When you begin working for a company, you are bombarded with a wealth of information pertaining to their benefit programs. With a thousand other things going on, this information is usually pushed aside to be looked at “later”. When you finally get a few minutes free, you start digging in and come across the 401(k) elections:
- What percentage of your pay do you want to contribute?
- Do you want this to be put into a Traditional 401(k) or a Roth 401(k)?
These are heavy questions and your time is limited. So you turn to Google. You read some inferior personal finance blog (because Milk My Money was still in the womb) about a “6% match or something like that”. Perfect. Question #1 done. 6% it is.
Now for Question #2. More mediocre personal finance blogs. More confusion. You keep reading the same standard advice:
“Compare your current income tax rate with the rate you think you will have at retirement. If you believe your income tax rate will be lower when you are retired (because your only job will be sipping Coronas on some beach) then you should use a Traditional 401(k) and defer the taxes until retirement. If you believe your current income tax rate will be lower now (because you are on an entry-level salary and your boss doesn’t appreciate your brilliance) then you should use a Roth 401(k) and pay the taxes now.”average personal finance blog
From a mathematical point of view this is great advice. After all, less taxes means more money in your pocket. However, how the f*ck are you supposed to know what your tax rate will be during retirement? That’s 30-40 years into the future! You love thinking that you will be on that beach with the Coronas. But in reality, you have absolutely no idea how your life (or future tax laws) will unfold.
So you pick Traditional because it sounds less complicated. You tell yourself that you will look at this more in depth at “some point”. Four years later and you’re still contributing 6% to a Traditional 401(k).
But today is a new day because Milk My Money is alive! This article will go beyond the standard advice and help you decide whether Traditional, Roth or both is right for you.
The Employer Match
Before discussing Roth vs Traditional, it is imperative that you understand your employer’s 401(k) matching policy. As part of their employee benefit programs, many employers will match the amount of money you put away for retirement. For example, if you decide to contribute $5000 to your 401(k), your employer will match this and contribute $5000 on your behalf. So at year end, you have a solid $10,000 in your 401(k). However, matching policies are almost never this straightforward and vary greatly from company to company. Some more realistic examples include:
- Dollar-for-Dollar Capped at Percentage of Salary – your employer matches every dollar you put into your 401(k) up to a certain limit. For example, you make $100,000 and your employer matches every dollar up to 6% of your annual salary. Therefore, the match is limited to $6000. You will get the full employer match if you contribute at least $6000.
- Fraction-of-Dollar Capped at Percentage of Salary – your employer matches 50% of every dollar you put into your 401(k) up to a certain limit. For example, you make $100,000 and your employer matches 50% of every dollar up to 6% of your annual salary. In this case the match is limited to $3000, but you would need to contribute $6000 to get the full match.
- Dollar-for-Dollar Capped at Dollar Limit – your employer matches every dollar you put into your 401(k) up to a certain dollar limit. In this case it doesn’t matter what your salary is, as the match limit is the same for all employees. For example, your employer matches every dollar you contribute up to $4000. You will get the full employer match if you contribute at least $4000.
Additionally, sometimes employers will only match Traditional 401(k) contributions. So before making any 401(k) elections, make sure to double check what the employer match applies to: Traditional 401(k), Roth 401(k) or both.
This employer match is free money. Understanding your employer’s matching scheme prevents you from leaving any of this free money on the table. So now that we’ve got the match covered, lets move on to the burning question:
Traditional vs Roth: Which is Right for Me?
The main difference* between a Traditional 401(k) and Roth 401(k) is the timing of taxation:
Traditional 401(k) – defer taxes bycontributing pre-tax dollars. Pay taxes when money is distributed to you during retirement.
Roth 401(k) – pay taxes upfront by contributing post-tax dollars now. Money is distributed to you during retirement tax-free.
*A more detailed description of these accounts can be found in the Money Accounts Cheatsheet
Unfortunately, there is no one-size-fits-all answer when it comes to choosing between a Traditional and a Roth 401(k). Fortunately, The Milk Man has laid out some considerations to help you come to a decision:
1. Easier to Get Employer Match
If you are hurting for cash and having trouble stashing money away for retirement, then a Traditional 401(k) may help you maximize your employer match. For example, assume your employer is willing to match $5000. To get this full match you could either:
- Set aside $5000 of your pre-tax salary and contribute it to your Traditional 401(k).
- Set aside $6,700 of your pre-tax salary. After paying taxes this will amount to roughly $5000, which you can then contribute to your Roth 401(k).
2. Low Expense Retirement
If you know for sure that you want to retire to Montana and live off $25,000 per year, then you’d be wise to defer taxes. Remember, Traditional 401(k) distributions during retirement count as income. So, if you have no other income sources, then your tax bill will be based solely on the distributions from your 401(k) nest egg.
3. Low or No-Income Year(s) Ahead
Do you plan to take a career break to raise a child? Will you be quitting your job for a year-long sabbatical in the near future? Do you plan to retire before 59.5 and have several years of no-income before taking distributions from your 401(k)?
If you know that you will have a year(s) with very low income, then you may benefit greatly from a Roth Conversion. I wont dive too deep into the details here, but the basic idea is as follows:
- Contribute to a Traditional 401(k) and defer taxes while you are working and have a higher tax rate
- In the low or no-income year, convert a portion (or all) of your Traditional 401(k) to a Roth
- The amount you convert will be considered taxable income. Therefore, your income for that year will be limited to the amount you decided to convert.
