Roth 401k Might Make You Richer

Roth vs. Traditional 401k

Roth 401k Might Make You Richer

Grant Sabatier

Founder of Millennial Money. Dubbed "The Millennial Millionaire" by CNBC, Grant went from $2.26 to over $1 million in 5 years, reaching financial independence at age 30. He's passionate about helping others build wealth and is addicted to Personal Capital.

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The biggest question you need to ask yourself when deciding to invest in a Roth 401k or Traditional 401k is do you think your tax bracket is higher today or will be in the future? If it will be higher in the future invest in a Roth 401k if it’s higher now invest in a Traditional 401k.

Whether you invest in a Traditional 401k (before tax) or Roth 401k (after tax), you will still be taxed at your effective income tax rate either going in with the Roth 401k or going out at withdrawal with the Traditional 401k. So the big decision is are you planning to be making less or more money in the future when you want to start withdrawing from your 401k? No one knows what the tax rate will be in the future, but because you won’t want to use your 401k money until retirement, you might be in a much lower tax bracket when you actually do retire, but who knows?

This is why in my opinion a Roth 401k will make you richer than a Traditional 401k. It’s all about control – since you put the money in a Roth 401k after you’ve paid taxes on it, it can grow tax-free and gives you more flexibility because the gains aren’t taxed when you withdrawal. While not all companies offer a Roth 401k option, more companies are adding this newer investment option everyday. According recent Vanguard data on Roth 401k plan participation 60% of the companies using Vanguard offer a Roth option, but only 15% of participants choose it.

You should check with your company and strongly consider investing in a Roth over a traditional 401K if you have one available. A Roth 401k will likely make you richer than a traditional 401k and is one of the best investment decisions you can make as a younger investor in your 20’s or 30’s because of the tax-free withdrawal advantages given an uncertain future.

Why a Roth 401k is the best 401k investment choice

 

Roth 401k’s compound over time and grow tax-free. You pay tax when you put the money in, but not when you take it out likely many years later. This means that all of the compound interest – or money that your money makes won’t be taxed when you take it out. But because you are putting the money in after you’ve paid tax on it you don’t get the benefit of the tax-free savings going in, but you do get it when taking the money out. But this also means you only pay tax on the initial principal (the money you put it), but NOT the gains. Tax-free gains are the real advantage of the Roth 401k.

 

But what about my tax bracket?

 

If you are in a lower tax bracket (32% and below) then a Roth 401K is a no-brainer. If you are in a higher tax bracket today it’s a little more complicated, but as a young investor it likely still makes more sense to invest in a Roth 401k instead of a traditional 401k. Even if you are in your 20’s or 30’s and making a lot of money, this just means you have to pay a higher percentage tax when putting money into a Roth 401k, but still get the advantages of tax-free withdrawals in the future.

Remember this is tax you are paying just on the principal (the money you are putting into a Roth 401k), but the gains will be tax-free. This is where the advantage is – because your gains will likely compound significantly more than the 10-15% that you paid when putting in money if you are in a higher tax bracket. This means because your gains continue to compound tax-free you will have made a better investment – and made a lot more than 10-15% return on your money over the longer term.

Also if you are in a high tax bracket today, because you will likely be in a higher tax bracket in the future (as you make more and more money) a Roth 401k with no tax on withdrawals is the still the better choice.

The Battle: Roth 401k vs. Traditional 401k

 

Let’s look at two different investment scenarios (low to high tax bracket and high to low tax bracket) to see why a Roth 401k is a better investment choice for a young investor who plans to be taxed at a higher rate in the future. If you want to test your own scenarios here is the 401k calculator I used.

 

Scenario 1: Low tax bracket now, high tax bracket later (Roth 401k wins!)

Investor age: 26 in 25% tax bracket

Planned retirement age: 65 in 40% tax bracket

Annual 401k contribution: $5,000

Growth rate: 5% annual return

Roth 401k vs Traditional 401k

Clearly, in this scenario, the Roth 401k is a better choice than the Traditional 401k

 

Scenario 2: High tax bracket now, low tax bracket later (Roth 401k wins!)

Investor age: 26 in 40% tax bracket

Planned retirement age: 65 in 25% tax bracket

Annual 401k contribution: $5,000

Growth rate: 5% annual return

Traditional 401k or Roth 401k

Clearly the Roth 401k wins again

How much can you contribute to a 401K?

 

The contribution limits for a Roth 401k and a Traditional 401K are the same, although you can’t participate in both. Through 2018 you can contribute up to $18,500 per year and a $6,000 catch up contribution if you are over the age of 50 in either a Traditional 401k or Roth 401k. To learn more about the requirements and restrictions of a Roth 401k check out the IRS website.

