401(k)s are employer-provided investment accounts designed to meet your financial needs in retirement. These accounts receive special tax treatment and creditor protection. It works like this: You put money in the account now – and take money out once you have retired.
When you put money into a traditional 401(k) account, you get a tax break. Invested money grows without being taxed – as long as the money stays in the account. When money comes out of the account, you get a tax bill. (Penalties exist if you use funds in the account before retirement.) Therefore, one advantage of using a 401(k) to invest is that your money grows without being taxed annually – since annual taxation decreases your investment return.
WHAT IS A ROTH 401(K)?
Unlike a traditional 401(k), a Roth 401(k) does not provide any tax breaks when money is put into the account. The benefit of the Roth 401(k) occurs when money is taken out of the account: all distributions are tax-free.
In addition to making his $1,000 contribution to his traditional 401(K), Joe also puts $1,000 into his Roth 401(k). Joe receives no tax write off for this contribution. 48 years later, the account balance is $100,000. Joe makes a distribution of $100,000 and pays no taxes.
Should I Pick a Traditional or a Roth 401(k)?
Anyone doing the math sees the value in forgoing $250 now for $25,000 in the future. However, there are other factors to consider – such as changes in tax brackets, or the aspects of human behavior. Fortunately, analysis from both of these perspectives points to the same outcome – at least for readers of this blog: pick the Roth.
The Tax Arbitrage Approach
Here is a rule of thumb in financial planning: those earning their peak income (relative to their earning history) need to opt for the traditional 401(k). This usually applies to those at the end of working career – i.e. older folks.
On the opposite side of the coin, younger folks (or more accurately those earning less income now than they will in the future) should opt for the Roth. This latter suggestion specifically applies to readers of this blog.
The Behavioral Finance Approach
Consumer expert Clark Howard confesses that his love of the Roth IRA (similar in tax treatment to the Roth 401(k)) stems from the fact that using the Roth means that you’re actually putting away more money for retirement. In our hypothetical example with Joe Danger, Joe actually puts away $1,000 after-tax dollars with the Roth – versus only $750 after-tax dollars with the traditional 401(k) option. The result (already shared) is that Joe has an extra $25,000 in retirement (although he misses out on a $250 savings earlier in life.)
I’m inclined to agree with consumer expert Clark Howard – because I like the idea of saving and investing more money than not. Also consider the difference in quality of life made possible by the two scenarios:
savings $250 during your earning years (now)
having an additional $25,000 in retirement (later)
Consider that if you’re earning north of $50,000 a year, $250 won’t have a large impact on your lifestyle. However, having an extra $25,000 at retirement just might.
Can I do both a Roth 401(k) and a Traditional 401(k)?
Another answer to the Roth vs. Traditional 401(k) question is to do both. And that certainly is an option. And with our Joe Danger, CPA example, Joe would be looking at a $125 deduction today, and a $12,500 tax bill down the line – had he split his 401(k) contributions down the middle.
Money invested in both the Roth 401(k) and the traditional 401(k) would grow tax-deferred. However, given this 50/50 strategy, you’re not taking full advantage of the Roth 401(k) option.
What Makes a 401(k) Good or Bad?
Taxes aren’t the only thing that impact your investment return. Another factor is investment fees. Investment managers charge you to invest your money for you. The less money you pay the money managers, the more money you can keep for yourself. Therefore, better investments cost less, and the not-so-great investments cost more – for the simple reason that paying a high fee means less money for you.
You can measure a manager’s fee by looking at a fund’s expense ratio (ER). The ER is usually expressed as a percentage, such as 1.00%. The lower the ER, the more money you keep as an investor.
Disclaimer: Any views or opinions presented in this article are solely those of the author and do not necessarily represent those of anyone. The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell any investments ever under any circumstances, most especially those investments mentioned, or to solicit transactions or clients. Past performance of the investments discussed will most likely not continue and the investments will likely not achieve the returns as implied. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for their specific situation.