The Battle For Your Retirement Dollar; Roth 401(k) vs Traditional 401(k)
So your company offers a traditional 401(k) AND a Roth 401(k) and your wondering which one is more advantageous? There’s many scenarios that can sway your position either direction, so let’s see which camp you side with.
Here are 5 reasons why Roth 401(k) may be better:
1) You expect to be in a higher tax bracket upon retirement.
Here are the tax brackets: 10, 15, 25, 28, 33, 35% tax rates. Do you plan on having a brighter financial future? Do you see yourself in the same financial situation you are now? OR do you see yourself in a worse off condition. People work for incentives, some do it to pay bills and support family, but ultimately that stems from MAKING more money and MOVING UP in the company. If you see yourself making more money in the future and believe you have not capped out at your income range, then Roth 401(k) is for you.
2) You’re able to sock away more money into a Roth 401(k) retirement account.
You can contribute $16,500 in a traditional 401(k) and a ROTH 401(k(). However, since ROTH 401(k)s are pre-taxed, you can adequately add more funds to the mix. For example: 2009 Max Contribution @ 25%
Traditional 401(k)
$16,500 pretax contribution
Roth 401(k)
$20,625 pretax contribution; $16,500 after tax
3) Distributions are tax-free.
This is certainly a major advantage for the Roth 401(k). You’re able to withdraw your money at ripe old age of 59 1/2 without any taxed discount.
4) No uncertain tax implications.
Our government is in debt. Sadly, tax reform is attached at the hip with running the economy. You never know what they will do.
5) The present value of a dollar now is worth more than the future value of the same dollar later.
What this means that the dollar you have now is worth more than a dollar later. This is a fundamental financial principle that is applicable due to discounting (ie inflation). That’s why if you win the lotto, instead of taking scheduled payments over 20 years, it’s best to take the lump sum now because it’s more valuable in the long run. If you can contribute more to your account now in an after-tax basis, then you’ll have more later.
Here are 4 reasons why the Traditional 401(k) may be better:
1) You expect to be in a lower tax bracket upon retirement.
This should be a major deciding factor for most of you. A lot of it really depends on where you are in life. If you are in college, working part-time, are in a job that has the potential of paying large dividends in the future, or are still budding in your career; then ROTH is for you. If you are already at the high-end of the income range, then Traditional may be for you.
2) Early retirement
If you plan on retiring early due to financial independence and picture yourself far away from your peak earnings potential, then Traditional 401(k) all the way. By the time you reach 59 1/2, you’ll definitely be in a lower tax bracket.
3) High state income taxes.
If you see yourself flocking to a state with NO personal income tax upon retirement, then Traditional 401(k).
States with no personal income as of 2009: Alaska, New Hampshire, Tennessee, Florida, South Dakota, Washington, Nevada, Wyoming, and Texas (source)
4) Value in rollover options.
With a Traditional 401(k), you have the option of rolling it over into a traditional IRA when leaving a company. from there you can roll it over to a Roth IRA when you would like to. With a Roth 401(k), you only have the option to roll it over to a Roth IRA. There is tons of value in the option because you can use it to your advantage depending on your situation. For example:
- You retire early
- Decide to marry someone with a significant income difference
- Go back to school
- Do a career change
- Become incapacitated
Here are some other resources from fine PF Bloggers that have also touched up on this topic:
[Pro Traditional 401(k)] – TFB at The Finance Buff wrote: The Case Against the ROTH 401(k)
[Pro Roth 401(k)] – Trent at The Simple Dollar wrote: The New Roth 401(k) Versus The Traditional 401(k): Which Is The Better Route?
I myself reside with the ROTH 401(k) camp for now. However, as I become more successful and I take down more of my financial goals, I will slowly reposition myself into the Traditional 401(k) camp. Where do you stand?
Veloma! (Malagasy)
Photo Credit: Urban Data
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I don’t have the option for Roth 401k at my work but I wonder if I am the only one that wonders if I put my after-tax money into a qualified retirement account such as Roth 401k and then lose money in my investments that I may actually be worse off than putting that in a regular brokerage account where I can keep track of my taxable basis and get income tax credit or tax loss carry forwards on future years of income.
I hate to be the pessimist but when you look at how the equity market has done over the past 10 years, the annualized returns over this period are nowhere near the historical long term averages over the 20-30+ years time horiaon of 7-9%. I forgot where I read this but I think the annualized return over last 10 years, was less than bond returns and even flat or negative depending on the index and time period you are averaging. To make matters worse, for those of us that have only been working for about 10 years (like myself who is in my early 30’s), I get this crap market on top of the fact that my contributions increased overtime and so my account balances were higher in the more recent years and thus performance is more heavily weighted in the later years (if you factor in cash flows). Therefore, I didn’t benfit as much when markets were doing well in 2005-2006 as I got hurt in 2007 so on a IRR perspecitive, I was probably negative. If I hadn’t put everything into a shortterm bond fund in 2008, I probably would have lost more, but my point is…it isn’t unrealistic to have losses in a qualified retirement account like 401k. So, under a market scenario where one experience losses…I think I would rather pay taxes later or ask uncle sam to please give me some tax credit for my losses. At least I didn’t put all my 401K in IndyMac Bank (my previous employer) like some people did and got completely wiped out…in that case they pretty much lost everything.
Long time reader, first time poster here.
To note on the above comment by Chih, I know where you’re coming from as I am in my early 30s too and my retirement accounts went no where fast in the past 10 years! I feel your pain brother.
It seems like your investment knowledge is much more sophisticated than your average investor so I’ll play to that. Your IRR probably was negative like 95% investors in the nation but it seems you still were able to mitigate some of the downside risks which is probably better than many others can say.
I believe the idea behind this post is more so for your average Joe that have no idea what investment options are out there for them. And the best way to mask their investment ignorance is by socking away money into a retirement account that is essentially automatic and out of sight. Also if you have an investment horizon longer than 10 years, then there will always be hiccups in the market cycle that you will inevitably encounter. For your average Joe, they’re best bet is to ride out the wave and dollar-cost average the entire way.
Lucas530´s last blog ..Ex Kings Scout Banned For Betting On NBA Games
@Chih – You’re definitely no pessimist, I like to think a realist. Unfortunately, we’ve been screwed with bad timing (Why couldn’t i be a 90s baby!). Luckily, your investment horizon is much longer than 10 years, so there is much to look forward to.
And you’re definitely right that you can lose money in a qualified retirement account. Regardless, if you lose or gain money, i think the idea is that SOMETHING is being put away for the future and you’re building yourself a nice nest egg through a diversification of investment vehicles.
Ultimately, I understand completely why you’d want to go post-tax.
@Lucas530 – “long time reader”. We have only been up and running for 2 months!
Nice fill someone in on and this post helped me alot in my college assignement. Thank you as your information.
“That’s why if you win the lotto, instead of taking scheduled payments over 20 years, it’s best to take the lump sum now because it’s more valuable in the long run.”
This is completely false. For the lump sum, they already discount the future payment values to the present, so you get a significantly less amount. The people at the lotto are not stupid.
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