Recently I transitioned from my job in New Orleans to one in California. While my job in New Orleans provided a traditional 401K, I remained intrigued by the Roth 401K. I had contributed diligently the last 2 years to a backdoor Roth IRA for my wife and myself, but the Roth 401K evaded me.
As I started my benefits paperwork I noticed that my new employer offered me a Roth 401K option! So I thought to myself “Bingo Bango Jango! Hot dog! Time to play ball!” Still I never stopped to think about the Roth 401K vs Traditional 401K. Most financial bloggers recommend going with the Roth option, but is this really the way to go? I now had 2 choices to make: 1) What kind of account to roll my current Traditional 401K into and 2) where should I contribute my future contributions to?
First off, before we get into the muck and mire of this topic lets answer some basic questions. As always, I am not a certified financial planner and do not provide financial advice. This is just the musings of one dad and not financial advice. Any decisions you make are your own. Ok now that we got that out of the way.
What is a 401K plan?
The 401K is an employer sponsored retirement savings plan and basically replaced the pension plans of the past. With it, employees are able to contribute up to $18,000 a year (plus and additional $6,000 if you are 50 + years old) to your retirement account. Your employer may or may not match a portion of these funds. Then invest these funds into your allocated plan (stocks, bonds, TIPS, etc.). This money is left in the market to grow or decrease (remember the Great Recession of 2008) until you withdraw it. You can start withdrawing money penalty free at 59.5 years of age and you have to start withdrawing a portion at 70.5 years of age.
What is a Traditional 401K?
Two words: Pre-tax dollars
A traditional 401K plan is one in which money is taken from your paycheck pre-tax and deposited into your 401K plan. The benefit of the Traditional plan is that it decreases your current take home and taxable income. Therefore, you will not need to pay taxes on the $18,000 placed into the account on this year’s income tax return.
This is great if you are a high earner or just above a tax bracket division. The money in the 401K then grows until you begin taking money out. As you take a withdrawal then it is taxes as regular income. Therefore, if your income is expected to be lower in retirement (as is most people’s) then the Traditional 401K makes sense. It lowers your current income level, improves month to month cash flow now, and will be taxed when you are older, presumably retired, and likely making a lower annual income.
What is a Roth 401K?
Two words: After-tax dollars
A Roth 401K plan is one in which money is taken from your paycheck on an after-tax basis and deposited into your 401K plan. The benefit of a Roth plan is that you have paid the taxes now and it will grow tax free for the remainder of your life (or your children if they inherit the money after you die). Take that government! Suckers!
That being said, paying taxes now is no fun if you are in a high tax bracket or need the cash flow, but the earning potential is much higher. The biggest drags on returns are fees and taxes. So if you can get rid of those taxes, then the drag gets markedly decreased and hopefully you already have a low fee plan. The Roth plan is great, particularly if you expect to be in a high tax bracket at retirement (i.e. have a pension, side gig, etc.).
So what to do- Roth versus Traditional IRA?
Well in thinking about the situation, it may seem like an easy decision- Go with the Roth dummy! But in reality it is not that simple.
Let’s first talk about my potential to rollover my prior Traditional 401K plan into a Roth 401K. This seems like a good idea initially but when looked at more closely the dangers present them selves. The biggest problem with a roll over from a Traditional to a Roth 401K is that you will have to pay taxes on all deposits and earnings the year of the rollover. This is because you have not paid any taxes on this amount yet. Therefore, the government wants their cut.
This could lead to a big tax bill for the year of the rollover. If you have a significant chunk of cash already saved in your 401K (say $100,000) and a high-income earner, it is best to not roll over the money from one to the other account (taxes would be approximately $40,000 on the $100,000). So I would not recommend rolling over a Traditional 401K to a Roth if it is a sizable account except for two times:
1) If there is a market crash and your account amount dwindles. Then the amount you are rolling over is smaller and the tax burden will be less.
2) If your expected annual income is less for a year. Let’s say you take a sabbatical or only work part of the year. Then you should consider rolling over funds from a Traditional to a Roth IRA. Otherwise just stay put and leave the accounts separate.
What about going forward?
I now have the option to contribute to my Roth 401K with every paycheck. This is a trickier situation and more dependent on each person’s individual needs. I am in the highest tax bracket and so I save approximately $7,200 on taxes annually at a 40% tax bracket (40% x $18,000) if I go with a Traditional 401K. Remember this is pre-tax money and so the government acts as if I did not make that $18,000.
This is a significant chunk of cash coming out to about $600 a month in cash flow into my checking account. So if I need that extra $600 to survive then I should go with a Traditional 401K. Interestingly, if I take that extra $7,000 and invest it in similar stocks then my earnings at retirement with the Roth and Traditional 401Ks are very similar. The problem is that most of us are not disciplined enough to that.
So the decision has to come to what I want to do with the $600 dollars a month difference between plans. My current financial goals are to pay off my $170,000 in student loans aggressively as I have my prior debts. Therefore, the additional $600 a month in cash flow from the Traditional 401K choice could go towards student loan payments. Once my student loans are paid off I can revisit my options and then switch my contributions to a Roth 401K. This requires discipline and if I take that money and buy an Audi S7 then I should have stuck with the Roth. You could actually think of the Roth 401K as a forced savings (much like they say about a mortgage).
So what should you do?
Well before you decide the best route ask yourself the following questions:
– Do you expect to be in a lower tax bracket upon retirement?
– What would you do with an extra $600 in your pocket monthly? Do you need the money to survive and pay the bills? If not, will you use it to pay off debt or place in other investments or will you blow it on unnecessary expenses like a car lease?
– Does your employer even offer a Roth 401K?
– Do you think the tax laws will change significantly in the future effecting the taxes on your Traditional 401K withdrawals?
So what do you think, is Roth or Traditional 401K the way to go? Please leave a comment and let me know.