#033: The Simple Guide to Traditional vs. Roth 401(k) Contributions

By: Fran Walsh

Read Time: 6 minutes

One of the most popular questions we get relating to retirement planning: Traditional 401(k) vs Roth 401(k). What are the differences, and which should I be putting my retirement money into? As always - the answer is… IT DEPENDS! Let’s dive in & find out what might be right for you:

Traditional 401(k): The Basics

How It Works:

• You contribute pre-tax dollars. This means the money goes into your 401(k) before taxes are taken out of your paycheck.
• Your contributions lower your taxable income for the year.
• The money grows tax-deferred, meaning you don’t pay taxes on the gains until you withdraw them in retirement.

Key Point: You get a tax break now but your money will be 100% taxable income to you in the future!

Roth 401(k): The Basics

How It Works:

• You contribute after-tax dollars. This means the money goes into your 401(k) after taxes are taken out of your paycheck.
• Your contributions do not lower your taxable income for the year. (AKA there is NO tax-break today.
• The money grows 100% tax-free, and you won’t pay ANY taxes on withdrawals in retirement, as long as certain conditions are met.

Key Point: You pay taxes now but enjoy 100% tax-free withdrawals in retirement. Whatever the value of your account is in the future, its 100% yours.

Key Differences

1. Tax Treatment:
• Traditional 401(k): Tax savings now.
• Roth 401(k): Tax savings later.
2. Income Level Considerations:
• If you expect to be in a lower tax bracket in retirement, a Traditional 401(k) might be beneficial.
• If you expect to be in the same or a higher tax bracket in retirement, a Roth 401(k) might be better.
3. Withdrawal Rules:
• Traditional 401(k): Required minimum distributions (RMDs) start at age 73.
• Roth 401(k): RMDs also start at age 73, but you can roll your Roth 401(k) into a Roth IRA to avoid them.

Employer Match: This is an important one to keep in mind! Regardless of whether you choose to make your contribution as all Traditional, all Roth, or even a healthy mix of the two, your Employer Match will always be 100% in the Traditional bucket.

Hence, any money that they are contributing on your behalf to the 401k plan will be 100% taxable to you in the future when you go to pull it out - even if all of YOUR contributions are in the Roth Bucket.

Case Study: Meet Alex

Alex earns $65,000 a year and wants to contribute $1,950 annually to their retirement plan. Let’s see how this works out with both options.

Scenario 1: Traditional 401(k)

• Contribution: $1,950
• Immediate Tax Savings:
• Alex is in the 22% tax bracket.
• Immediate tax savings: $1,950 x 0.22 = $429.
• Future Tax Scenario:
• If Alex’s tax rate in retirement is 20%, they’ll pay 20% on withdrawals. Imagine he had saved up $1,000,000 in his portfolio. If he wanted to pull out $5,000 a month, he would have to pay $1,000 in taxes each month & net $4,000 per month.

Scenario 2: Roth 401(k)

• Contribution: $1,950 (post-tax, so it’s already taxed)
• No Immediate Tax Savings:
• Alex’s take-home pay is reduced by the full $1,950.
• Future Tax Scenario:
• Withdrawals are tax-free, as long as Alex meets the conditions. Imagine he had saved up $800,000 in his portfolio. If he wanted to pull out $4,000 a month, he would not owe any taxes on either income or gains. Therefore he would net the full $4,000 each month.
•  

Which One is Right for You?

Deciding between a Traditional 401(k) and a Roth 401(k) depends on your current financial situation and your expectations for the future. It’s important to know also that you don’t need to be “All in” on one or the other! As your situation changes & evolves over time - we can always change your contributions to reflect your unique situation.

Consider a Mix: Some people split their contributions between Traditional and Roth to balance the tax benefits.

There are a few important considerations to make. 

If you anticipate being in roughly the same tax bracket in the future as you are today, on paper it makes no difference in what your after-tax money will look like. Even though on paper your account will look bigger if you make all traditional contributions today, there will be no difference in what you actually get to keep.

See attached for example: If you go ahead and take a look at Year 20. The "After-Withdrawal" Column for both Traditional & Roth stands at $167,920.

Typically, if you anticipate your tax-rate being lower in the future, it's usually worth considering making your contributions on the traditional side knowing that you'll owe less taxes in the future.

Here is an example of this shown below: As you can see in Year 20, our After-Tax Withdrawal stands at $189,448 vs the $167,920 on the Roth side. 

On the other side, if you are on the lower earning side today, and anticipate continuing to make more & more money in the future, it may be worth considering making your contributions on the Roth side knowing that that money will be 100% tax-free to you in the future regardless of what your income/tax rate is at that time. 

In our final example here, if we expect our future tax rate to be higher than it is today, now all the sudden our Traditional Bucket stands at $155,003 vs the $167,920 in our Roth Bucket.

Here’s the looming issue that unfortunately nobody can help us with…

Nobody knows what taxes are going to look like in 10, 20, or 30 years from now. I have no idea, and I can promise you that anyone who claims they do is full of it!

However, taxes are near historic lows (despite how hard that may be to believe.) It is hard to imagine things are going to get better tax wise, but at the end of the day - who knows. Just another thing to keep in mind as you make the decision that is right for your family. 

If you are in the boat of believing taxes are 100% going to keep increasing over time - it may be another reason to consider putting at least a portion of your contributions into that Roth bucket.

Remember, the key is to start saving and be consistent. Your future self will thank you!

Look at the power of COMPOUNDING here in years 30-50 for our sample individual Alex. Imagine he started right at age 21 out of college. 50 years old he would have half a million dollars saved. 70 years old? He'll have over $2 million dollars. 

At the end of the day, everyone’s personal financial situation is just that - PERSONAL! There is no one right way to do things, what makes sense for one individual may not for the next. It’s important to take all things into consideration when building your financial plan.

Just Please Start! If you liked the charts I've been showing examples with today - feel free to use this free online resource I found online where you can download and play around with your own situation! 

Final Thoughts

No matter which option you choose, contributing to your retirement is a smart move. If you’re still unsure, feel free to reach out with any questions - we are always happy to help & guide you down the right path.

Stay smart and keep planning for a secure future!