Retirement plan decisions made easy
Drill Down: Regular 401k or Roth 401k?
The original 401k plan took money that would otherwise have gone into your paycheck and put it into a 401k plan. That money was not taxed at the time it was earned, but it was taxed years later when you took it out during your retirement. Recently Congress added another possibility, the Roth 401k. Some companies give you this new choice, but others do not offer it. Here's how it works. The money that goes into your Roth 401k is taxed as you earn it, but is not taxed when you take it out during your retirement. If your employer matches your contributions, all of the matching money goes into a regular 401k. So you may well end up with both a regular and a Roth. Let’s figure out which type your money should go into.
Regular 401k
Roth 401k
Here’s an example. Reggie and Ruth both plan to save $300 this month. Reggie will put his money into a regular 401k, but Ruth will put her money into a Roth 401k. They are both in the 25 percent tax bracket now, and both will be in the same tax bracket when they retire. Both Reggie and Ruth will withdraw their money in 20 years. Their investments will also be identical. I’ve peaked into my crystal ball, and I can tell you that their money will grow by a factor of four over those 20 years, so each dollar they put into their retirement account today will grow to four dollars by the time they retire.
Here’s how the numbers work out:
- Reggie puts $400 into his regular 401k plan. This reduces his tax bill this year by $100, so it only costs him $300.
- Reggie’s $400 grows to $1600 over 20 years.
- Reggie withdraws his $1600, pays a 25 percent tax which costs him $400, and nets $1200.
It’s only a little different for his friend:
- Ruth puts $300 into her Roth IRA. She gets no tax benefit right now.
- Ruth’s $300 grows to $1200 over 20 years.
- Ruth withdraws her $1200 tax free.
The simple answer: it does NOT make any difference whether you choose the regular or the Roth IRA, under these assumptions. Let’s figure out if it might make a difference for you.
Lois won’t have much taxable income in her retirement; she’ll be living exclusively on Social Security and a little bit of money from her retirement account. Her tax bracket now is 25 percent, but it will only be ten percent when she retires. If she chose a Roth 401k, her results would be just like Ruthie’s. But if she chose a Regular 401k, look at what happens:
- Lois puts $400 into her regular 401k plan. This reduces her tax bill this year by $100, so it only costs her $300.
- Lois’s $400 grows to $1600 over 20 years.
- Lois withdraws her $1600, pays a ten percent tax which costs her $160, and nets $1440.
The moral to Lois’s story is this: If you will be in a lower tax bracket when you retire, use a regular 401k.
Hiram was unemployed for the first half of the year, so his tax bracket will be just 15 percent this year. However, he expects to be in a 25 percent tax bracket when he retires. If he uses a Roth 401k, his result is just like Ruthie’s. However, a regular 401k is a little different.
- Because he’s in the 15 percent tax bracket, Hiram won’t get as big a tax benefit from his contribution as Reggie did. Hiram puts $353 into his regular 401, which cuts his tax bill by 15 percent of that amount, or $53. Just like Reggie and Ruth, the contribution cost him only $300.
- Over 20 years, Hiram’s money has grown to $1412.
- Hiram pays a tax of 25 percent, which is $353, leaving him with only $1059.
Hiram’s results show another lesson: If you will be in a higher tax bracket when you retire, use a Roth 401k.
Now I’ll consider the most realistic case of all. Connie is confused. She isn’t sure what tax bracket she’ll be in when she retires. She listens to the politicians, but she can’t figure out whether they will raise taxes in the future or cut taxes. She’s concerned about the worst possible case: that she pays taxes that are higher than she has to.
Connie would benefit from “tax diversification.” That means having some of your assets taxed today, and some tomorrow. Connie’s best strategy is to use both a regular and a Roth 401k, or to make her decision so that, with her other investments, she is tax diversified. She won’t make the best possible choice, but she guarantees that she’ll be better off than if she made the worst possible choice.
Reduce your risk by having assets in different tax categories.
Finally, let’s talk about Max, who wants to save the maximum amount possible. The federal government limits the contribution to $15,500. (This amount may change over time; for the latest limit, search “irs.gov 401(k) limitation.”) The same limit applies to both regular 401k plans and Roth 401k plans. That means that the Roth allows a greater effective contribution. If you are in the 25 percent tax bracket, a regular 401k contribution of $15,500 only costs you $11,625 (which is the $15,500 contribution minus the tax you would have had to pay if you had not made the contribution). A Roth 401k contribution costs you the full $15,500. When it comes time to withdraw the money, however, the Roth 401k withdrawals are all tax free, whereas the regular 401k withdrawals are taxed. Max uses a Roth 401k, paying more now so that he can sock away as much as possible. If you want to maximize your retirement contribution, use a Roth 401k.
You are not logged in. Log in or create an account.
Click here to sign up for our monthly newsletter delivered via email.
Lesson 1: What the Heck is a 401k, and What’s So Great About It?
» Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is text. You may also switch to the audio or video formats by clicking on the icons at the top of the main lesson page.