Traditional vs Roth 401k?

Now - no matter how much I google, I always see that ROTH 401k is better. Everyone I talk to advises that ROTH 401k is the way to go because you don't pay taxes when you are old. 

But which one is truly the best?

Is it better to have a traditional 401k for individuals making 100k+ so our taxable income is lower? Take the extra savings on your income and invest it on your own on stock/crypto? Or just extra cash on hand?

Or it better to have a roth 401k and so pay it all upfront now and not to worry later? 

We don't know how the tax brackets will be 30-40 years from now, so is it worth taking the risk? Or should be go half/half in both roth and traditional 401k?


Thoughts? How do you guys see this situation? How do you invest?

 

Here's a good report Vanguard wrote about this issue:

http://mmmadvisory.com/wp-content/uploads/2018/08/A-BETR-Approach-to-Ro…

It'll depend on your life's situations, but splitting it up 50/50 is probably the best approach barring some situation when you know your tax rate will be different (going to grad school for example).

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.
 

Most posters here are fairly early in their careers and are targeting an amount of wealth that will (hopefully) lead to higher income in their retirement years than they have now. 

If you look at tax rates now vs. the past few decades, it seems difficult to expect rates to go materially lower overall.

If you expect some years with little or no income (like business school, or possibly entrepreneurship) traditional is attractive in that you can roll over to Roth in those lower income years. 

Overall I think a higher Roth allocation makes sense for most young professionals. 

 

Depends on your age / current income / projected retirement lifestyle. For most on this site, with a younger and high income tilt, I think the majority will be better suited with Roth. Given debt increases and whatnot... I think it's fairly safe to say taxes won't be going down in our lifetimes. 

 

Most employer matches and contributions are done into traditional 401ks so I do 100% of my personal contributions into Roth and then let the company contributions be the balancing towards the traditional.

 

I could be wrong, but I think all employer contributions are into traditional without exception, but that may have since changed as of a few years ago.

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.
 

Reason I made this post is because I don't know if I am misunderstanding anything. 

I have always been closer to Roth - but now looking into traditional. Not because I want "extra" cash in my hand now with traditional 401K. More so because the money I would save from my taxable income going down, I can increase my contribution towards my 401K - or even look to invest it on my end in a separate IRA or individual brokerage account. 

After doing the math, at the current stage - I am looking at close to $300 extra in cash every month - $3,600 for the year. Would it be wrong to assume that this $3,600 + every year savings re-invested in a 401k/other investments would go a long way? (Assuming I put it in S&P 500 and 8% annual return compounded annually?). Assuming filing status change from single to married/jointly - in my case, I would be saving 195k in taxes by doing this (I assumed same salary with 2.5% increase every year). Employer match + my contributions, came out to nearly 850k in difference if I do Traditional vs Roth. If I go aggressive even when I retire and start taking withdrawals, the traditional 401k with higher balance will be compounding more $$ annually. 

Am I missing something or not calculating correctly? (Also assumed that tax brackets stay the same since we don't know the future). 

 

Yes this is wrong. Putting money in Roth effectively puts more money in tax advantaged accounts since it is already after tax (i.e. 10k in a traditional 401k hasn't gone through taxes yet whereas 10k in Roth has, so you're effectively investing 10k + the amount taxed).  Example:

You invest 10k in traditional and 10k in Roth and tax bracket is 25% both today and in retirement. Let's say you 5x. In scenario 1, the 10k in traditional goes to 50k PLUS the 2500 of tax savings goes to 12.5k. At a 25% tax rate, the 50k in traditional is worth 37.5k and the 10k of gain on your taxable account let's say there's 20% LT cap gains, then your 12.5k is worth 10.5k, so you're looking at 48k net of taxes from the traditional investing. In the Roth, your 10k went to 50k and that's all tax free, so in this example you're better off with Roth

 
Username_TBU

Yes this is wrong. Putting money in Roth effectively puts more money in tax advantaged accounts since it is already after tax (i.e. 10k in a traditional 401k hasn't gone through taxes yet whereas 10k in Roth has, so you're effectively investing 10k + the amount taxed).  Example:

You invest 10k in traditional and 10k in Roth and tax bracket is 25% both today and in retirement. Let's say you 5x. In scenario 1, the 10k in traditional goes to 50k PLUS the 2500 of tax savings goes to 12.5k. At a 25% tax rate, the 50k in traditional is worth 37.5k and the 10k of gain on your taxable account let's say there's 20% LT cap gains, then your 12.5k is worth 10.5k, so you're looking at 48k net of taxes from the traditional investing. In the Roth, your 10k went to 50k and that's all tax free, so in this example you're better off with Roth

Umm no.  First of all, this is a really weird way to do this problem and I literally had to read it like 3-5 times to even figure out what you were doing.  All that to say - your error is at the very beginning. 

