Roth 401k Will Make You Richer

Roth vs. Traditional 401k

Roth 401k Will Make You Richer

This post will explain why a Roth 401k is a significantly better investing vehicle than a traditional 401k for most Millennial investors. You will also see the returns of a Roth 401k vs. Traditional 401k in different investing scenarios and can test your own.

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. Here’s why:

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. This 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.

This make you richer than a regular 401k and here’s why: In a traditional 401k you don’t pay tax on the principal (the money you put it) when you put it in, but you do pay tax on the principal AND gains when you take the money out. This is why a Roth 401k will almost always be a better investment vehicle than a traditional 401k if you are young investor in your 20’s or 30’s. It often makes the most sense to pay taxes before the money goes in (Roth), since it will be a smaller bucket of money than pay taxes on the interest (Traditional) which will likely be much larger when you take it out.

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. While it’s tough to estimate what your tax bracket will be in the future, even if it is lower than today, the tax free compounded gains of a Roth 401k will be significantly more valuable that the pre-tax advantages of a traditional 401k.

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. In both cases the Roth 401k will make you richer than a traditional 401k. 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

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

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. Through 2017 you can contribute up to $18,000 per year and a $6,000 catch up contribution if you are over the age of 50. Remember that this $18,000 you contribute will grow tax free in for as long as you keep it in your account.

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. The money will be worth a lot more tomorrow than it is today.

To learn more about the requirements and restrictions of a Roth 401k check out the IRS website.

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

 

Photo credit: Hurwit Photo

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Grant @MillennialMoney

Grant @MillennialMoney

Millennial | Entrepreneur | Investor | Business Consultant | Globetrotter | Art Collector | Living the Good Life
Grant @MillennialMoney

Latest posts by Grant @MillennialMoney (see all)

Grant @MillennialMoney
grant@millennialmoney.com

Millennial | Entrepreneur | Investor | Business Consultant | Globetrotter | Art Collector | Living the Good Life

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