As a financial advisor, I often hear the question, “Should my 401(k) contributions be Roth or Traditional?”
There are many considerations that may make my response different for different people. A large part of this decision relates to income tax treatment of each. A Traditional 401(k) allows me to contribute dollars before they’re taxed, no tax occurs while they’re invested, and then all future withdrawals from the account will be taxable. A Roth is kind of the opposite in that all contributions are made with dollars that have already been taxed, again no tax occurs while they’re invested, but then future qualified withdrawals are income tax free.
So let’s look at the basic math differences between the two.
Traditional 401(k) Contribution Scenario
Let’s say I’ve been able to commit $10,000 per year from my budget to contribute to my Traditional 401(k). Let’s say this $10,000 increases in value by 100% before I need to withdraw the cash in retirement. The balance is now $20,000. Assuming my future tax rate is 25%, I’ll then owe $5,000 in tax and have $15,000 left to spend.
Roth 401(k) Contribution Scenario
Now let’s assume I decide instead to make Roth 401(k) contributions today. Assuming my current tax rate is 25%, I only have $7,500 to contribute today because I first must pay tax on my $10,000. Assuming this money is invested the same way as in the Traditional example, it grows by 100% before I need to withdraw the cash in retirement. The balance is now $15,000. Since qualified Roth withdrawals are income tax free, the entire $15,000 is available to spend.
So assuming my income tax rate today is the same as it will be when I need the money in retirement, I end up with the same amount of spendable cash – $15,000 – in both examples. Interesting, isn’t it?
What we haven’t considered in this example is the complexity of today’s income tax code. As one example, Social Security benefits may or may not be subject to federal income tax depending on other income on my tax return. Qualified Roth withdrawals are not reported as income on my tax return, so those withdrawals would not cause additional tax on my Social Security, whereas taxable Traditional 401(k) withdrawals may possibly create more tax on my Social Security income.
There are many other details and considerations surrounding this decision, but a comparison of my tax rate today vs. my future tax rate (when I plan to withdraw the money) may be a good indicator of which to choose. If I think my tax rate today is higher than it will be, I may choose Traditional contributions today. A lot of people think this way, but it’s not always the case. We have another video on that topic. Now, if I think my future tax rate may be higher, then Roth contributions may be wise. (Higher future tax rates favor Roth)
Maybe I choose to split my bets by contributing some Roth and some Traditional. It’s also important to know that current law requires employer contributions to be Traditional. Even if all my contributions are Roth, my employer’s cannot be. So the dollars contributed by my employer – and the growth on those dollars – will be taxable when withdrawn in the future.
Be wise in your tax planning. Remember, Uncle Sam isn’t really your uncle!
Published: December 9, 2015
Author: Terry Prather, CFP®, ChFC®, MSFS
Phone: (812) 602-6307
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