Last week, I discussed the best retirement investment tool, the 401-K Plan (401-K). This week we wil look at a variation of the 401-K, called the ROTH 401-K. For those of you who have a ROTH IRA, the rules and benefits are similar.

Vanguard Investments’ data indicate 60% of their client companies offering a 401-K plan offer both a traditional plan, and the ROTH 401-K. However, Americans may not completely understand the difference as only 15% of employees select the ROTH 401-K. Either plan is a win for growing your investment dollars for the future.

If you have the option of the traditional 401-K versus the ROTH 401-K you need to decide if you want to pay your taxes in the future, by making before tax dollar contributions in a Traditional 401-k. Or, pay your taxes when you make your annual contributions into the ROTH 401-K. With a Roth 401-K you contribute to your retirement account with money from your paycheck AFTER it has been taxed (same as designating a portion of your pay check to a checking or savings account). Once in the account, your money grows tax-sheltered. Then at retirement or at the age of fifty-five, withdrawals come out tax-free.

Your decision is based on comparing your tax rate today, with what you believe your income and tax rate will be when you retire; or start taking withdrawals. Historically, majority of Americans pay a lower tax rate in retirement. Makes sense as most retirees have stopped working. As for future tax rates, all we know for sure is that Congress will change it several times in our lifetimes.

The 2018 annual contribution limits for both types of 401-K is the same. Eighteen thousand, five hundred dollars ($18,500) in 2018, plus $6,000 more if you’re over 50. {Note; Last week’s blog in error used the 2017 limits of $18,000. Congress raised the limits to $18,500 for 2018} You are free to begin making withdrawals at age 55. And required minimum distributions begin for retirees at 70 1/2.

The Case for a Traditional 401(k)

If you think your tax rate when you retire will be LOWER than it is now, the traditional 401-K may offer you advantages. You avoid having to pay taxes on your contributions now, when your tax rate is high.
Then, when you start to withdraw at retirement, or after the age of 55, you pay the current applicable income tax at that time. If your tax rate is lower this may save you money.
Here is a calculator to help you project the difference:

http://www.dinkytown.net/java/RothvsTraditional401k.html

EXAMPLE #1: TAXES DROP FROM 25% (WHILE WORKING) to 15% in RETIREMENT

In above example, the traditional 401-K is a better investment.

The Case for a Roth 401(k) 

In a ROTH 401-K, you contribute income that’s already been taxed from your paycheck to your ROTH 401-K.  Once contributed, the money grows tax free and is not subject to income taxes when you start withdrawing money, earliest at 55.

If you are young and just starting out and in a low income bracket— and think you’ll be in a higher tax bracket at retirement, a ROTH can make a lot of sense. You will be paying taxes up front at a time when the actual tax bill will be small.

Roth 401-K dollars, compound over time and grow tax-free. You only pay tax when you put the money in your ROTH 401-K plan, but not when you begin withdrawals years later. This means that all of the compound interest and investment returns, will NOT be taxed when you take it out.  Because you are putting the money in after you’ve paid tax on it you don’t get the benefit of the tax-free savings going in, but you do get it when taking the money out. Tax-free gains are the real advantage of the Roth 401k.

ROTH investors are assuming their tax rate will roughly stay the same or increase in retirement.  Either expecting a high income retirement or that taxes will increase over time.  Younger people may be attracted to the ROTH 401-K, since you lock in low tax rates up front.  But, keep in mind that if overall tax rates are actually lower in 30 years, you may lose some money in favor of the traditional 401-K.  There is a possibility the Federal government could replace some of today’s income tax with a value-added tax.

Another advantage of a Roth 401-K, you can withdraw a large portion of your Roth 401(k) after age 55, to pay for, say, a medical emergency, home purchase, etc. without incurring the tax bill you would have with a traditional 401(k).

EXAMPLE #2: TAXES REMAIN UNCHANGED IN RETIREMENT @ 25%.  IN EXAMPLE #2, THE ROTH 401-K IS A BETTER INVESTMENT. 

 

THE CASE FOR INVESTING IN BOTH 401 PLANS

You can divide your contributions $18,500- $24,500, between the two 401-K plans.  This diversifies your tax exposure in retirement.  By using both a Roth and a traditional 401-K you lower at least a portion of your current taxable income, maintain a diversified retirement plan, and give yourself some cover if future tax rates change.

EXAMPLE #3: TAXES DROP SLIGHTLY FROM 25% (WHILE WORKING) to 20% in RETIREMENT.  LITTLE DIFFERENCE IN AFTER TAX TOTALS.

If your employer doesn’t offer a Roth 401-K  and you are eligible, (In 2016, income max is $133,000 for single filers and $194,000 for married filers)  consider contributing to a ROTH IRA, in addition to your traditional 401(k). On top of potential tax benefits, there’s another advantage: You can withdraw your original contributions (not your gains) to a Roth IRA tax and penalty free — which you can’t do with a Roth 401(k).

LET ME BOTTOM LINE THIS FOR YOU:
Both the 401-K and ROTH 401-K have a place in your retirement portfolio.  No one (in his or her right mind, so maybe politicians) have any idea what taxes will look like in 2019, let alone 30 years into the future.  Focus on what you can control: your future financial welfare. FUND YOUR 401-K OR ROTH 401-K PLAN!  Pick one or pick both, but get started-TODAY!

THIS WEEK’S QUOTE:

“Always bear in mind that your own resolution to success is more important than any other one thing.” –Abraham Lincoln