Roth 401(k) vs Traditional 401(k)?

Roth 401(k) vs Traditional 401(k)?

Today’s post is inspired by a client, who asks about his Roth 401(k):

I just looked at my 401k account and I have the option to do a Roth 401K. What are your thoughts between traditional and Roth?

I’m a strong believer in the Roth option. I’ve got a few reasons why.

Tax Arbitrage

The client asking is in her later 20’s. Given her young age, the rule of thumb on “Roth vs. Traditional” provides a simple answer: pick the Roth. The reason is that you’re in a lower tax bracket today than you will be in the future.

Tax Bracket Today  <  Tax Bracket in the Future

Young folks are just starting to tap into their earning potential. Their salary reflects this. While their starting salary is relatively low now, it will increase with time. And with that higher salary comes a higher tax bracket (and higher taxes).

Therefore, a young person doesn’t get (relatively) a lot of tax savings by choosing the traditional 401(k) option. By picking the Roth option, a young person pays a little bit of taxes now (on salary income) to save a lot of taxes (on investment income) in the future.

Roth option at a young age:
Money Paid in Taxes Today  <  Money Saved on Taxes in the Future

It might make sense to switch to a traditional 401(k) in the future – when you’re in a higher tax bracket, when you’re paying more income taxes.

Traditional option with high salary:
Money Saved in Taxes Today  > Money Paid on Taxes in the Future

In short, young individuals (who are making relatively less income today compared to their future earnings) should opt for the Roth option.

Now that we’ve covered the plain vanilla answer on the traditional vs Roth question, let’s get to the real reason why I want you to use the Roth option.

You’ll Save More Money with a Roth

This particular reason for choosing the Roth 401(k) is less popular than the tax arbitrage reason just discussed. (And I’m actually stealing this idea from Clark Howard.) But I like the Roth option (regardless of your age, future earnings, etc.) because the Roth 401(k) does one thing that the traditional 401(k) never does: the Roth 401(k) makes you save more money.

When you put $18,000 into a traditional 401(k), you get a tax break. And that’s all well and great. But what are you going to do with that tax break? Usually, getting a tax break does not mean more money saved. i.e. You put $18,000 into your traditional 401(k), get $4,500 back from the Federal government in the form of a refund, and then put that same $4,500 into an investment account for retirement. Usually, that doesn’t happen. Usually, that $4,500 goes anywhere but additional retirement savings.

What’s the consequence of not investing that tax break? You have less retirement savings than what you could have had with a $18,000 contribution to a Roth 401(k). So, one way to look at a traditional 401(k) is that you’re really not saving as much money – compared to a Roth 401(k).

When you make a $18,000 contribution to your traditional 401(k), you’re not actually saving $18,000. You’re only really saving $13,500 (assuming a 25% future tax bracket). This is because of the taxes you get hit with when you take money out of a traditional 401(k).

Traditional 401(k) contribution  –  tax refund today  =  less money in the future

How do you avoid getting hit with taxes when you take money out of your retirement account (and therefore effectively save more money)? Use the Roth 401(k). With a Roth account, when you put in $18,000, you’re saving $18,000. In retirement, you get to take out $18,000 (and its growth) without any taxes. When you use a Roth account, you’re effectively increasing your retirement savings by your tax bracket (compared to a traditional 401(k) account). Between state and Federal taxes, this means you can have more than twice as much money.

Of course, some folks will argue that there are better tax and investment strategies when you save $18,000 in a traditional 401(k) and then invest your tax refund. But, most people don’t invest their tax refund! They spend their tax refund.

In short, using a Roth account means that you’re saving more money. And when you save more money, you HAVE MORE MONEY!

No RMDs When You Do a Rollover to a Roth IRA

Here’s the final reason why I like Roth 401(k)s more than traditional 401(k)s. You can avoid RMDs.

If it wasn’t already obvious, retirement accounts (like IRAs and 401(k) plans) are a great place to invest because these accounts receive special tax treatment. This means more money for you, because your investments grow without taxes slowing them down.

Unfortunately, you don’t usually get to take advantage of that tax treatment for forever. An RMDs mean you must take a certain amount of money out of the tax-advantaged account every year. When that happens, the money taken out of the accounts loses its special tax treatment. Once outside the account, that money cannot grow as quickly because it’s no longer receiving special tax treatment.

Growth of Money with Good Tax Treatment > Growth of Money without Good Tax Treatment
This rule applies to 401(k)s. You must make RMDs. This means that eventually the money you have invested will lose its special tax treatment. RMDs on money in a traditional 401(k) are unavoidable. That’s not the case with a Roth 401(k). You can avoid RMDs on your Roth 401(k) by rolling your Roth 401(k) into a Roth IRA. (This is not an option for traditional 401(k)s. If you roll your traditional 401(k) into a traditional IRA, you must still make RMDs.)
Now, the question of rolling your 401(k) into an IRA has all sorts of considerations – such as investment options, fees, and creditor protection. So, discuss with your advisor if a rollover is right for you. For now, we’re going to stay focused on advantage of doing the Roth 401(k) to Roth IRA rollover: no RMDs with a Roth IRA.

The Advantage of Not Having RMDs

I already talked about the value of keeping your money in an investment account getting special tax treatment: your money grows quicker. (And when your money grows quicker, you HAVE MORE MONEY!) But, another reason I like not having to do RMDs is related to the reason that the Roth IRA makes you save more money: human behavior.

As a human being, you may be tempted to spend the entirety of your RMD money. After all, if you have to take money out of an account, why not spend it? And if you have even more money saved in non-RMDs accounts, that may be OK.

But most people are dealing with a shortage of savings, not a surplus. And with the 401(k) as the foundation of their retirement, it may not make sense to spend money just because tax law requires you to move it out of an account.

People who saved too much  <   People who saved too little

Because of human behavior, I like accounts without an RMD – like a Roth IRA. (Remember that you can roll your Roth 401(k) into a Roth IRA to avoid RMDs.) With a Roth IRA, not spending money is the default option. Money only comes out of the Roth IRA when a conscious decision is made to spend money. This is opposed to those accounts with RMDs (like a traditional 401(k) account). With a traditional 401(k), money falls into the account owner’s lap every year – regardless of the client’s actual need. With a Roth IRA, the default option is to save money.

Pick the Roth

I strongly suggest the Roth option. I suggest Roth accounts for all clients, of all ages, in all tax brackets, every time, always, forever. Most of the reason is simply because of human behavior.

Of course, there are always exceptions. There are folks who will invest their tax refund or re-invest their RMDs. But, to make it easy on yourself, pick the Roth 401(k).