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March 25, 2013 | Posted By: Bryan Marsden
So you have finally found work in these hard economic times, and are eligible to start saving for your retirement via the company’s 401k plan. You have gathered up all the paper work, and are looking over the details, only to find that there are two totally different plans that you can contribute too. Even more confusing is that they are both 401k plans! One is a standard 401k plan and the other is a Roth 401k plan, and you don’t know the difference between the two, or which one better suits your needs.
Well set your mind at ease, as I am here to help! While I am not a financial professional, I was just as confused as you about the subject, so I decided to dig into it to see if I could become more informed about my own 401k accounts. Then I figured if I was this unsure about these two retirement accounts, then others must be too. With that in mind, I wrote this article to go through what each plan is, and how they differ from each other, and then to inform you so you can make the choice that is best suited to you.
401k vs Roth 401k: How do they differ?In 1978 the first 401k plan was implemented. It was set up as a tax deferred retirement plan that lets you take money out of your paycheck before taxes are taken out. This system has a couple of advantages. First, it allows you to put away money pre-tax, and any gains on that money is tax deferred until you start to pull them out at retirement. When you retire, any funds you pull out are subject to all current state and federal tax rates, and laws.
Second, if you were just over the next income tax bracket, you could put more into your 401k, up to the cap of $17,500 (or $23,000 if you are over 50), and drop your income into the next lower bracket. Many people forget about the second advantage, but it really does need to be mentioned, as it can mean the difference between paying 15% in federal taxes, and paying 25% in federal taxes on the income that is over the tax bracket. For example, if you and your spouse have a taxable income of 100,000, and you both put 14,000 into your 401k for a total of 28,000 with the top of the 15% tax rate at $72,500, you will avoid paying the taxes on that $28,000. That $28,000 will grow, and if you are in a lower tax bracket when you start to cash it out, you will pay the lower tax rate, rather than the higher rate when you put it into your 401k. If tax rates don’t change, and you can get your retirement income under $72,500 this means that you could be paying 10% less in taxes when you pull that money out.
The Roth 401k was born out of the Economic Growth and Tax Relief Reconciliation Act of 2001, and is the exact opposite of the traditional 401k, but it also has a few advantages. First, the way a Roth 401k retirement account works is that any contributions you put into the account after they are taxed at the current federal, and state tax level. However, any gains on that money are tax exempt when you start cashing it out at retirement age. While this sounds like a worse plan than traditional pre-tax 401k does, it really depends on what taxes will be in the future, and what your projected income will be when you retire. By paying taxes up front and letting your money grow tax free from that point on, you are betting that taxes will be higher, or you will be in a higher tax bracket.
The second advantage to the Roth 401k is the ability to roll it over to a Roth IRA. Let me explain why this is an advantage. All 401k accounts have what is called a “required minimum distributions” that starts at age 70 ½. That means at 70 ½, you are required to start cashing out your 401k plan. However, Roth IRAs are not bound by the “required minimum distributions” rule, so by rolling your Roth 401k into a Roth IRA you get around it. There are a couple scenarios where this will become an advantage. The first is if you plan on working later into life, and you just want leave the money as an inheritance. This allows it to grow past 70 ½ without having to draw out the funds, which means more inheritance for your heirs if that was the plan. The second is if you exceeded your retirement goals, and really don't need the money. This allows you to keep the money growing, for more costly emergencies, or as above leave more to your heirs.
The third advantage is that there is no income level cap for a Roth 401k. A Roth IRA has an income level limit. Meaning that if you make more than $127,000 as a single filer, or $183,000 as a married filer, you are not eligible to participate in a Roth IRA. This advantage is important because people over this wage cap didn’t have an option on if they wanted a pre-tax, or post-tax retirement accounts. The Roth 401k allows higher wage income people to have this choice. You can put away money post -tax in a similar manner as a Roth IRA, or stick with the pre-tax option of a standard 401k. However, you are still limited by a cap on how much you can put into your 401k plans total (17,500 for 2013, or over 50 $23,000). So you can’t put more in if you participate in both 401k plans, but at least you have options.
So which one is best for me?The honest answer is “it depends.” If tax rates don’t change, and you are in the exact same tax bracket, both will perform equally, so neither is “better” in this scenario. Based on a 10 year time frame, if you invest $100,000 into a traditional 401k with a return rate of 5%, you can expect to have around $162,890 (for the math people 100,000*(1.05^10)). With a combined tax rate of 35% ($57,010 in taxes), you will end up with roughly $105,880 to spend. With the Roth 401k you will pay 35% in taxes on the $100,000 up front, so your total investment would be $65,000. At the same 5% growth rate your Roth 401k will grow to roughly $105,880, and since no additional taxes are taken out, you will have all this money to spend. As stated above, the results are pretty much the same.
If you think you will be you will be in a lower tax bracket at retirement, then the standard 401k plan will be better for you, as you avoided paying taxes at a higher tax rate. So if your total tax rate is 25% when you retire, that same $162,890 would be worth $122,167, which is quite a difference compared to the Roth 401k at $105,880.
If you feel that the tax rates will be higher, or that you will be in a higher tax bracket at retirement, then the choice to make would be the Roth 401k. You will be paying lower up front taxes, compared to future higher taxes. If your combined tax rate goes up to 40%, then that $162,890 is now only worth $97,734 or almost $8,000 less than if you had used at Roth 401k.
Which one would I use? Well if the government has taught me anything, it’s that they can’t manage their own money, so my bet is on taxes being higher for all tax brackets when I retire. To this end, I am going to start slowly moving my money from a standard tax deferred account, to Roth style accounts.
The most important thing keep in mind, is to start saving period. According to statistics, 49% are not contributing to a retirement plan at all! So whether the standard 401k, or the Roth 401k is right for you, it won’t make any difference at all if you don’t start using it. Feel free to give us your thoughts on the subject in the comments section below.
What would the experts do?
I'd use the 401k first to get a company match, then go to a Roth IRA, then back to a 401k. Now it's in that return to the 401(k) that you want to start thinking whether you want a Traditional or Roth 401k, I'm inclined to try to keep the amounts in the Traditional and Roth buckets similar. I call it tax diversification, since I won't know what future tax rates will be, and so I want to keep the two balanced.
I would lean towards contributing to a regular 401k and a Roth IRA. That way you can get the tax benefits now of the 401k and the tax benefits in the future of having the Roth IRA grow tax-free. Then you can take withdrawals in retirement that keep you in the low tax bracket by taking just that much from the 401k, which will have taxable withdraws, and using the Roth IRA to pay the extra you need since those withdraws are tax-free.
Which is "better" depends on a person's particular investment needs and financial planning strategy. One isn't inherently better than the other, so crunch the numbers.
Special thanks to Vince Cimino for helping me with this article.
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