A simple way to choose the Roth account.
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Why choose a designated Roth account in a 401k or similar plan? The simplest reason is that the tax rules allow you to build a Roth account just as large as a traditional account, but when you retire, the Roth account will be more valuable.
Same total account size
Choosing the Roth account doesn’t have to affect the total amount you end up with in your retirement savings. The contribution limits for the Roth account are the same as for the traditional account. You get the same matching contributions, and you have the same investment opportunities. Put it all together and you can end up with an account that’s the same size.
The Roth account is more valuable
Nevertheless, the Roth account is more valuable. Distributions from a traditional account are taxable, but distributions from the Roth account are not. The difference can be surprisingly large. For example, if you’re in the 25% tax bracket, you have to withdraw $133.33 from a traditional account to have $100 in spending money, because $33.33 will be used to pay tax on the distribution. Here’s a chart showing the amount you would need in a traditional account to have the equivalent of $100 in a Roth account, for each of the current tax brackets.
Saving in a Roth account can make you as much as 65% wealthier in retirement! When you take state income taxes into account, the difference can be even greater.
Paying tax in retirement
Unless you’re close to retirement and have a good handle on what your income and deductions will be, it’s hard to even guess what your tax bracket will be. If you’re guessing it will be on the low side, be sure you aren’t overlooking the following:
- More and more people work at least part time during “retirement,” either to help make ends meet or simply to keep active.
- Up to 85% of your Social Security benefits can be taxable.
- With a sound investment approach, your retirement account should grow substantially over the years, and that will mean large withdrawals when you begin taking the money out. If the money is in a traditional account, these withdrawals will boost your income and possibly put you in a higher tax bracket than you might otherwise expect.
- Various budget realities, including huge costs associated with the aging and retirement of the baby boom generation, will make it difficult for the federal government to sustain low tax rates.
So the traditional account always loses?
Not exactly. Choosing the Roth means paying more tax in the year of the contribution, because a Roth contribution doesn’t reduce your taxable income. If the tax difference ends up as a difference in the total amount you save, it’s possible for the traditional account to come out ahead.
Example: You’re prepared to contribute $1,000 per month to a traditional account, but if you switch to the Roth you’ll cut back to $750 per month because you’re losing the tax deduction.
In this situation we can’t be sure which account will end up providing more wealth in retirement. Your Roth account starts out 25% smaller than the traditional account, and that means the traditional account can end up being more valuable if your tax rate in retirement is below 25%. Yet the Roth account has enough advantages so it can still end up winning. For example, rolling a Roth 401k account to a Roth IRA will allow you to avoid the minimum distribution rules. Depending on your situation in retirement, this can be a huge advantage.
Here’s the bottom line. To come out ahead with a traditional account, you have to contribute more money than you would have contributed to a Roth account. Even then, there’s a good chance the Roth will provide you with more wealth in the long run.