Comparing the effects of a Roth 401(k) and a traditional 401(k)
With Roth 401(k) plans becoming more available, many workers are wrestling with the question of whether to maintain their standard retirement plan or take advantage of the benefits that Roth plans provide, namely the ability to have their retirement assets grow tax-free and withdraw income tax-free.
Many people assume that having tax-free growth and tax-free retirement income is worth paying a few extra in taxes during their working years, versus the immediate tax savings of contributing to a traditional 401(k).
While this is a safe assumption for many situations, it may not always be the case.
Below are a few hypothetical examples to demonstrate how different circumstances can impact whether it’s best to save for retirement in a standard 401(k) or a Roth 401(k).
In this first scenario, assume you contribute an average of $10,000 a year to a 401(k) for the next 30 years on an average salary of $100,000. You earn an average annual rate of return of 6 percent on your investments. Your tax rate before and during retirement is 25 percent.
If you elect to contribute and maintain a traditional 401(k), plan you will save $2,500 a year on your federal taxes than if you had made after-tax contributions to a Roth 401(k).
Assuming you live 30 years in retirement, you could expect estimated annual retirement income of $57,000 using the Roth 401(k) versus $43,000 from the traditional 401(k).
The difference results from the fact that the Roth 401(k) funds will grow tax-free and will allow you to withdraw them tax-free, assuming you are at least age 59 1/2 or are disabled.
Withdrawals from the traditional 401(k) plan, on the other hand, will be taxed as regular income, which reduces the amount of money you have available to you.
Here’s another example:
Assume you contribute $15,000 per year into your 401(k) for 25 years on a $150,000 salary, earning an average annual return of 6 percent before retirement.
In this scenario, your tax bracket is 30 percent during your work years. Therefore if you opt for the pre-tax contributions of the standard 401(k), you’ll save $4,500 in taxes each year.
In this assumption, your retirement will last 25 years, and your estimated tax rate has fallen to 10 percent. Also, because you want to be more conservative in retirement, you’ve reallocated the fund’s assets to a portfolio that averages 3.5 percent annual return.
In this scenario, your net retirement income is $50,600 with the tax-free income from the Roth 401(k), versus $45,500 with the taxable income from the standard 401(k). In this hypothetical, you’ve almost made an even trade between the taxes paid during your working years for the tax savings during retirement.
In this hypothetical example, you’re a 55-year-old at the peak of your earning years, contributing the maximum of $24,000 a year for ten years. Your annual salary over the ten years is $240,000, and you’re in the 35 percent tax bracket. During retirement, your tax bracket drops to 25 percent
The account grows at an average of 6 percent per year during your employment, and 3.5 percent a year during retirement when you reallocate to a more conservative portfolio.
If you contributed to a 401(k) instead of a Roth 401(k), you’d save approximately $8,400 in taxes during those ten working years. Your expected annual net income during a 30-year retirement would be $17,400 with a Roth 401(k) and $13,000 with a standard retirement plan.
In this last hypothetical scenario, a person has just started his or her career making $60,000 a year and contributing 5 percent of that salary to a 401(k). The employee has 40 years to retirement and a more aggressive investment approach yields 8 percent average annual return.
The current tax savings, if the person has a 20 percent tax rate, between a traditional 401(k) and a Roth 401(k) is only $600 a year.
But assuming the person’s salary, contributions and rate of return stayed constant for 40 years, and also assuming a 30-year retirement in a 25 percent tax bracket with a portfolio growing 3.5 percent annually, the net annual income would be $43,250 from the Roth 401(k) versus $32,400 for the regular 401(k)
What factors into which plan is best
Determining which option is best will require you to make many assumptions including:
Your income while working
The amount you expect to contribute to your plan each year
The number of years you have until retirement
The expected rate of return on your retirement account
Your estimated tax rate while working and during retirement
These numbers will vary from year to year, making these assumptions trickier to calculate. Your income could continue growing during your working years, or it could decline for a period. You may have a financial situation that makes it difficult to maintain the percentage of your income that you contribute to your retirement plan. Certainly, rates of return on your investments will be volatile; they could gain 30 percent one year and lose 12 percent the next. And there’re no guarantee tax rates will remain constant.
The simplest way to consider which option is best is to estimate as best as you can whether you’ll save more on your taxes today by making pre-tax contributions to a standard 401(k), or whether you’ll benefit from the tax-free income during retirement on your Roth 401(k).
That means comparing your income and tax rate today and for the remainder of your working years with a projected income and tax rate during retirement.
You can be better informed by using a comparison calculator and factoring different scenarios, plus talking with a retirement specialist about your unique situation.