- The tax savings is not 2,500, it's 3,333. 

- 13,333 * .75 = 10,000 to get to the Roth

- You're calculating it as if the original pre-tax dollars for the Roth was $12,500 (10,000 + 2,500)

- If tax rates stay the same, you should be indifferent between Roth and Traditional (without taking into account the potential for lower withdrawal rates in retirement that could potentially lower your tax bill

 

100% of my contributions and savings are either in brokerage accts or in roth (401k + backdoor/mega backdoor), here's why

  1. we're at historically low tax rates - the likelihood that I'm leaving huge tax savings on the sable is slim to none. our country is so heavily indebted that I see no way out of this apart from a tax structure like belgium
  2. I'm in my 30s, tax free compounding for 30y>tax deferred compounding for 30y - this math could change when I'm in my 50s and have a shorter time horizon to retirement
  3. in an emergency that takes out 100% of my liquidity, roth is easier/more efficient to tap into
  4. the known known of what my retirement will look like

let me expand on #4. I see what 30y of traditional 401k savings gets you in real life since most of my clients have at least 1/4 of their assets (and some 3/4) in traditional IRAs that came from employer 401ks. they were sold the story that your retirement income will be lower and therefore your taxes will be lower so it makes sense to take the tax break now. there are a couple of problems with this - the magnitude of tax savings and the lack of investing your "savings" thus eliminating the leverage implicit in this strategy.

to be specific, I have a client who was making 6 figures in the 90s and 2000s at tax rates of 30-36%, he did 100% traditional, so let's see how that would play out

$10k cont in 2000 assuming 31% tax bracket saves you $3,100 at 6% CAGR turns into $36k today on the contribution or $47k today (assuming you invested your tax savings)

today, said retiree has a portfolio of investments that puts his taxable income in the 24% range, meaning that $47k turns into $36k after fed taxes (including his other income from SS, dividends, cap gains, etc.) and even less after state taxes. had that retiree only invested the $10k but in a roth (so no investing of the tax savings) it would've turned into $36k that is completely free from all taxes

I am sure someone has a mathematical proof that says you should do X% traditional and Y% roth. my bias is based upon my experience, my doubt that the federal government can get its shit together and lower taxes, my budget being so far below my means that I don't miss the extra cash, and the comfort of certainty that in retirement I will have only have to pay taxes on dividends, capital gains, and whatever employer matching contributions I've gotten over the years.

the only downside I see is - opportunity cost in case I'm wrong about the direction of taxes - I view this as a tolerable risk versus the uncertainty and reliance on hoping I'm right about the direction of taxes. in other words, knowing I'll pay 30-some percent now versus the unknown of hoping I'll have a 20-something rate in the future versus 30 something now

 

Your figures are incomplete as you need to factor in the additional taxable brokerage contributions that the Traditional tax shield enabled. This is the number one error people make when calculating these figures. 
 

 

don't think there's a mathematical proof as it really is a prediction on today's tax rates vs. future tax rates. as others have said, the only thing that makes me nervous is the government getting greedy and seeing a bunch of money that's not otherwise going to get taxed and saying they're going to tax it (it isn't crazy to think the government says if you have over $XX we're going to assess taxes on the Roth accounts). You could say not apples-to-apples because those funds have already been taxed, but you can say the same thing with estate taxes...

 

thebrofessor

$10k cont in 2000 assuming 31% tax bracket saves you $3,100 at 6% CAGR turns into $36k today on the contribution or $47k today (assuming you invested your tax savings)

today, said retiree has a portfolio of investments that puts his taxable income in the 24% range, meaning that $47k turns into $36k after fed taxes (including his other income from SS, dividends, cap gains, etc.) and even less after state taxes. had that retiree only invested the $10k but in a roth (so no investing of the tax savings) it would've turned into $36k that is completely free from all taxes

Dude either you and the poster above are smoking something or I am.  First, why do you guys insist on doing this problem this way (using a FV of the tax benefits)?  An easier breakdown using your example:

Traditional:

- 10,000 contribution at 6% for 22 years = $36,035 FV

- 36,035 x (1-.24) = $25,386 FV after taxes

Roth:

- 10,000 x (1-.31) = $6,900 post tax PV contribution

- $6,900 at 6% for 22 years = $24,864 FV after taxes

Your client was correct and saved money by putting money into the traditional, but you said he was worse off.  What am I missing here because both you and the poster above did the same thing and this strikes me as being relatively straightforward.

