In 2005, Congress passed a law creating the Roth 401(k). What follows is an overview of 401(k) options as well as some thoughts to consider when figuring out which one is right for you.
How a regular 401(k) works:
Contributions to your 401(k) are pre-tax, meaning that the contribution amount reduces your taxable income. Any contributions that your employer makes do not count as income to you. At age 59 and a half, when you are able to start making withdrawals, you will pay tax on the distributions at your regular tax rate.
Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $85,000. This reduction in income results in is a substantial reduction in taxes – especially for those of us who live in high tax places such as NYC.
Retirement: Beginning at age 59 and a half, you start to take withdrawals from your 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will be counted as ordinary income and you will pay federal, state & local taxes on the full amount at whatever your tax rate happens to be at the time.
How a ROTH 401(k) works:
Contributions to your ROTH 401(k) are after-tax, meaning that the contribution amount does not reduce your taxable income. At age 59.5, when can start making withdrawals, you will not pay any tax at all on the distributions. By age 59.5, the majority of the money in your account will not be money you put in (principal) but it will be capital gains on the principal. Thus, you will be paying ZERO tax on the massive amount of capital gains and interest that will compound in your account over the next 40 years!
Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $100,000.
Note: unfortunately, the employer contribution has to go into a traditional 401(k), not the Roth 401(k)
Retirement: Beginning at age 59.5, you start to take withdrawals from your Roth 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will not be counted as income and you will pay zero tax on the withdrawal.
Which should I choose – the Roth 401k or the regular 401k?
There is no simple answer here – it depends upon the individual and also your belief of what your future holds. Consider this hypothetical situation for Sarah & Jane. These gals have a lot in common: they are both 25 years old, earn $100,000 per year, and can contribute $15,500 to a retirement plan this year:
Sarah: Sarah has big-time career ambitions and plans to have a much higher income in the future. She loves to work and plans to do so, either for a company or herself, until at least age 75. She is an “aggressive saver” and already has substantial non-retirement assets. She loves New York City and plans to stay there forever. Also, she expects to get a substantial inheritance from her parents one day. It is very likely that Sarah will be in the highest tax bracket when she retires.
Jane: Today Jane has the same income level as Sarah but Jane has very different ambitions for her career. Jane plans to stop working at age 65 and live off of her 401(k) and perhaps a part-time job. It is unlikely she will have substantial assets outside of her house and 401(k). Given these circumstances it is likely that her tax bracket will be lower in retirement than it is now.
In this example, Sarah’s contribution to the Roth 401(k) will only be $11,250 (because of the $3,750 in taxes she will have to pay on the additional $15.5k in income.) Jane’s contribution into her retirement plan will be for the full $15,500. All other factors equal, Sarah and Jane will probably end up in roughly the same, after-tax position when all is said and done. This is because Jane’s higher contribution now, will result in a much higher future amount due to the miracle of compounding. However, since Jane will owe a bunch of tax on the future distributions, it probably evens out.
Of course, all other factors are never equal… Since Sarah is going to have substantial assets and income in retirement, her tax bracket will likely be very high. Also, it is quite probable that Sarah can afford to pay the $3,750 in additional taxes out-of-pocket and thus not reduce her current contribution at all. In other words, Sarah will contribute the full $15,500 into the Roth 401(k) – she will find the money somewhere to pay the tax.
If she does this for the next 40 years, Sarah will have $5.3 million (assuming a 9% CAGR) – all of which can be withdrawn completely tax free. If she invests in the traditional 401(k), she could owe 40%+ of this amount to the IRS!
Bottom-line: It is very clear to me that “aggressive savers” with high future earning potential should go with the Roth 401(k). For people not in this category, the answer isn’t so clear.
Follow these links for additional resources:
Bloomberg Calculator: Roth 401(k) or Traditional?
Wikipedia: Roth 401(k)