Traditional vs. Roth 401(k) - Which One Should You Choose?
AdviceBy_ #7
In my previous article, I discussed Roth IRAs. Today, I’ll discuss 401(k)s - another important retirement account that can help you become a millionaire💸! The key is to learn about the accounts and start contributing as early as possible. Please share this with your friends and subscribe above to get my next articles on Education Accounts and Credit Cards straight to your inbox. Disclaimer: nothing here is financial advice, just my personal thoughts/learnings.
Part 1: Savings vs. Checkings Account (read here)
Part 2.1: Investing - Definitions (read here)
Part 2.2: Investing - Start Now (read here)
Part 3.1: Retirement Accounts - Roth IRA (read here)
Part 3.2: Retirement Accounts - 401(k) (this one!!)
Part 3.3: Education Accounts - 529 & Coverdell (read here)
Part 4: Credit Cards
📝 Today’s Agenda
What is a 401(k)? • Traditional 401(k) vs. Roth 401(k) • Which One Do I Choose? • How Can I Contribute? • How Much Can I Contribute?
🧐 What is a 401(k)?
A 401(k) is an employer-sponsored retirement account with tax benefits. Employees contribute to this account, and employers often make matching contributions (essentially free money for you as an employee)!
Suppose you contribute ~$19,500 annually (maximum allowed) after college and earn an average annual return rate of 10%. By the time you’re 60, these accounts can have over $5 million in them (excluding company matches). Regardless of how much you contribute, both these accounts will benefit you in the long run. The key is to start early and contribute as much as you can (after covering your other, current expenses & making sure you have an emergency fund with 3-6 months of living expenses saved).
There are two types of 401(k)s - Traditional 401(k) and Roth 401(k).
📊 Traditional 401(k) vs. Roth 401(k)
In a Traditional 401(k), you put your money in pre-tax (don’t pay taxes right now), but you get taxed on the principal (money you put in) and gains (from investing the money) when you withdraw the funds at your retirement tax rate.
In a Roth 401(k), you put in your money post-tax (after paying taxes) at your current tax rate, but you don’t get taxed on the capital gains when you withdraw the funds.
🧠 Which One Do I Choose?
This is a tricky question because it really depends on your personal circumstance and preferences. While there’s no clear answer on one being better than the other, I’m going to discuss some things you should consider when choosing. The main takeaway is to make sure you contribute as much as you can each year, as both accounts have tax benefits.
Current tax bracket: If you recently started working, you will likely fall in a lower tax bracket now than in the future. In this situation, it could make more sense to put your money in a Roth 401(k), pay your taxes now so that you can avoid paying a higher rate in the future at retirement. However, if you think you fall in a higher tax bracket now than in the future, it could make more sent to put money in a Traditional 401(k) and (hopefully) pay a lower tax rate in the future.
Lower tax bracket now, expecting higher tax bracket in the future — Roth 401(k)
Higher tax bracket now, expecting lower tax bracket in the future — Traditional 401(k)Future tax uncertainty: I say ‘hopefully’ above because there is a lot of uncertainty around future tax rates. Several people believe that tax rates will only continue to rise, so your future tax rate at retirement could be higher than you’d expect based on today’s tax rates. If your future tax bracket will be higher than today’s, a Roth 401(k) can make more sense. You will pay your taxes today and not have to worry about the future tax rate rising.
Higher tax bracket future, lower tax bracket now — Roth 401(k)
Lower tax bracket future, higher tax bracket now — Traditional 401(k)Investing in the market: With a Traditional 401(k), you could choose to invest your tax savings (from not paying taxes today) in the market. The gains from the investment will be taxed. However, these gains can compound over the years and grow a lot by the time you retire if you religiously invest these tax savings instead of spending them. If you invest the tax savings, your overall account balance at retirement can be much higher through a Traditional 401(k) than Roth 401(k). The key to making the most of the Traditional 401(k) account is investing the tax savings and not spending them. If you don’t invest it, the Roth 401(k) would likely make more sense even if you have a higher tax bracket now than in the future.
Higher tax bracket now, expecting lower tax bracket in the future AND invest tax savings in the market — Traditional 401(k)
Higher tax bracket now, expecting lower tax bracket in the future BUT do not invest tax savings — Roth 401(k)
Lower tax bracket now, expecting higher tax bracket in the future AND invest tax savings in the market — Roth 401(k)
Lower tax bracket now, expecting higher tax bracket in the future BUT do not invest tax savings in the market — Roth 401(k)I couldn’t find a calculator online that took all the points above into consideration. So, I’m building a basic return calculator in Excel where you can change the variables per your specific situation to see the difference in returns when contributing to a Traditional 401(k) vs. Roth 401(k). If you’d like access to this to make an informed decision for yourself, please reply to this article (if it’s in your inbox) or reach out at abagri@umich.edu.
Again, more than debating between the two accounts, the most important thing is to make sure you contribute to one of these two (or both) and get as close to the $19,500 limit as possible (after covering your other, current expenses & making sure you have an emergency fund with 3-6 months of living expenses saved) as both accounts have tax benefits. Last year, I contributed 50-50 to both the Traditional 401(k) and Roth 401(k). This year (as of now), I’m contributing only to the Roth 401(k).
📈 How Can I Contribute?
Money will be contributed directly from your paycheck. Your employer will have a benefits portal where you can choose what percentage of your paycheck goes to your Traditional 401(k) and Roth 401(k) if they offer both.
You will also choose which funds you would like your money to be invested in. Unlike a Roth IRA, where you can invest in anything you want, 401(k)s only allow you to invest in specific funds. You should choose funds based on total return (look at the past performance) and expense ratio (the fee you pay). Ideally, you want to look for funds with high total returns and low expense ratios. However, funds with higher returns often have higher expense ratios. It could be worth it to pay the higher expense ratio because the returns outsize the extra fees paid. I illustrate this example here under ‘what is an expense ratio?’.
💰 How Much Can I Contribute?
There’s an annual contribution limit of $19,500. Keep this in mind when calculating what percentage you want to contribute from each paycheck. It is $19,500 pre-tax for Traditional 401(k) and $19,500 post-tax for Roth 401(k). This amount does not include employer contributions.
If your employer matches your contributions, make sure you contribute enough to get that match since it’s essentially free money. For example, my employer matches up to 4%. So, I make sure that my contribution is at least 4% every paycheck. Make sure you are contributing enough to get your entire employer match!!
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