Saving for Retirement
Many people have an opportunity to save for retirement through an employer-sponsored 401(k). This is a great way to save for retirement. Many plans now offer Traditional 401(k) contributions AND Roth 401(k) contributions. But what is the difference between them, and which one is better? This article will explain the similarities and differences between a Roth 401(k) and a Traditional 401(k) and why I feel most people should save to a Roth 401(k) over a Traditional 401(k).
Similarities of Roth 401(k) and Traditional 401(k)
A common misconception is that a Roth 401(k) and a Traditional 401(k) are separate employer plans. Although the contribution types are different, both options fall under the same plan rules found in the summary plan description of the 401(k). Both options allow you to consistently save for retirement and offer the same investment options. Whether you choose Roth or Traditional contributions, a company match will not be affected. Most employers will match using pre-tax dollars.
Additionally, the contribution limits are the same for both a Roth 401(k) and a Traditional 401(k). That contribution limit for 2024 is $23,000 ($30,500 if you are 50 or older). Remember, that is the TOTAL you can contribute to any employer-sponsored plan in any given year. Meaning, you cannot save $23,000 in Roth 401(k) and an additional $23,000 in Traditional 401(k). However, you can also save an extra $7,000 ($8,000 if you are 50 or older) in a Roth IRA, even if you are maxing out your Roth 401(k)!
Differences between Roth 401(k) and Traditional 401(k)
While there are many similarities between Roth 401(k) and Traditional 401(k), the differences are where the Roth 401(k) shines.
It all comes down to when the tax is paid on the contributions going into the 401(k). If you make Traditional contributions, these go into your 401(k) as pre-tax dollars. The funds will grow tax-deferred, and distributions after 59 ½ will be taxed at your regular income tax rate. Additionally, your pre-tax contributions will lower your income tax owed for the year you made the contributions.
If you make Roth contributions to your 401(k), you will pay the tax now, but the account will grow tax-free, and you will be able to make tax-free distributions after 59 ½ and having the Roth 401(k) funded for at least five years. Roth contributions will not lower your taxable income in the year they were contributed. BUT THAT IS OKAY! Why? Your contributions grow tax-free over a significant number of years. Would you instead be taxed on $1000 now or $1,000,000 when you take distributions in retirement? If your effective income tax rate is 20% and your Traditional 401(k) is worth $1,000,000, then it is actually worth $800,000 because you will be paying the government $200,000 in taxes.
Let's put it in a Scenario
Here is a scenario where Will Smith saved only Traditional dollars to his 401(k), and Chris Rock saved only Roth dollars to his 401(k):
Will Smith had 30 working years left, made $65,000 per year, contributed 15% of his income to his Traditional 401(k), and averaged a 10% rate of return. Saving in the Traditional 401(k) gave Will $2,145 additional take-home pay per year. Multiply that by 30 years; he took home an additional $64,350 during his working career. Will met with his advisor and they ran a scenario where Will has 20 years of retirement, averages a 6% rate of return on his portfolio, and has an estimated income tax rate of 15%. His advisor estimated that Will’s retirement income could be $120,917 annually. Not bad.
But how did Chris do?
All things being equal, EXCEPT Chris Rock saved 15% in his Roth 401(k). He missed out on $64,350 of take-home pay because he opted to pay the tax upfront so his investment could grow tax-free and he could receive tax-free distributions in retirement. Chris sits down with his advisor, who Will Smith referred him to, and they review his annual retirement income estimate. Chris also has 20 years of retirement, averages a 6% rate of return on his investments, and has a tax rate of 15%. His advisor estimates that Chris will have an annual retirement income of $142,256. That is $21,338 better than Will PER YEAR!
In just over three years, the additional income from saving in the Roth 401(k) will be more than Will's take-home pay over 30 years. Chris will have $426,760 more income than Will during his retirement, all because he paid the taxes on the contributions during his working years.
Source: https://content.schwabplan.com/download/RothCalc/RothCalculator.htm
Conclusion
In most cases, contributing to a Roth 401(k) is more beneficial in the long run than a Traditional 401(k). Although they have several similarities, the tax advantage between them is significantly different. You should always speak with a financial professional before making an investment decision, and this article is not intended to provide advice. A financial advisor can also help you with your investment options in your plan and look at other investment options outside of your plan. If you would like to schedule a time to discuss your 401(k) or any other type of investments or planning, feel free to schedule a meeting with any of our advisors at Whitaker-Myers Wealth Managers.
Traditional 401(k) vs. Roth 401(k)
October 14, 2024
Kelly Kranstuber
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