Choosing Between a Traditional 401K and a Roth 401K, Part II: How will my Choice Effect Early Retirement?
In a recent post, The Complete Guide to Choosing Between a Traditional 401K and a Roth 401K, we discussed all of the factors that you should consider when choosing the percentage breakdown between the two retirement vehicles. Since then, many have asked me what my personal strategy is. At this time, I have decided to go with 100% in a traditional. Please do your homework before choosing either way.
Reasons why I’m contributing to a traditional 401K vs. a Roth 401K:
- My long-term goal is to retire at an early age, prior to when I would be eligible to start receiving distributions from my 401K (at age 59 and 1/2).
- Unless you’re a pro athlete, investment banker, doctor, or lawyer (you get the idea) it’s very hard to retire early unless you are investing a decent amount outside of your retirement accounts and starting at a very early age. Saving on taxes now allows me to start saving more earlier than I normally would.
- Every dollar contributed to a traditional 401K is a dollar taken off the top of your taxable income. For instance, if I earned $40,000 this year and I contributed $15,000 to my 401K, my taxable income would be $25,000 ($40,000 – $25,000). Not only would I be taxed on less income, but I could be pushed into a lower tax bracket, and taxed at a lower tax rate on that income.
- I will be disciplined enough to invest my tax savings in non-tax-sheltered mutual funds to be applied towards an early retirement.
- So long as circumstance allows, I will be maxing out my 401K contributions, which will result in a nest egg larger than I could ever blow in retirement. In other words, I’m not too worried about my tax bracket in retirement.
The Debate: Roth vs. Traditional
So, a colleague at work and I were debating which strategy was better. His personal strategy is to put 100% of his contributions into a Roth 401K so that he will be taxed less in retirement. His strategy works great if your plan includes working until you are 60 years old, putting more of your after-tax income towards long-term investments, don’t have the discipline to invest your extra tax savings, or you are simply not contributing quite as much towards retirement altogether.
I enjoy financial debate because it allows you to see different perspectives and consider alternatives to your current strategies. Really, there was no winner in this debate because our two strategies were completely different and based more on life philosophy than anything else. However, I wanted to take it to the next level and run some numbers to see what kind of financial shape each of the two paths would take you on.
Traditional 401K vs. Roth 401K, Which Results in More Savings?
First, we’ll need to make some arbitrary assumptions for the sake of a fair comparison:
- The average annualized rate of return for U.S. stocks was 13.4% from 1926 to 2000. The worst average annual rate of return for U.S. stocks in any 65 consecutive year period has been 8.5%. For this comparison, let’s take the average between the two, and assume both my colleague and I are able to get a 10.95% return on our investments every year in both our retirement and non-retirement investments.
- We stay employed at the same company, who kindly matches 50% of our total 401K contributions.
- We are both 23.
- Our salaries are $40,000 this year.
- Our annual salaries, and the IRS’s annual 401K contribution limits and tax bracket income limits all increase at a rate of 5% per year over our career.
- I will contribute the amount that I save in taxes each year (over what he is taxed) to a non-sheltered early retirement account.
- Additionally, we both contribute 5% of our salaries towards early retirement.
- The magic amount for retiring early and living off of our interest until we can begin withdrawing retirement distributions (at age 59 and 1/2) is $1 million in non-tax sheltered money. Once we hit this amount, our salary drops to $0 the following year.
- We also stop contibuting to our non-sheltered accounts in the year following retirement and convert our investments to municipal bonds that return 5% per year, and live off the interest.
Here are the results:
To view the results through a Google Docs spreadsheet:
Trad 401K vs. Roth 401K (Google Docs)
- I am able to hit the magic retirement amount (column E vs. column H) by age 48, a full 9 years before he does. The extra amount that I was able to invest made a huge difference in allowing my non-retirement savings to grow.
- We both have a ridiculous amount of retirement income (over $15,000,000) as a result of the power of compound returns because we saved early, saved much, and saved often. Neither of us will be hurting for cash in retirement. Compound returns are you best friend; save early, save much, and save often and you won’t have to worry about your tax bracket in retirement.
- My total retirement amount ends up being about 10% less, despite stopping contributions a hefty 9 years earlier. Saving early allows you to save less later on. Compound returns again? Yes.
- My colleague will have much more tax free income in retirement ($11,547,351). Tax free savings have got to be enjoyable.
- Either way you cut it, when you have financial discipline, save early, and save often, you win.
Which strategy are you implementing?