After my last article on traditional and Roth IRAs, one of my friends asked me what I thought about the traditional 401(k) compared to the Roth 401(k) options. At that point, I wasn’t as familiar with what a Roth 401(k) was but I was vaguely aware that it works similarly to how Roth IRAs work. I decided to do some research.

Roth 401(k)s

401(k)s are employer-sponsored retirement plans. Like IRAs, they can be used to put money away for retirement in tax-advantaged accounts. Traditional 401(k)s are funded with pre-tax dollars, meaning you get a tax break in the same year that you make contributions. In addition, many employers will match a certain percentage of your contributions, essentially giving you free money to put towards retirement. While your funds sit in your 401(k) account, they get to grow tax-free. When you finally decide to pull the funds out, they’re treated as income and taxed as such.

Roth 401(k)s are nearly identical. They carry the same tax-free growth as traditional 401(k)s. But in Roth 401(k)s, contribution are made with after-tax dollars. Therefore, you don’t get any tax benefits when you make contributions, but distributions in retirement are tax-free. This is exactly how Roth IRAs work.

There are a couple important aspects of Roth 401(k)s. First, getting money out of your account is actually more difficult. That’s because in order to take any money out, you have to be of retirement age and your first contribution to the account has to be at least 5 years old. If you meet this criteria, your withdrawals are considered “qualified distributions.” If your account is only 3 years old and you’ve reached the retirement age of 59½, you still have to wait 2 years before you can withdraw that money without penalty. If you decide to take a non-qualified distribution, the IRS will slap a 10% penalty on your withdrawal.

You might be thinking, “but that only applies to profits since the contributions were made after tax, right?” That is a logical assumption, especially since Roth IRAs allow you to withdraw up to your contribution limit at any time. Too bad the US government isn’t always logical. The IRS website specifically addresses this question in one of their publications which states:

“the same restrictions on withdrawals that apply to pre-tax elective contributions also apply to designated Roth contributions” (emphasis added)

In the above quote, pre-tax elective contributions are those made to traditional 401(k) accounts while designated Roth contributions are those made to Roth 401(k)s. This means you can’t withdraw any funds until you’ve met both of the aforementioned conditions. If you’re early in your career and you’re not going to reach age 59½ for at least 5 years, the extra restrictions on Roth 401(k)s won’t mean much to you. But if you’re retiring in the near future, it’s important to understand when you can access those funds.

In addition to the stricter requirements for withdrawals, Roth 401(k)s also carry Required Minimum Distributions (RMDs). Once you reach age 70½, you have to withdraw a minimum amount each year according to the IRS formula. This again differs from Roth IRAs which do not have RMDs.

When you fund a Roth 401(k), you’ll likely still have a traditional 401(k). That’s because if your employer matches any of your contributions, the contributions that come from your employer are made on a pre-tax basis so they can’t be added to your Roth 401(k). Employer contributions will instead be placed into a traditional 401(k) in your name.

If you scour the internet for advice on which account to choose, you’ll find that conventional wisdom uses the same logic to determine when to fund Roth 401(k)s as it does for when to fund Roth IRAs. If you’re expecting to be in a higher tax bracket during retirement, you should pay the taxes now by funding a Roth 401(k) instead of funding a traditional 401(k) and paying higher taxes in the future.

But we’ve looked at this before and found that that logic doesn’t stand up to scrutiny. When looking at IRAs, if you take the tax break up front with the traditional IRA and invest it, you end up with more money than if you were to fund a Roth IRA, even if you pay more in taxes! Do the numbers show the same result for 401(k)s?

Crunching the Numbers (Again!)

To see which account is better, let’s review a few scenarios with our friend Tommy. Here are our assumptions:

  • She will start working and contributing to her 401(k)s at the age of 25 and retire at 62.
  • Her starting salary will be $60,000.
  • Her salary will increase in real terms (after inflation) at 2.5% annually.
  • She is married.
  • She will contribute 10% of her income annually to 401(k)s.
  • Her employer will match up to 3% of her contributions.
  • Her investments will average 7% real growth annually (after inflation).
  • Her retirement expenses will be 75% of her pre-retirement income.
  • She will not have any additional income for retirement other than her 401(k)s.

