Deciding Between Types of 401(k)s

Pay Now or Pay Later

There are two types of 401(k) accounts, what are called traditional or regular 401(k) accounts and the newer Roth version of the 401(k), modelled after the Roth IRA. It took many years for the Roth IRA to be rolled out, as there is a natural tendency toward the standard version given that employers cannot ever contribute to a Roth account, or at least the rules do not allow for this presently.

It’s not that we couldn’t devise a set of rules that would allow employers to contribute directly to a Roth 401(k), although if full taxes were paid on 401(k) contribution amounts, this would remove the tax break that employers get for the money they contribute to us. So, this would require some serious changes to the rules and tax codes and therefore isn’t on the horizon, although it may be one day.

The main difference between a traditional and Roth 401(k) is that with a traditional one, we defer paying income tax on the amounts we contribute, and also have to pay income tax on both matched amounts by our employer and any earnings within the account. This will all be paid whenever the funds are taken out of the traditional 401(k) and either withdrawn or rolled over into a Roth account, either a Roth 401(k) or a Roth IRA.

When we roll over money in a traditional 401(k), it generally doesn’t make sense to put it in a Roth 401(k), because there’s no benefit in having it there as opposed to a Roth IRA, because Roth 401(k)s are more restrictive and also have rules surrounding them that may not be beneficial, such as the need for required disbursements and the way that withdrawals are treated generally.

The focus when deciding between the two types of 401(k) accounts has therefore been on the difference between the tax you would pay now with a Roth account and your anticipated tax rate when you take the money out of a traditional one, where you’re seeking tax savings from deferring tax with a traditional 401(k) and pay a lower rate in retirement.

Deciding This Based Upon Expected Future Tax Rates

The standard advice here is to only go with a Roth 401(k) if you expect to pay more in income tax at retirement, which of course is not a typical situation at all. What this does is steer the great majority of people away from a Roth 401(k), and in some cases, they would be better served to choose a Roth account instead of a traditional one.

When we retire, we lose our earnings from employment, or at least our full-time earnings if we choose to continue working on a reduced basis. It is possible to amass enough savings such that we can raise our standard of living at retirement, spending more than we did while we were working, by having the distributions from our portfolio, our withdrawals, exceed our previous income.

Even those fortunate enough to be able to do this don’t really choose to do this very much, as the fundamental goal here is to limit the reduction in income that comes with retirement, and if one were able to enhance their spending in retirement, they probably still wouldn’t choose to do so. They instead would likely look to preserve their wealth to last them, or perhaps look to leave substantial amounts to their family after they are gone.

The majority of people struggle to just get to the point where they don’t have to cut back spending, and in retirement, cutting back spending means withdrawing less from our retirement accounts. In retirement, our income varies by how much we take out of our portfolios, so in the great majority of cases we will not see ourselves climbing to a higher tax rate when we retire.

Unless we really understand how traditional and Roth 401(k)s compare, taking the standard advice will therefore almost always have us choosing a traditional 401(k) based upon this.

Future tax rates do matter in this decision, and if our tax rates will go down in retirement as they generally will for people, then it does make sense to go with a traditional 401(k). If they remain the same, there is no real difference between them actually, at least as far as differences in the amount of tax we will pay, so we’ll have to look at other reasons to decide.

There are more things to think about then just the bottom line, how much we can save in tax, and one of them is the fact that it is easier to roll over a Roth 401(k) into a Roth IRA, which is where we want our retirement money to end up eventually. After we retire, we cannot get our money into a Roth IRA fast enough, but having to declare rolled over amounts as income and pay tax on them is going to be a real limiting factor.

Getting a Better Idea of the Numbers

While we are making contributions to a 401(k), we usually think of the potential for paying less tax on deferred amounts, but the real power of this account is actually in our earning a return on this money over time.

If we, for instance, put $10,000 in a traditional 401(k), and our marginal tax rate is 28%, this means that if we paid the tax on this money as we normally would, we would only be left with $7200. We end up with this extra $2800 in our account and if the value of our account doubles and our tax bracket drops to 25% in retirement, we’ve saved 3% on this tax and will end up with a direct benefit of $300 from this part of the deal.

However, we’ve also doubled the $2800 in deferred tax money and that means that we will have an extra $2800 in our account as a result of this. We get to keep 75% of this which cashes out to a direct benefit of $2100 from using this tax money.

We would have made $7500 on the amount net of the tax deferral and will have to pay taxes on that, but this is common to both types. With the Roth, we make the $7500 and get to keep it, while with the traditional 401(k) we will make 75% of that, or $5625, but we get to add the other amounts to this.

It is therefore not the lower tax rate that has made us most of the money from the traditional account, it is the return on the deferred tax over time. However, when we do realize a tax savings on the principal amount, this does matter and can put us over the top.

The total amounts in the end for this scenario net of taxes for the traditional 401(K) is $15,000, where with the Roth we end up with $14,400, so overall this did result in a bit more money in our account. If we drop from 25% to 15% in retirement though, the extra amount is larger, 17,000 with the traditional 401(k) versus $15,000 with the Roth.

That certainly could tempt us to go with the traditional account, where if the difference is only $600, we might still want to favor the Roth, and if we expect our tax bracket to remain the same, we should also strongly consider contributing to a Roth 401(k). If for some reason our tax rates will go up, then the Roth wins clearly.

How These Types Compare after 59 ½

After age 59 ½, this is where the Roth 401(k) really shines, and it all has to do with what we can do with this type versus a traditional option. Both accounts require that we make forced withdrawals after age 70 ½, but we can avoid that by simply rolling our Roth 401(k) into a Roth IRA.

Since Roth accounts do not have any tax implications after 59 ½, we can roll over all of our Roth 401(k) funds into a Roth IRA with no issues. With a traditional IRA, we could do the same thing but that will require us to declare the entire value of the account as taxable income, which can involve serious tax consequences if we have even a decent amount saved.

We will likely have to roll over most if not almost all of the money in a traditional 401(k) into a traditional IRA when we retire. From there, we can only roll over certain amounts to not invoke a higher marginal tax rate, and either lose our tax advantage on the principal or even end up paying a higher rate than we did originally.

Having to make withdrawals of given amounts may fit into our plans quite well, but in some cases not so well if this involves some of this money moving us into a higher tax bracket, which can happen, depending on how close you are to the maximum of your current one.

This need not be much of a concern for a lot of people, who may be happy enough to just keep all their money or most of it in a traditional IRA after retirement, but this is not the only difference at this point.

Not only can we roll over money from a Roth 401(k) at 59 ½ and onward, we can help ourselves to any amount of this as needed with no taxes being paid, no penalties, or any other issues. Sure, we do want to keep our money in retirement accounts as long as possible, but situations do arise and we may need access to funds while we’re still working, where withdrawing these amounts would indeed put us in jeopardy of paying too much tax.

Any withdrawals from a traditional retirement account prior to retirement will be added to our current income, and that means we’ll be paying the full marginal tax rate, or worse, a higher one on some or even most of the money if we move up marginal rates.

The importance of this really comes down to how likely we think that we’ll need to do something like this, but there is value in just knowing we could if we need to.

Looking at our expected tax rate is still the main driver of these decisions, but when we look at the entire picture, it’s not a bad idea at all to end up choosing a Roth if you don’t expect a significant reduction your tax rate at retirement, in order to seek to have your money more readily available without risking messing up the tax savings portion of these plans to some degree at least.