Traditional 401k vs Roth 401K

.

I would suggest a mental exercise, where do you see the country's debt, tax revenues, and real GDP per capita in 30-40 years? Specifically, unfunded liabilities like Medicare and SS (these will make the $16T debt look relatively small).

Me, well... There are a ton of baby boomers that will retire in the next 10-20 years. If SS keeps up with inflation, we're screwed - we'll have 1.8 workers per retiree. Add in that life expectancy is increasing by months every few years, and the birth rate is tanking. The longer this economy stays in this mode (half of new jobs added in June were service-sector; 30% of part-time workers would rather work full-time but can't find anything), the longer the birth rate will stay low.

Defined benefits plans / Ponzi schemes collapse if the boom slumps for too long (minimally, there needs to be a growth in the tax base to continue supporting them).

What's more likely, Congress reneging on the tax-free withdrawal of the Roth IRA, or Congress increasing taxes?

Let me put it like this, you're a captive audience once your money is in a Traditional IRA - you will get taxed when you withdraw, and you'll be stuck with a 10% penalty on top of the tax, should you try to avoid impending disaster. So realistically, that limits you to 10% + current tax rate(ish). But what if the tax rate just goes up a couple percent every few years? What if they make tax law on New Year's Eve that's effective on the next day? In theory they could take 50%, 80%, whatever they wish.

Best case? Traditional IRA might be better. Worst-case? You know your cost for a Roth, ie you can target a certain yield and have a much better idea of what cashflow you'll have when you retire. I think the added certainty a Roth gives you makes it worth it, even if it somehow is a worse deal 30, 40 years from now.

But also consider you're not stuck for life in one or the other. You could go Traditional now and convert later.

A financial advisor can only help so much - nobody can predict the future, but which is better entirely depends on the tax rate 30+ years down the line. As for politics - Latinos are the fastest growing demographics and they vote strongly Democrat. Deomcrats tend to raise taxes.

I don't think you want to be making retirement investment decisions based on tin foil hat theories of the government raising the tax rate to 90% for the same reason you don't want to try and time the market in your retirement portfolio. Remember, taxes can go down too (see 1986) and theres so much uncertainty over the next 40 years.

Also, if the doomsday scenario that the poster above is talking about where America basically falls apart because of unfunded liabilities you're pretty fucked regardless, so scenarios like that aren't even worth worrying about. Also not that it matters but I'm pretty sure the government would be willing to reneg partially on social security/medicare before raising taxes to infinity - they're not as stupid/evil as they seem.

Just look at your marginal tax rate now and compare it to what you expect to have at retirement (under current law, once again your guess is as good as mine where taxes are going to be). Also consider state tax implications.

If you're really worried remember you can always mix it up, contributing 50/50 traditional/roth. That way you're tax change neutral. But going 100% roth just as a way to speculate that taxes will go up is pretty reckless when it would otherwise make sense to go traditional based on your marginal tax rate now vs expected retirement.

For a Roth you only have to pay taxes on what you contribute but you pay the taxes now. Traditional you pay on contributions and any gains but you pay the taxes in the future.

A lot of people would tell you that not having to pay taxes on the gains outweighs the cost of paying taxes when you contribute.

SonOfNike:

For a Roth you only have to pay taxes on what you contribute but you pay the taxes now. Traditional you pay on contributions and any gains but you pay the taxes in the future.

A lot of people would tell you that not having to pay taxes on the gains outweighs the cost of paying taxes when you contribute.

The argument against this view is that you can contribute more money to a 401k (equal to whatever your tax bracket is) because you aren't paying the tax right away. So, your take home income would be the same, but you'd have more [pre-tax] dollars in your retirement fund. Assuming things remain constant, these two methodologies would wind up with the take home pay in retirement.

I'm personally not a fan of trying to predict the future, so I split my retirement contributions ~50/50 Roth 401k and Trad 401k. Plus, there are some benefits to the Trad 401k (for example, it lowers my income so I can write off some student loan interest) and assuming we still have a progressive tax bracket in the future, there will be the 10%, 18%, etc. brackets to fill with income that are lower than my current bracket.

my understanding is you pay taxes on say 100000 now for the roth and when it grows to $1MM or more over the next 40 years you dont have to pay taxes later(maybe 15% capital gain?)

Whereas Traditional 401k you dont pay taxes now and when it grows to $1MM plus you have to pay that bracket it drops you in

I could be way off though.

You can argue future tax rates, projected interest rates, or time to retirement, but the Roth is superior in the majority of situations.

Lets use a simple example. Say you put $5,000 in a Roth today and it grows at a 10 percent rate for 40 years and grows to over $300,000. You only pay tax on what you invest in a Roth, so you just paid about $1,500 in taxes for $300,000 in income, or about a 0.6 percent tax rate. If this same investment were in a 401k, you'd be paying taxes on the full $300,000 or closer to $90,000 in taxes. Would you rather give the government $1,500 or $90,000?

Thanks guys - appreciate the posts.

Roth does offer more certainty now... and it seems more likely than not taxes will rise in the future to some extent.