With these assumptions in place, our first scenario will be for Tommy to only fund a Roth 401(k). When she retires, her final salary is $145,000 per year (yea, she became a big shot) and she has $1.68 million between her Roth 401(k) that she funded and the traditional 401(k) that holds her employer contributions. During retirement, she pulls funds from her Roth 401(k) first since she wants to hold off on paying taxes on the traditional 401(k) funds for as long as possible. When Tommy is 86, her expenses amount to $109,000 but her RMDs from both accounts come to $112,000.

Instead of spending the extra $3,000 she’s forced to withdraw, Tommy decides to reinvest those withdrawals (after paying applicable tax) in an after-tax investment account. Her RMDs continue to climb over the years and Tommy keeps reinvesting the surplus. Doing so allows her to keep her retirement funds in tact and at the age of 100, she still has $1.38 million.

So let’s imagine that Tommy instead follows the conventional wisdom to fund a Roth 401(k) when she’s in a lower tax bracket compared to retirement. She knows her retirement expenses will be about $109,000 so she funds her Roth 401(k) while she’s in a lower tax bracket. After age 46, she finds that she’s in a higher tax bracket than she will be in retirement and starts funding her traditional 401(k). Once she starts funding her traditional 401(k), Tommy takes the taxes she saves and invests them in an after-tax investment account.

Here, she has $1.75 million at retirement. Taking the tax deductions earlier and investing them gives her more money to work with during retirement. In this scenario, she has three accounts to choose from to fund her retirement: the traditional 401(k), the Roth 401(k), and her after-tax investment account. In order to maximize her tax savings, she first pulls from the Roth 401(k) since it’s completely tax-free. Once her Roth 401(k) is depleted at age 83, she starts to pull from her after-tax investment account. She does this because only the profits are taxable, and even then, only the profits above $77,400 are taxed, which is at the lower 15% capital gains rate. Before her after-tax investment account is depleted though, her RMDs start to exceed her required expenses. At age 89, she’s putting money from the excess RMDs into her after-tax accounts. Doing this actually grows her account value to $1.96 million at age 100! Taking the tax breaks upfront, investing them, and being efficient with her withdrawals allowed her to grow her assets through retirement.

But what happens if Tommy funds only a 401(k)? In this case, she funds just a 401(k) for her 37-year career. The whole time, she takes her tax breaks upfront and invests it into an after-tax account. As expected, at retirement, she has a larger nest egg of $1.86 million, which includes her 401(k) and after-tax investments. In this scenario, Tommy again pulls from her after-tax investment account first. In the previous scenarios, she didn’t need to pull from her after-tax investment account until about mid-way into retirement which gave those accounts more time to grow. But since she starts pulling from this account as soon as she retires here, it only lasts the first two years of retirement. After that, Tommy is relying solely on her traditional IRA funds.

Even doing so, her RMDs start to outpace her expenses at age 84 and she puts those funds back into her after-tax investment account. Doing this leaves her with $2.23 million at age 100. That’s nearly a full $1 million more than when she chooses just the Roth!

As you can see in the graph, the traditional-only approach grows Tommy’s accounts’ values more quickly since she is saving from the tax breaks. But then in retirement, paying the taxes doesn’t bring her account value down as many “experts” predict. The head start from investing the upfront tax breaks more than makes up for the taxes she has to pay in retirement. On the other hand, with only a Roth 401(k), we can see that paying the taxes upfront doesn’t build her portfolio up as much and we start to see a down trend as Tommy moves farther into retirement. With the combined strategy, you would think it’d be “the best of both worlds”, but really, it’s the Roth 401(k) dragging down the advantages of the the traditional 401(k).

In the end, regardless of which account Tommy chooses, she had more than enough funds for her retirement. But funding a traditional account provided her with more money in the long run. If your goal is to have as much money as possible in retirement (and let’s face it, what other goal is there to have?), forget about the Roth 401(k) and just go with the traditional.

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