- So essentially you pay the taxes on your retirement money in the year which your tax rate is under your control.
4. Future You Will Figure It Out
By deferring taxes until retirement, you will give yourself time to craft a tax minimization strategy. For example, you may move from NYC (state and city income tax) to a place like Florida (no state income tax).
On top of that, the rules of the game will surely be different 30-40 years from now. There will likely be changes to regulation and new types of tax-advantaged accounts. You may be able to leverage these future changes and minimize your tax bill.
5. More Disposable Income
Utilizing a Traditional 401(k) lowers your taxable income which means you will pay less taxes this year. Less taxes means more money in your pocket. Do you have strong command over your wallet? Will you be disciplined enough to save or invest your tax savings? Or did you already mentally spend that money while reading this paragraph?
6. Mental Games
It is easier to contribute larger amounts to your 401(k) when you use pre-tax money. Remember our example above about contributing $5000 to get the employer match? Your future seems more secure when you see a large sum in your 401(k) account. If you combine this with “4. Future You Will Figure It Out”, retirement no longer seems so scary.
1. Maxing Out the Contribution Limit
401(k) Contribution Limit (2019): $19,000 (<50 years old); $25,000 (>50 years old)
The contribution limit applies to the sum of all 401(k) contributions. An $100 pre-tax Traditional contribution and a $100 post-tax Roth contribution will both count as $100 towards the limit.
Contributing $19,000 on a post-tax basis (Roth), requires setting aside roughly $25,000 of your pre-tax salary. Contributing $19,000 on a pre-tax basis (Traditional), requires setting aside exactly $19,000 of your pre-tax salary. So, by utilizing a Roth you can effectively set aside more money for retirement.
2. High Income Retirement
With modern medicine, 60 is the new 50. Some people will not want to stop working when they reach 59.5 (age where 401(k) distributions are no longer subject to early withdrawal penalty). Maybe they are still full of energy and plan to be CEO by that age. Maybe they believe living to be 100 years old is a real possibility and the next 40 years will not fund themselves. Maybe they will have a real estate empire or some other forms of passive income. Maybe all three will be true.
Whatever the case may be, it is easy to see how your income at age 59.5 could surpass your current income.
3. Future Tax System is Uncertain
It is impossible to say what our tax system will look like in 30-40 years. European countries with more socialist regimes tax their citizens well over 50%. If the US starts adopting some of these principles, then income taxes could significantly increase. Paying a known tax rate now may be preferable to an uncertainty 30-40 years down the road.
4. Less Disposable Income
Without the taxable income reduction, you will end up paying more taxes now and have less money in your pocket. Essentially you are contributing to your 401(k) and paying taxes on your retirement money all in one go. That means you will have less money to blow. If you are really good at spending your disposable income on non-essentials, then paying upfront could be very beneficial. As opposed to Traditional 401(k)s where you contribute now, and the taxes become a problem that future you will handle.
5. More Flexibility
When you contribute to Roth 401(k) you are using money that has already been taxed. Because of this, Roth 401(k) accounts offer a bit more flexibility than Traditional 401(k)s when it comes to accessing your retirement money before age 59.5.
Roth 401(k) distributions are NOT taxed or subject to any penalties as long as they are a “Qualified Distribution”:
- Account is 5+ years old AND you are older than 59.5
- Account is 5+ years old AND you become disabled
However, if you decide you want to pull out some money early and take a non-qualified distribution, then you will pay taxes and penalties on a pro-rata basis:
For example, say you have $100 in your Roth 401(k) account. $85 is from your post-tax contributions and $15 is from investment earnings. If you take a non-qualified distribution, then 15% of the money you withdraw will be subject to income taxes and an early withdrawal penalty.
Bonus: If you want a truly flexible retirement account where you can access your contributions tax and penalty-free at any time then check out Roth IRAs. Your investment earnings will still be subject to taxes and penalties if they are distributed early. However Roth IRA allows you cherry pick which money you want distributed (Contributions, Investment Earnings or both). There are certain income restrictions and lower contribution limits, but it can be an extremely powerful and flexible option for those who qualify.
The Final Verdict
Both Traditional and Roth 401(k)s offer unique benefits when it comes to saving for retirement. So why choose just one? By splitting your 401(k) contributions between a Traditional and Roth you achieve tax diversification. You will have more flexibility when it comes time to craft a distribution strategy.
Furthermore, you will not be overexposed changes in the tax system. For example, if you only contribute to a Traditional 401(k) and taxes rates are increased, then you may end up with a much smaller nest egg than expected. Alternatively, if you only contribute to a Roth and tax rates are decreased, then you probably paid more taxes than necessary.
No one can predict how their life or government policy will unfold over the next 30-40 years. So don’t stress over selecting the “right” account. Instead make use of both accounts by using the following flowchart:
Let’s put this into practice. Imagine you plan to set aside $25,000 of your pre-tax salary for retirement. Your employer will match your 401(k) contribution dollar-for-dollar up to $5000. In the example below, you would end up with $11,000 in a Traditional 401(k) and $10,500 (~$14,000 pre-tax) in Roth accounts.