Industry84:

You can argue future tax rates, projected interest rates, or time to retirement, but the Roth is superior in the majority of situations.

Lets use a simple example. Say you put $5,000 in a Roth today and it grows at a 10 percent rate for 40 years and grows to over $300,000. You only pay tax on what you invest in a Roth, so you just paid about $1,500 in taxes for $300,000 in income, or about a 0.6 percent tax rate. If this same investment were in a 401k, you'd be paying taxes on the full $300,000 or closer to $90,000 in taxes. Would you rather give the government $1,500 or $90,000?

Uhh... no... they're equivalent if you remain in the same tax bracket.

Also who cares how much you pay the govt. What matters is what you get at the end of the day.

Example:

Traditional: You put in $5000. After 40 years at 10% annually you get $205,000 in your account. Taxed at 30% when you take it out, you have $144,000 for your retirement.

Roth: You put in $3500 because you pay the taxes on the 5,000 at the start. $3500 compounded annually at 10% for 40 years leaves you with 144k. The same amount.

What matters is if your future tax bracket is greater or less than your tax bracket today.

job.resume:

Industry84:

You can argue future tax rates, projected interest rates, or time to retirement, but the Roth is superior in the majority of situations.

Lets use a simple example. Say you put $5,000 in a Roth today and it grows at a 10 percent rate for 40 years and grows to over $300,000. You only pay tax on what you invest in a Roth, so you just paid about $1,500 in taxes for $300,000 in income, or about a 0.6 percent tax rate. If this same investment were in a 401k, you'd be paying taxes on the full $300,000 or closer to $90,000 in taxes. Would you rather give the government $1,500 or $90,000?

Uhh... no... they're equivalent if you remain in the same tax bracket.

Also who cares how much you pay the govt. What matters is what you get at the end of the day.

Example:

Traditional: You put in $5000. After 40 years at 10% annually you get $205,000 in your account. Taxed at 30% when you take it out, you have $144,000 for your retirement.

Roth: You put in $3500 because you pay the taxes on the 5,000 at the start. $3500 compounded annually at 10% for 40 years leaves you with 144k. The same amount.

What matters is if your future tax bracket is greater or less than your tax bracket today.

Good catch, I realized that just after I sent in the comment. Regardless, most financial experts recommend only contributing to a traditional 401k up to your company match percentage then maxing out the Roth, so there must be a reason they give that advice. one if the benefits is that you have less restrictions with a Roth. With a 401k, you need to start taking minimum distributions at age 70. With a Roth, you can let the money continue to grow throughout all of retirement and pass it down to heirs tax free.

Lets also assume you live until that age and don't die before hanf

Thanks for asking the question OP and thanks for all of the input all.

This may be a bone-headed question but how is your tax bracket determined once you're retired and start taking distributions? Is it just calc'ed off your monthly distribution x 12?

These are just some points and do not constitute a recommendation. You can always consult a non fee-based wealth advisor for your specific situation to avoid paying hourly fees for consultation.

Keep in mind tax brackets are determined by your total taxable income, regardless of retirement. Traditional 401k will be taxed on the full withdrawal limit since it was funded with untaxed dollars. Also important to note that these accounts that use untaxed dollars have a RMD (required minimum distribution) when you reach age 70 1/2 where if you do not take out the required amount determined by the IRS you will be penalized upwards of 50%. If you plan on depleting the account over 10 years, starting form age 60, it would not be a problem, but note that some of the latest insurance actuarial tables average our lifespan to 86 and 88 years for males and females respectively. You don't want to run out of money at that age. Typically it is acknowledged Roth is superior, e.g. Roth IRA, for its tax-free withdrawals. There are several ways to withdraw money, qualified withdrawals, from a Roth IRA without penalties, and two of the biggest selling points are the ability to withdraw your cost basis at any time and the ability to withdraw gains for qualifying higher education for you or your children. Traditional 401ks are also used for dropping you into a lower tax bracket if you are near the cutoff limit, whereas a Roth cannot provide such benefit. Currently 401ks have a maximum contribution limit of $17,500. Since we're talking about someone just starting to work, and assuming he or she is able to dump in 17.5 every year at a modest 6% you get $2,227 thousand if you contribute from ages 23 to 59. Withdrawing over 10 years starting at age 60 you get 302.6k/year, which is completely taxable at your future tax bracket. If you were retiring today, for example, and that was your total taxable income, you are in the 33% bracket for this year.

This is just a very simple example, and overlooks some nitpicking the IRS has for withdrawals.

Insurance is another form of retirement income people use, and that income stream is tax-free as long as you maintain certain guidelines set by the IRS. However, many people find the idea of insurance as a long-term investment vehicle appalling. If set up and used properly, it can be a gold mine later on down the road.

There's a whole lot more that come into play given different variables in life, but this is the basic idea.

One last thing, as I saw a prior comment about Roth > 401k, 401k's have employer restrictions which is why it is recommended to have a Roth IRA which is fully in your control. Employer matching maximizes your investment, only if it is vested however, and gives you an upper edge when rolling it over in to a personally owned account upon separation.