How much should you save in a 401k?

 

As much as you can, or at least as much as you need to contribute to receive your company match (some companies match your contributions up to a certain percentage of your contribution). If you can max out your 401k it will make you a lot richer in the future than if you don’t. Whether you ultimately choose to invest your money in a Roth 401k or Traditional 401k it will be worth a lot more tomorrow than it is today. So the big question is will your tax rate be higher or lower in the future?

 

Did you invest in a Roth 401k? Why or why not?

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Grant Sabatier
grant@millennialmoney.com

Founder of Millennial Money. Dubbed "The Millennial Millionaire" by CNBC, Grant went from $2.26 to over $1 million in 5 years, reaching financial independence at age 30. He's passionate about helping others build wealth and is addicted to Personal Capital.

6 Comments
  • JulianT
    Posted at 15:39h, 15 February Reply

    I think the Roth 401k only makes sense if you are already maxing out your tax sheltered accounts, because the Roth 401k allows you to invest a higher “effective savings rate” since you’re saving after-tax dollars. Investing Roth at that point would beat investing Traditional and then investing your traditional tax savings into a taxable account.

    • Grant @MillennialMoney
      Posted at 16:21h, 15 February Reply

      I see your point. But I think you’re not accounting for the post-tax compounding effect of the Roth 401k. It makes more sense, in my opinion, to pay the taxes today (on the small contribution) and let it grow tax-free and withdrawn tax-free (when the balance is A LOT bigger). The tax advantage on the withdrawal no matter your future tax rate is with be greater than paying tax today because of the compounding. Right?

  • JulianT
    Posted at 10:51h, 16 February Reply

    Comparing a $5,000 roth contribution to a $5,000 traditional contribution is not apples-to-apples, unless $5,000 were the theoretical max. If a person is in a 25% tax bracket, then you would compare a $3,750 roth contribution to a $5,000 traditional contribution.

    Furthermore, because a traditional contribution allows you to reduce your taxable income, you’re effectively spreading your income over your lifetime, which lowers your overall lifetime tax rate because of the way the tax brackets are scaled. This wouldn’t be the case if there was a flat tax, but because of the way the tax rate scales as your income gets higher, there is space for manipulation through traditional contributions. I don’t think that retirement calculator takes this effect into account. Your income below ~$9.5k is taxed at 10%, then your income up to ~$38k is taxed at 15%, your income up to ~$92k is taxed at 25%, and your income up to ~190k is taxed at 28%, and so on. Because of the big jump at 38k, I would think it’d be best that you contribute traditional until you get enough deductions through your traditional 401k/ira and other deductions to where your taxable income is ~38k. At that point, you’re only paying 15% taxes on income, and a roth contribution is worthwhile compared to traditional because you’re only paying 15% tax on the roth money.

    As I said before, the only scenario where this tax argument breaks down is if you’re maxing your accounts to where you’re basically forced to contribute the same amount because of a contribution limit via either traditional or roth. At that point, as long as your top tax bracket is at or below ~28%, paying the taxes to contribute roth could beat investing traditional + investing your tax savings into a taxable account. Yes, you are paying potentially high taxes on the roth contributions, but it’s a higher effective savings rate that is fully tax sheltered, vs the traditional where the contribution is tax sheltered, but the tax savings go into a taxable account.

    Personally, I max my traditional 401k and I invest my “tax savings” my maxing a Roth IRA. I do this because I get to play with stocks in my IRA rather than just mutual funds in my 401k, and I’m lucky to be in the income sweet spot where I can afford to max my 401k and IRA, and I’m eligible for both. The point of this wall of text though is that although I’m technically at my “max”, I am not at all against increasing my effective savings rate by switching some or all of my 401k contribution to Roth. Most people reading your article though are probably contributing less than the max to their retirement accounts though so you just want to make sure the comparison is apples-to-apples.

    • Grant @MillennialMoney
      Posted at 08:06h, 18 February Reply

      These are all great points Julian! Thanks for sharing.

  • Millennial Money Matters
    Posted at 22:05h, 16 February Reply

    what are your thoughts on maxing out a traditional 401k while continuing contributions to a roth 401k, up to $53,000?

    As my income grows, I am purposely maxing out my traditional 401k to reduce my taxable income by maintaining it within a lower tax bracket. After my traditional 401k is maxed out, I continue contributions on a post-tax basis (roth 401k) and have the ability to do so until my combined 401k contributions hit $53,o00 as allowed by my plan.

    • Grant @MillennialMoney
      Posted at 10:22h, 18 February Reply

      Maxing the Roth 401k up to $53K before even doing the traditional is the best option in my opinion. Tax free growth!!!

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