerage account. This would only work if your employer’s 401(k) plan allowed additional after-tax savings above the $17,500 max (this would hold more assumptions as well) and you invested the tax savings there and then rolled this over into a ROTH IRA at retirement.

This is a good point. For investing the tax savings, I assume a rate of return, without tax considerations in the intervening years. There are options available to achieve tax-deferred growth (e.g. a non-deductible IRA can take up to $5500), but the annual drag from a taxable portfolio is very likely not zero.

For most people who cannot afford to max out their account, the issue tends to be moot because they can effectively deposit more in the traditional 401k due to the tax savings.

I am still confused. I will try to expand on their example to further explain.

Traditional 401k:

$1000 pretax investment saves you $450 in taxes upfront but you have to pay taxes (say the same 45%) on the $2300 when you take out the money. That leaves you with $1265 in your hands.

Roth 401k:

Depositing $1000 after taxes, you have $2300 at time of withdrawal. If you subtract the $450 you would have saved if it were a traditional 401k, you have $1850; a difference of $585 in favor of the Roth 401k.

The only way I could see my example being way off is if the tax rule for a traditional 401k is that you would only pay taxes on that initial $1000. I don’t believe that is the case.

Could someone please explain if I am understanding this correctly and if so, why the Roth 401k wouldn’t be the obvious choice for someone 20 years away from retirement?

I thank anyone in advance for taking the time to answer this.

Hi Sean,

The problem with your analysis is that you don’t take into account how the $450 will grow over time, if invested. You can’t compare money today with money tomorrow directly. For example, you could put the $450 tax savings into a non-deductible, traditional IRA. You could also invest the $450 in a low-cost, tax-efficient account with tax loss harvesting.

The post walks through this math, with larger numbers. There are very good reasons to be biased towards Roth accounts (especially when estate planning and required distributions are taken into account), but there are quite a few variables to consider when choosing.

Adam