Many companies have begun to offer the choice of a Traditional 401k or Roth 401k. The first thought that comes to mind when I hear Roth 401k is zero taxes due on withdrawals in retirement. The idea of not paying taxes on withdrawals from your retirement nest egg is a BIG deal. Let’s face it, your withdrawals go much further in retirement when no taxes are taken out. Plus, it’s a great feeling! But is it enough to justify not taking the Traditional 401k tax deduction all those years while you were saving for retirement?
To answer this, we have to make some assumptions. Let’s assume you’re contributing $20,000 to your 401k. Fifty percent to a Traditional 401k and 50% to the Roth 401k. We’ll also assume you’ll stay invested for 30 years, receive an annual rate-of-return of 8%, you have a 20% current tax rate, and a 15% retirement tax rate.
When analyzing the results, we notice the drivers are: tax rates, rate-of-return, and time in the market. If, in our example, the “tax rate while working” was 37%, it would make sense to choose a Traditional 401k. Just like if the rate-of-return was 30%, it would make sense to choose a Roth 401k.
Traditional 401k contributions give you a tax deduction on the front end, but no tax benefit on the back end, thus withdrawals are 100% taxable. Whereas with a Roth 401k contribution, you receive a tax benefit of $0 taxes due on withdrawals on the back end, but don’t receive a tax deduction on the front end. Pay taxes now or pay taxes later, that’s the dilemma.
Each person’s situation is different. Therefore, consult your financial advisor to see which choice is best for you.