Edit: You're miscalculating the tax savings at the beginning, which is why you're getting different numbers than I am at the end.  The tax savings is not $3,100, it's $4,493 ($14,493 x (1-.31)) = 10,000

 

I typically lean into traditional for a few reasons:

- Increased Investments Today: More capital into investments upon each contribution as it's before-tax. More capital early -> more compounding

Lower Adjusted Gross Income: Traditional lowers your taxable income. I tend to teeter on the next tax bracket (the way I structure my compensation/negotiations) and this helps me qualify for tax incentives I wouldn't normally get 

Income-eligibility restrictions: my MAGI is above the Roth limit and contributions just get phased out after like ~$140k single/~$210 joint. 

Already have a trust account: Roth has no required distributions making them interesting for wealth transfer. I already have a living trust set up for that very purpose

Distribution Tax Options: I have lending relationships that will make me liquid using my traditional 401k as collateral and my employer allows this activity. So I get the loan and the I/R I'd be paying is much lower than the tax on the distribution, I avoid pre-payment penalties, etc.,  and--hopefully--the gains in the portfolio outweigh the cost of capital

- Municipal Bonds Brokerage Account: My brokerage account is--for all intents and purposes--like a Roth. My contributions are after-tax and all the Munis I involve myself in are federal and state tax free (about 10% of the portfolio is subject to state tax). The yield on this account could be used to pay back any loans I take out on the 401k

Employer Contribution Match: My firm--for whatever reason--matches more on traditional than Roth IRAs. If I leaned into Roth, I'd be leaving money on the table

With that said, I can see the benefits of Roth for sure. Especially since taxes are not likely to go down. 

 

Repeating here because of the misconception of increased investments today. All else being equal, you actually come out ahead with the Roth and you're actually investing more net of taxes through the Roth. See the example below. 

Yes this is wrong. Putting money in Roth effectively puts more money in tax advantaged accounts since it is already after tax (i.e. 10k in a traditional 401k hasn't gone through taxes yet whereas 10k in Roth has, so you're effectively investing 10k + the amount taxed).  Example:

You invest 10k in traditional and 10k in Roth and tax bracket is 25% both today and in retirement. Let's say you 5x. In scenario 1, the 10k in traditional goes to 50k PLUS the 2500 of tax savings goes to 12.5k. At a 25% tax rate, the 50k in traditional is worth 37.5k and the 10k of gain on your taxable account let's say there's 20% LT cap gains, then your 12.5k is worth 10.5k, so you're looking at 48k net of taxes from the traditional investing. In the Roth, your 10k went to 50k and that's all tax free, so in this example you're better off with Roth

 
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I actually think that it is much simpler than this. On an apples-to-apples basis, you are better doing Roth if your taxes will be higher later, and Traditional if they will be lower. If you think you have differentiated insight into where tax rates will be in your retirement relative to now (including the impact of any tax law changes in addition to what your actual annual income will be in that time period), then you should go ahead and base it on that assuming you think that difference will be significant.

Assuming you decide that you don't have that ability, and you are maxing out your 401(k), Roth is the correct choice for a simple reason. If you contribute $20,500 to a Traditional 401(k), those are pre-tax dollars, which means that ultimately you are tax advantaging $20,500 of pre-tax dollars. If you contribute to $20,500 to a Roth 401(k), those are post-tax dollars, which means that you are tax advantaging $20,500 / (1-tax rate) pre-tax dollars. So if you assume a 40% tax rate, you are contributing $34,167 pre-tax dollars into a tax-advantaged account. In other words, you are substantially increasing your allocation of funds to a tax-advantaged account by using a Roth. The degree to which this actually matters in practice will depend on how much shifting between assets you do, and how yield-y your investments are. But the fundamental math is that the Roth is better absent a difference in tax rates over time. You would have to run the math to see how much of a difference in tax rates you would need to overwhelm the difference.

 

One quibble with the second paragraph. You are not contributing 34k pre-tax since the taxes you pay go to the government and do not earn you a return. I get what you're trying to convey, but think it could be confusing if read literally.

Assuming that 40% tax rate, contributing 20.5k to a traditional will save you 8.2k in taxes today compared to a Roth; a Roth would lead to 26.3k more invested in 20 years (after the 40% tax on the traditional IRA) assuming a 6% CAGR, which is 8.2k NPV, equal to the benefit from the traditional contribution assuming no change in tax rate.

