To Roth or not to Roth 401K – That is the Question?
In this article, we’re going to examine the difference between a traditional 401K and a Roth 401k. In addition, we’re going to do some long-term calculations with various income levels, post-tax savings rates, and potential future tax rates to look at how each 401K stacks up to one another. Here’s how this article is broken down:
- Difference between Traditional and Roth 401K
- Crunching the numbers for different scenarios
- General takeaways & conclusions
Difference Between Traditional and Roth 401K
The main difference between the two types of planes is when you pay taxes. For a traditional 401K you don’t pay any taxes on the investments going in, but when you retire you have to pay income tax on the withdrawals. With a Roth, you invest with after-tax dollars and when you retire, you don’t have to pay taxes on the gains or the withdrawals.
So let’s say we make $80,000 a year; with the 2020 401K limit of $19500 we can put that into our traditional 401K and then lower our taxable income to $60,500. Since our taxable income is lower, we pay less in taxes and end up with about $45,000 post-tax income (this is assuming a state income tax of roughly 4%).
If instead, we contribute to a Roth 401K, we contribute to it after paying federal taxes. So that same $80,000 gets taxed first which will leave us with around $60,000 post-tax income. Then with that $60,000k post-tax income, we contribute $19500 to our Roth 401K which leaves us with around $40,500. The drawback here is that we have the slightly less post-tax-post-401K-contribution income to take home. In this example, we have around $5000 less than when we contributed to a Traditional 401K.
So we’re left with a couple of questions:
- Is it worth it to invest into a Roth 401K if it means we have less post tax income? In the example above we could have invested that extra $5000 in the stock market, used it to save for a house, or buy a boat.
- Is it better to save on taxes now versus saving on taxes later? With a Roth 401K we have to pay taxes now, but none in the future.
- What are some general rules for which plan, traditional or Roth, is better for your circumstance?
In order to answer those questions, I’ve run crunched some numbers. Let’s take a look.
Crunching the Numbers for Different Scenarios
Here are some of the assumptions we’re going to make:
- Our income grows at a rate of 1.5% every year to stay steady with inflation
- Average market rate of return every year is 10%
- We are able to save the same fixed percentage of our income every year at every age (this is a bit unrealistic since our expenses increase certain times in our lives i.e. when you buy a house or have kids).
- Our withdrawal rate from our 401K at 60 is 4% per year
- We live to 80 years old
- 401K limit go up on average $250 a year for the foreseeable future
- Our FICA Tax is always at 7.5% (This is incorrect since there is a marginal rate after a certain income limit) and our state tax is a flat 4.25%
Simulation #1 – Average Income, Average Post Tax Savings, Taxes Stay the Same in the Future
How much we earn at 22 years old – $80,000
How much of our post-tax income we save – 20%
Tax Rates – They stay the same as today (2020)
Tax Status – Single
| Age | Income (Pre-tax) | Total Cumulative Taxes Paid At That Age (Roth) | Total Cumulative Taxes Paid At That Age (Traditional) | Total Cumulative Post Tax Savings (Roth) | Total Cumulative Post Tax Savings (Traditional) |
| 22 | $80,000 | $14,174 | $9,187 | $8,141 | $9,139 |
| 60 | $140,863 | $846,962 | $594,375 | $3,732,677 | $4,185,883 |
| Age | Income from 401k Withdrawal (4%) | Total Federal Taxes Paid on Roth 401k Income | Total Cumulative Federal Taxes Paid on Traditional 401k Income |
| 60 | $341,345 | $0 | $94,664.28 |
| 80 | $150,875.36 | $0 | $1,206,583 |
Our gain by contributing to a traditional 401K over a Roth 401k is derived from how much extra “post-tax” money we will be able to invest over the time span compounded at 10% a year. We stand to net $453,206 extra by contributing to a traditional 401K. However, as we begin to withdraw from your 401K in retirement the potential total tax we will pay from 60-80 is $1,206,583.
Even after adjusting the $453,206 for inflation, under the given circumstances, it’s better to contribute to a Roth. However, if we continued to invest the extra $453,206 which we accumulated by taking the tax advantage of a traditional 401K at 5% a year from age 60-80, this will give us about $1.2million. In that case, we break even with the Roth path. I would say that this is unlikely since we would probably end up spending the $453,206 on living a cushy life after retirement ( buying a nice retirement house, traveling, eating good food, helping our kids/grandkids financially).
