The Complete Guide to Choosing Between a Traditional 401K and Roth 401K
The Great Debate: Roth Vs. Traditional 401k
A growing number of employers are beginning to offer not only a Traditional 401K, but now a Roth 401K as well. If you still don’t know who this ‘Roth’ guy is, or what he does, choosing between the two can be a matter of random guess. At best. This guide will show you how to choose between the two and become an expert amongst your co-workers.
As its name implies, a Roth 401K combines aspects of a Roth IRA and a Traditional 401K. But, before we get into the differences between the two, let’s first find out what they have in common.
Common characteristics between Roth 401K’s and Traditional 401K’s:
- It’s a 401K, which means you must be at work, since you cannot invest in 401K’s on your own. IRA’s, on the other hand, are all on your own.
- The maximum 401K contribution in 2014 to one or both of them combined is $17,500 (add an additional $5,500 if over 50).
- Your employer’s 401K match don’t count towards your annual max of $17,500. They are ‘in addition to’.
- You should always invest to the level of being able to get your employer’s max match before investing in any other retirement vehicle (i.e. Roth IRA, Traditional IRA, annuity, etc.). Why turn down free money? Many employers match half, equal, or even double your contributions. You will never get a 50, 100, or 200% return in the open market on a consistent basis, so don’t turn that down if it’s being handed to you, without risk.
- Your employer’s match on both vehicles is pretax and is automatically put into a Traditional 401K. Sorry, folks, but you will not be given more money in the form of an after tax match from your employer if you are investing in a Roth 401K, so don’t let that be an incentive to choose it over a Traditional.
- You must begin withdrawing funds starting at age 70 and 1/2, unless you are still employed, or you can face penalty.
How Roth 401K’s Differ from Traditional 401K’s:
- A Roth 401K is taxed up front. All of your contributions and earnings are tax free once you reach age 59 and 1/2. Your account must be at least 5 years old at that point, with some exceptions.
- Traditional 401K contributions and earnings are taxed when you start receiving distributions at age 59 and 1/2 in retirement.
- You can withdraw Roth contributions tax and penalty free if your account has been open for 5 or more years. This does not include earnings on contributions. With a Traditional, you cannot withdraw without a 10% penalty, but you can possibly get a loan against from your employer (never do this, please).
- Roth 401K’s can be rolled into a Roth IRA when you leave your employer, tax free. Similarly, Traditional 401K’s can be rolled into a Traditional IRA tax free. If you try to roll a Traditional 401K into a Roth IRA, you must pay income tax on your rollover during the year it is completed.
Other things to note:
- Once your money is in a Roth 401K, it cannot be transferred to a Traditional 401K or Traditional IRA, it can only be rolled over to a Roth IRA at the time of departure from your employer.
- You can put money into both a Roth 401K and Traditional at the same time, which balances out your tax burden both now and when you retire.
Roth or Traditional: Which do I choose? Let’s consider the main 3 arguments:
1. Tax now or tax later? A Roth 401K is designed to be advantageous to a younger employee who may be in a lower tax bracket at their young age, than in retirement (typically, when you get older, your taxable income increases, pushing you into a higher tax bracket). If you’re a younger employee, do you actually care about what you might be taxed in retirement compared to what you are taxed right now? Only your answer to this question matters.
2. Will the Federal income tax rate increase or decrease? Another argument brought up commonly, is that the federal income tax rate could change over time. If you believe it will go up and want to take advantage of lower taxes now, the thought is that you should opt for Roth retirement vehicles versus Traditional. On the flip side, if you believe tax rates will go down, you should avoid taxation now by going with a Traditional retirement vehicle, and taking the lower tax hit when you retire.
Usually, the ones who bring up this debate are the ones who think that taxes will rise over time. So, I decided to do a little research into this. Wikipedia has an interesting historical tax rate chart, which lays out the federal tax rate for the lowest and highest tax brackets since 1913.
What it shows, without bias, is that since the 1960′s, the federal tax rate has stayed essentially identical for those in the lowest tax bracket (about 15%), and has actually decreased significantly for those in the highest bracket from around 70%, to 40% today. Projecting this out another 40 years, you can probably bet on more of the same or perhaps slight increases to the lower tax bracket, but for the higher tax bracket, your guess is as good as mine. If you believe the trend will continue, it will probably be lower. If you believe that will lead to a revolution, expect it to go back up again. Either way, a decision on your 401K investment vehicle should not be made on guesses, so this argument is a wash.
3. What is my long-term financial plan and what are my goals in life?
Perhaps the most important point that nobody discusses when it comes down to choosing between a Roth 401K and Traditional is life philosophy.
Investing in a Traditional 401K allows you to deduct taxes now, which means you have more money to invest, perhaps towards an early retirement. Plugging away in a Roth 401K does not allow you to do this, you will face more taxes throughout your working career in exchange for less taxes later on. So you need to ask yourself: would I rather have more money now to enjoy life and to save for early retirement, or would I rather have more money to live it up in retirement, have extra for medical expenses, and not worry relatively as much about running out of money the further my retirement lasts?
If you don’t have the discipline to invest outside of a retirement account for a possible early retirement, then you may want to consider the Roth so that in the long run, more of your money is invested. If you do have the discipline, and want to have a shot at retiring early, then consider the Traditional. The choice is yours.
Check out Part 2, in this series, on how your choice between traditional and Roth 401K’s could impact early retirement.