 

I don't think that I agree on that. On the 401k piece isolated, you can just run the simple math. Assume that you invest $20,500 in your 401K:

Roth

Starting Balance: $20,500, 100% total return -> Ending Balance = $41,000; Tax Burden = $0 -> Final Ending Balance = $41,000

Traditional

Starting Balance: $20,500, 100% total return -> Ending Balance = $41,000; Tax Burden = 40% * $41,000 = $16,400 -> Final Ending Balance = $41,000 - $16,400 = $24,600

To get to the same Ending Balance in your Traditional as you have in your Roth, you need Ending Balance = $41,000 / (1- 40%) = $68,833.33. To get that Ending Balance, you need Starting Balance = $68,833.33 / 2 = $34,167. So inherently, your Roth is giving you the equivalent exposure of $34,167 pre-tax dollars in a Traditional 401k. 

 

Roth 100%. Makes no sense to do traditional if you make 100k+ now and expect to make multiples of that a few decades from now. We have historically low tax rates today & the political tides increasingly favor ganging up against the rich (even among Republicans the % that distrust big business / the rich is much higher today vs 20yrs ago as per survey data). Automation / AI will continue to put people out of jobs. We have a historically high debt / GDP ratio

The above are structural forces that are NOT going to get better and there is no reason to expect that the gov will get its crap together. Roth gives you peace of mind that you know what you'll be getting upon retirement in an era where you will NOT see any ROI on social security / cap gains is seeing upward pressure / all other taxes continue to rise. Do the Roth

 

There’s an argument to be had for both but the thing the only Roth people need to understand is that a dollar into Traditional avoids tax on the last dollars you make, which are taxed the most, and a distribution from Traditional later are managed to be the first dollars in and thus the least taxed. 
 

Assuming your tax is the same on both ends is wrong. It’s basically impossible to manage your W2 income when you’re working; the avoidance of tax on your last marginal dollar is extremely valuable and allows you to in turn invest the delta that you saved from taxes now into a taxable brokerage account. 
 

 

The way I understood it is that assuming tax rates are equal now and in the future, the Roth and traditional will yield you the same post-tax result, only if you take the extra income saved from contributing to the traditional 401k over a Roth, and invest that in a taxable account (assuming same returns as well). In reality, I and many other people are not going to calculate the exact dollar amount saved using a traditional 401k and invest that difference every paycheck cycle. So I'm probably better off with the Roth 401k. This all changes with your assumptions around future tax rates, but assuming they remain the same, then to my understanding thats the only scenario where they come out around equal. 

Array
 

Lots of good perspectives ITT. I'm going to give the boring, "it depends" answer. For me personally, I max out the traditional 401k and here are my reasons why:

1. I'm not in a position to predict future tax rates nor do I believe anyone ITT is (sorry y'all). All I know is right now, I'm getting taxed 24% on each marginal dollar I earn and maxing out the traditional nets me an extra ~$5K per year or in savings. This isn't an obscene amount of money, but I can either put it towards travel, having more cushion for rent/entertainment expenses, other investments beyond index funds, etc. Not all of these uses of money are the best ROI, but I feel like I'm already being super responsible by saving a good chunk of my income right away, so having extra spending money helps give me a good balance between prepping for the future and living in the present

2. If the government does become tax hungry, I don't think Roths will necessarily be safe from their wrath either. I can easily forsee a scenario where if your account value is over $X00,000, those amounts will be taxed one-time or annually to pay for whatever they need to pay for. I feel like this would be harder to implement retrospectively, as would be the case for a Traditional IRA/401K, but perhaps this is a naive perspective.

3. I don't think the difference is so great to the point that it'll make or break your retirement, especially if you reinvest the tax savings from your trad contributions. As such, I think it's better to focus on how badly you need the pre-tax savings now. For me, I don't earn nearly as much as most of the people on this site, so the extra few Gs actually help me out much more than someone who is making $250K at 25/26 like a lot of people in finance are. So yeah, I might be losing some money by going trad vs Roth, but I prefer the savings now to use as I see fit vs an extra few thousand down the road when lord knows what'll happen to my health, the tax environment, etc. 

So long story short, I do trad because I value the savings now more for non-monetary purposes as well. If you're making a lot of money and wouldn't benefit that much from an extra $5K or so in savings, it seems mathematically the Roth will provide the best ROI on average and you should run with that. 

 

I've literally never thought about your idea in point number 2, but have now seen multiple posters talk about this "risk."

My question is, don't you think the Gov't would be more likely to go after money that hasn't been taxed yet? Even if the Gov't got super desperate, I think there would be more up roar with again taxing money that has already been taxed (Roth money). 

 

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