Verdict – In this case ROTH wins
Simulation #2 – High Income, Average Post Tax Savings, Taxes Stay the Same in the Future
How much we earn at 22 years old – $150,000
How much of we post tax income you save – 20%
Tax Rates – They stay the same as today (2020)
Tax Status – Single
| Age | Income (Pre-tax) | Total Cumulative Taxes Paid At That Age (Roth) | Total Cumulative Taxes Paid At That Age (Traditional) | Total Cumulative Post Tax Savings (Roth) | Total Cumulative Post Tax Savings (Traditional) |
| 22 | $150,000 | $33,622 | $28,254 | $17,181 | $18,254 |
| 60 | $264,120 | $1,992,665 | $1,672,412 | $7,838,938 | $8,362,003 |
| Age | Income from 401k Withdrawal (4%) | Total Cumulative Federal Taxes Paid on Roth 401k Income | Total Cumulative Federal Taxes Paid on Traditional 401k Income |
| 60 | $341,345 | $0 | $94,664.28 |
| 80 | $150,875.36 | $0 | $1,206,583 |
In this case, we are assuming that we have a pretty high income ($150,00 a year). In this calculation, we are able to earn an extra $523,065 in net post-tax savings over 40 years by contributing to a traditional 401K. We pay $320,253 more in taxes by contributing to a Roth, and since the traditional 401K allows us to pay less in taxes, we have more post-tax income to save and invest. This “more post-tax income” that we can save and invest accumulates over time so that in 40 years we have $523,065 more by contributing to a traditional 401k. Adjusted for inflation, the $523,065 still isn’t worth it because our post-retirement tax burden from age 60-80 is $1,206,583. Like in the example above, we can continue to invest the $523,065 at 5% a year, but this may be unlikely.
Verdict – In this case, ROTH wins
Simulation #3 – High Income, High Post Tax Savings, Taxes Stay the Same in the Future
How much we earn at 22 years old – $150,000
How much of we post tax income you save – 30%
Tax Rates – They stay the same as today (2020)
| Age | Income (Pre-tax) | Total Cumulative Taxes Paid At That Age (Roth) | Total Cumulative Taxes Paid At That Age (Traditional) | Total Cumulative Post Tax Savings (Roth) | Total Cumulative Post Tax Savings (Traditional) |
| 22 | $150,000 | $33,622 | $28,254 | $25,771 | $27,381 |
| 60 | $264,120 | $1,992,665 | $1,672,412 | $11,758,407 | $12,543,005 |
| Age | Income from 401k Withdrawal (4%) | Total Cumulative Federal Taxes Paid on Roth 401k Income | Total Cumulative Federal Taxes Paid on Traditional 401k Income |
| 60 | $341,345 | $0 | $94,664.28 |
| 80 | $150,875.36 | $0 | $1,206,583 |
In this case, we are assuming that we can save much more of our post-tax income. In this calculation, we are able to earn an extra $784,598 in net post-tax savings over 40 years by contributing to traditional Roth 401K. This extra savings adjusted for inflation, we are now at about the break-even point for Roth 401k vs Traditional 401k.
Verdict – In this case, ROTH and TRADITIONAL Tie
Simulation #4 – High Income, High Post Tax Savings, Higher Taxes in the Future
How much we earn at 22 years old – $150,000
How much of we post-tax income do you save – 30%
Tax Rates – Tax rates on income brackets above $80,000 go up by 5% and 10% on income brackets above $160,000 by the time we hit 60 years old
Tax Status – Single
| Age | Income (Pre-tax) | Total Taxes Paid At That Age (Roth) | Total Taxes Paid At That Age (Traditional) | Total Post Tax Savings (Roth) | Total Post Tax Savings (Traditional) |
| 22 | $150,000 | $33,622 | $28,254 | $25,771 | $27,381 |
| 60 | $264,120 | $1,992,665 | $1,672,412 | $11,758,407 | $12,543,005 |
| Age | Income from 401k Withdrawal (4%) | Total Federal Taxes Paid on Roth 401k Income | Total Federal Taxes Paid on Traditional 401k Income |
| 60 | $341,345 | $0 | $122,615.04 |
| 80 | $150,875.36 | $0 | $1,567,986 |
If we assume that in the future, we will face higher taxes, then the case for a Roth 401K becomes even more compelling. We end up avoiding around $320,000 in taxes from ages 22-60 but then take a $1.5million tax hit from ages 60-80.
Verdict – In this case, ROTH wins!
General Takeaways and Conclusions
- In order to take full advantage of a traditional 401K we need to be close to a lower tax bracket so that deducting the 401K contribution limit puts us in the lower tax bracket AND we need to save upwards of 30% of our post tax income in an investment vehicle that gets us 10% a year. If we don’t satisfy these conditions, it seems that the Roth route is going to come out on top because we’re going to end up paying a lot in taxes during retirement if we go the traditional route.
- We need to hope that taxes in the future will not be higher, because when we pull from our 401K we will be in a higher tax bracket. I personally believe that with all the government debt, it’s more likely than not that we will have higher taxes in the future. If you think that the US Federal & State governments will increase taxes in the future, then a Roth account is a better option.
When I first began contributing to my employer’s 401K plan, I opted for the traditional route, but I’ve since changed my strategy to fully Roth. The guidelines and conclusions discussed can also help you decide between a Traditional IRA (individual retirement account) or a Roth IRA.