Which Type of 401(k) Is the Best Option?

Roth 401(k) or traditional 401(k)? It’s a simple question that when answered correctly, has the potential to add hundreds of thousands of dollars to your net worth during your lifetime. Unfortunately, many people arrive at the wrong conclusion, but it’s not for lack of research or advice. Conventional wisdom from financial pundits and the internet often tout the Roth 401(k) as the better choice, suggesting that you will end up with more after-tax dollars during retirement. However, in almost every case, the opposite is true, making the regular 401(k) the right choice for just about everyone. Let’s take a look at the main reason why.  

Taxes

“The hardest thing to understand in the world is the income tax.” – Albert Einstein

While there are several factors to be considered when comparing a Roth 401(k) to a regular 401(k), none are more compelling than taxation. Understanding how the United States’ progressive tax structure applies to 401(k)s is the cornerstone of our analysis. Let’s begin with an example of marginal and effective tax. (For related reading, see: This Is the Biggest Risk to Your Retirement.)

Joe and Jane are married, filing jointly, and make $100,000 per year in taxable income. Every dollar they make above $70,700 (2012 tax year) is taxed at their marginal rate of 25%. However, their effective tax rate on the entire $100,000 is 17.06%. This difference in taxation is revealing, as it tells us that the last dollar made is taxed the most. The table below illustrates the power of this concept as it shows the differences between the taxation of contributions to and distributions from a regular 401(k) and a Roth 401(k):

Joe and Jane, Married, Filing Jointly

$100,000 Taxable Income During Working and Retirement Years

 

Working Year Contribution

(Marginal Rate)

Retirement Distribution

(Effective Rate)

Actual Tax Paid

Regular 401(k)

25% tax avoided

17.06% tax paid

17.06%

Roth 401(k)

25% tax paid

17.06% tax avoided

25%

 

 

Regular 401(k) Tax Savings vs. Roth 401(k)

7.94%

 

 

 

 

 

 

 

 

 

 

What have we learned? Assuming that Joe and Jane take $100,000 a year from their portfolio in retirement, they will be better off using the regular 401(k) by 7.94%. In fact, the Roth 401(k) won’t even break even with the regular 401(k) until Joe and Jane take close to $300,000 of annual income in retirement to equal their marginal rate of 25% during their working years. Since most people don’t take 100% of their income in retirement, taking 200% is extremely unlikely, making the Roth 401(k) a poor choice. (For related reading, see: A Closer Look at the Roth 401(k).)

Here’s the bottom line. Whenever the marginal tax rate applied to contributions while working will be higher than the effective tax rate on withdrawals during retirement, a regular 401(k) will outperform a Roth 401(k). Just about everyone falls into this category, but there are a few exceptions to consider.

Candidates for a Roth 401(k)

Very High Earners

If you are routinely making over $470,000 per year and expect to live off of a similar income in retirement, a Roth 401(k) begins to make sense. This is because marginal and effective tax rates begin to converge as you progress deeper into the top tax bracket, meaning that even a slight increase in the top marginal tax rate during retirement has a profoundly negative effect on you. It can be better to lock in your current marginal rate, which is historically low, rather than risk an increase. (For related reading, see: Strategies for Your Roth 401(k).)

Very Low Earners

Generally, teenagers and college graduates fit this category, but if your marginal tax rate is 10% or lower, a Roth 401(k) is the ideal choice.

A Quick Word about Future Tax Policy

While an entire article could be written about what could happen to future tax policy, this one will just touch on the most important takeaway. Almost all possible changes in tax structure would favor the regular 401(k), not the Roth, making the regular 401(k) a choice that has much less downside tax risk.

The Bottom Line

The Roth 401(k) has many advantages for the small segment of very wealthy taxpayers to which it mostly applies. Roth 401(k) structures also have many advantages not considered in this article when used for purposes other than providing retirement income—such as estate planning or obtaining early access to funds. Aside from those considerations, a regular 401(k) is most certainly the best choice and will provide a significant boost to net worth and after-tax income when compared to the Roth. (For more from this author, see: Financial Steps to Take for a Prosperous 2017.)