Thursday, October 12, 2006

ROTH 401(k) vs. Traditional 401(k)

The Problem
More and more companies are beginning to offer a ROTH 401(k) option to employees, in addition to a traditional IRA. You found this site because you need to decide whether to keep your company retirement savings in a traditional 401(k) plan, or switch to a new ROTH 401(k) that is being offered by your employer. You have looked for help on the internet, but have encountered some of the following problems:

1. The sites you found give good information, but do not give any useful recommendations.

2. The sites are too confusing.

3. The sites have calculators, but they are impossible to use because they ask you to guess about a number of variables and give confusing results.

You have come to the right place. By the time you finish this article, you should have a better idea what decision to make. I wrote this article to mention some items that I think others don't mention because they are unwilling to speculate or trying to be too politically correct.

Summary of the Differences
The plans are very similar. With the traditional, you invest part of your paycheck tax-free but you have to pay taxes on the contributions plus investment earnings when you collect the money for retirement. With the ROTH, you pay taxes now but then don't have to pay any taxes later on the investment earnings when you start collecting the money. So if your tax rate is the same now as it will be at retirement, the two options are almost identical. This is explained mathematically at the end of this article if you are interested.

Most Important Factors to Consider
1. Tax Rates - The higher your tax rate is now, and the lower you think it might be when you retire, the more you should lean toward the traditional 401(k). This is very difficult to predict, but you have to try to get a feel for this since it is the most important factor in your decision. Here are my opinions on this matter:

(a) If you're paying more than 35% now, it is likely to be lower later. Advantage: traditional

(b) If you are paying less than 20% now, it is likely to be higher later. Advantage: ROTH

(c) I have a hunch that congress will lower tax rates on the elderly as the baby boomers retire. This is because politicians will do anything to get elected. Advantage: traditional

(d) Since people have been so horrible at saving, Congress may take DRASTIC measures in the future to encourage saving. Who knows, maybe they will eliminate taxes on earnings altogether in all retirement plans. This is unlikely, but if something like this happens it will be a massive windfall for traditional and anyone with a ROTH will be a colossal loser. Advantage: traditional

(e) What if the tax code is radically changed before you retire, as is sometimes discussed in presidential campaigns? If we convert to a sales-tax-only system of taxation, for example, it seems that this could be a huge windfall for those who chose the traditional option (similar to the previous item).

(f) If you think Congress will ultimately have to raise tax rates to pay for our bloated entitlement programs (Social Security, Medicare, etc.), bridges to nowhere, and the cost of pre-emptive wars on terror around the globe, then advantage ROTH.

2. Contribution Limits - There is an annual limit of how much you can contribute to these plans. If you are trying to maximize your effective annual contribution, investing as much money as possible without being double taxed (once when you earn it, and again on investment earnings), then the ROTH is much better. This is because $15,000 after taxes (plus catch-up contributions, if you're over 50) is a bigger net contribution than $15,000 tax-free that will be taxable later. This might be a little confusing. If you don't understand this, you will have to take my word for it. This is probably the most important reason that most people should go with the ROTH option. But are you mentally ready to put away as much as [$15,000 / (1 - tax%)] each year? For most of us, this is $20,000 or more. If you are not in this range of contribution, then you need to eliminate this item entirely from consideration.

Other Factors To Consider
1. The contributions you make to a ROTH are yours and they can be withdrawn later without penalty. Contributions to the traditional will incur a penalty if you need to withdraw them. So another advantage of the ROTH is that you can pull some money out later without penalty if you need to for an emergency. (Of course, it is recommended that you don't do this unless absolutely necessary)

2. There is an emotional advantage of the ROTH to consider. The traditional 401(k) shows you inflated account values, because you still owe taxes. So if you have a mental picture of how much you want to have in your "nest egg", the ROTH shows you a lower number on your annual statement, which might encourage you to invest more in other places.

3. Contributing to the traditional 401(k) typically will lower your tax bracket, because it lowers the salary that you list on your tax form. So this can make it a little harder to determine your "current tax rate" on contributions. For example, let's say you make $56,000 and decide to invest $8,000 in your 401(k). Also, suppose the tax rate is 20% for earnings up to $50,000 and 35% for earnings above $50,000. In this case, you might decide to contribute $6,000 to the traditional and $2,000 to the ROTH.

4. Do not overlook the administrative burden. You will need to keep track of which of your money you have paid taxes on (ROTH) and which you have not (traditional). Also, you will have to trust your employer to handle your elections properly. I have personally had problems with this in the past with previous employers. For this reason, I always prefer to keep my investments through my employer as simple as possible. At the very least (and despite example #3 above), I would suggest you do all of one or the other, and not allocate some contributions to ROTH and some to traditional (although legally you are allowed to split the contributions). Advantage: traditional, if that is what you currently have

Factors That Don't Really Matter
You may think the traditional is better, because you can invest more now and pay the taxes later when you will be old and not need the money. Or you are worried that there will be a nuclear holocaust, in which case ROTH contributors will die having pre-paid taxes on their retirement fund. Or perhaps you are a smoker, and are wondering whether you will even make it to retirement. But selecting the traditional option for this reason is a flawed decision. Whatever amount you can invest now is the total net amount that you should invest. Whether you select the traditional or ROTH would again simply depend on the tax rates as mentioned above. The traditional will have a higher balance prior to retirement, but they will be equivalent when you collect the money.

For example, let's say you decide (for all of the reasons stated above) that you only have $4,000 you want to invest this year and suppose you are in a 25% tax bracket. You conclude that it is better to put all $4,000 into a traditional plan than to pay $1,000 taxes and put only $3,000 into a ROTH. Not so fast! If your tax rate will be higher than 25% at retirement, then you are actually better off putting $3,000 into the ROTH! If you understand this example, then you understand everything you need to know about this issue.

1. If you have credit card or other debts with interest rates higher than 10%, and you think you can avoid running up future debts, pay them off completely before putting any money into any 401(k) plan.

2. Regardless of which 401(k) you choose, make sure you are contributing in a way that you are getting the maximum match from your employer. In most cases, the match will be the same under either the ROTH or traditional plan. But you should check to make sure.

3. If you want to "max out" the system and shelter as much as possible each year for retirement, you must select the ROTH 401(k).

4. If you can't contribute the maximum this year, consider your best guess about tax rates. If you think your current tax rate is the same or lower than it will be when you retire, select the ROTH 401(k). Otherwise, go with the traditional.

5. If you're not sure, keep in mind that in general the laws to date seem to let people convert traditional to ROTH. But I doubt you will ever be allowed to convert a ROTH to a traditional. So if you're not sure, the safer move may be to stick with the traditional until you make up your mind.

6. If you are still confused, just pick one or the other. Either the traditional or ROTH is better than spending the money, or investing it in taxable investments outside of your company retirement plan.

Mathematical explanation
Here is the mathematical explanation of why the difference in tax rates is the only factor that affects what you get from the two different options (ROTH/traditional).
Assume you have $A to invest
Assume your current tax rate is B%
Assume your tax rate at retirement is C%
Assume your money will earn D% between now and retirement

Traditional: Your money you will have at retirement after taxes (investment + return - taxes) = A x (1+D) x (1-C)

ROTH: Your money you will have at retirement after taxes (investment - taxes + return) = A x (1-B) x (1+D)

So if B is bigger than C, the traditional is better. And if C is bigger than B, the ROTH is better.

Did I leave anything out? If so, please let me know in commments.


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