Many companies are starting to offer employees the choice of Roth 401(k)s as well as traditional 401(k)s. Both are tax-favored accounts. A traditional 401(k) invests pretax money and is taxed upon withdrawal, while the Roth 401(k) invests post-tax money and is not taxed upon withdrawal. Which is a better way to invest?
If tax rates are constant, then a traditional 401(k) is technically the same as a Roth IRA. That is, it does not matter whether the account is taxed at the beginning or the end. Since tax is deferred in a traditional account, more money is invested and the total earnings are greater than in a Roth account. However, when taxes are paid upon withdrawal, it turns out that the tax on the extra earnings is exactly equal to the lost earnings from the tax paid in the Roth account. The taxes and extra earnings cancel each other out, leaving the Roth and traditional accounts with the same amount of after tax money.
This does not, however, mean that Roth and traditional accounts are equivalent. We assumed above that taxes are constant and that the investor can save the same amount of money in either type of account. However, not only is the individual likely to face a different tax rate upon retirement than when earning the money, but also, it turns out that more money can implicitly be saved in a Roth account than a traditional account.
The change in tax rates is straightforward. If you expect the government to raise tax rates, then a Roth 401(k) would be the better investment vehicle because you would be paying less tax at the lower, earlier rate. On the other hand, if you expect to drop to a lower tax bracket upon retirement, then a traditional 401(k) is the better way to go.
What is less commonly understood is that a Roth account allows you to save more money in a tax preferred manner. In 2013, the maximum contribution to a 401(k) is $17,500. This is the same whether you use pre-tax dollars for a traditional 401(k) or post-tax dollars for a Roth 401(k). However, tax has already been paid on the Roth account. Implicitly, this means you are saving more money in a tax-deferred manner using a Roth than a traditional once you approach the investment limits. Each account may start out with $17,500, but once money is withdrawn, the traditional account will be taxed, meaning it has less money.
As always, the optimal strategy will vary from individual to individual and is very dependent upon their expectations for the future. One possible strategy would be to combine traditional and Roth 401ks. Having both creates a hedge, allowing the individual to prepare for either rising or falling tax rates. Mixing in some Roth with the traditional account will also serve to lower the retirement tax rate. In this case, it generally is best to invest in the Roth in early years and traditional 401(k) later. There are two reasons for doing so. First, the individual's tax is almost certain to be lower in early earning years. Secondly, it is best for those early investments, which will experience the greatest compound growth, to grow in a retirement account and minimize the capital gains tax.
In the end, the most important decision is to invest. Whether you use a Roth, a traditional 401(k) or both, it is important to make that commitment early on and to maximize your investment.
Ann G. Schnorrenberg is a Financial Planning Associate at Monument Wealth Management, a Registered Investment Advisor located just outside Washington, DC in Alexandria, Va. Ann is not a registered investment advisor representative. Follow Ann and the rest of Monument Wealth Management on their blog which can be found on their website, on Twitter @MonumentWealth, and on the Monument Wealth Management Facebook page.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly. This is a hypothetical example and is not representative of any specific situation. Actual results will vary.
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