Traditional or Roth 401k – Which is Better for You?

By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA

Until recently, all 401k plans were “Traditional”: contributions were made with before-tax dollars, earnings grow tax-free until withdrawal, and then the withdrawals are taxed at ordinary income tax rates. But now some employers offer their employees the opportunity to direct some or all their 401k contributions into a Roth version of the IRA. This article outlines the major elements of the Roth 401k and provides our view on determining which plan is better for you.

Roth 401k

The Roth 401k is patterned after the Roth IRA. The employee contributes after-tax dollars. But then there is no tax on the withdrawals after age 59 ½, if you have held the account for at least 5 years.

As with Traditional 401k plans, it is almost impossible to withdraw funds from your Roth IRA until you terminate your employment with that company. Upon your termination, you can roll your Roth 401k into a Roth IRA. If the Roth IRA is at least 5 years old, you can use the funds to purchase an immediate annuity that provides tax-free payments for the remainder of your life.

The limit on the amount of money you can contribute to your 401k is a combined limit – the sum of your contributions to a traditional and a Roth 401k cannot exceed $18,000 in 2015, or $24,000 if you are 50+ years of age.

The employer match to a Roth 401k is before-tax; the funds are held in a separate Traditional 401k account and are fully taxable at withdrawal.

Comparison of Traditional and Roth 401k Plans

The large difference between the two plans is the timing of taxation. An employee enrolled in a traditional 401k plan contributes before-tax dollars to the plan, and pays no tax on the earnings until funds are withdrawn. With a Roth 401k, the employee contributes after-tax dollars, but then there is no tax on the withdrawals. Both plans have restrictions to discourage withdrawals before age 59 ½. We think of it this way: the traditional plan is no tax now, but tax later; the Roth is tax now and no tax later.

Let’s start by clearing up a common misperception: you may have read (we have) that contributing to a Roth 401k, compared with contributing to a Traditional 401k, will reduce your take-home pay because you must pay taxes on the Roth contribution. This statement is incorrect.

The mistake occurs because of a failure to start at a common point – we need to start at the point where you have decided to allocate some amount of pre-tax dollars to your 401k. Suppose you decide to allocate $10,000 in pre-tax funds. If you contribute to a Traditional 401k, you pay no taxes now on the contribution. If you contribute to a Roth 401k, you use part of the $10,000 to pay the tax on that $10,000 (it’s all part of your taxable income) and you contribute the remainder to the Roth 401k.

Yes, you pay more in taxes – but your take-home pay is the same. Furthermore,

If your tax rate remains unchanged at T and the investment vehicle is the same, you will end up with the same after-tax return whether you use the Roth or the Traditional.

To illustrate this point, suppose you invest $10,000 in pre-tax dollars, your combined Federal and state tax rate is 32%, and your annual return is 10%. Then your total return at the end of 20 years is:

Traditional: $10,000 x (1 + .10)20 x (1 – .32) = $45,747

Roth: $10,000 x (1 – .32) x (1 + .10)20 = $45,747

So let’s turn to the factors that DOaffect your decision:

  1. Your contribution amount relative to the maximum level matched by your employer. If your contribution of after-tax dollars to a Roth would fall below the maximum level matched by your employer, you would receive more matching funds by contributing the equivalent pre-tax dollars to a Traditional 401k. You will receive more matching funds because the employer matches the contribution amount without considering whether you are paying taxes on your contribution or not.
  2. Your wish to allocate even more to your 401k. Your allocation of pre-tax dollars can be considerably larger if you use the Roth 401k. The limits for Roth and Traditional are the same, but the Roth dollars are after-tax. So, if you wish to allocate more than $17,500 ($23,000 for age 50+) of pre-tax dollars to your 401k in 2014, the Roth will allow you to do so.
  3. Your view about your future tax rate compared to your current tax rate. A view that future tax rates will be higher (or a desire to protect against that possibility) will favor the Roth 401k. A view that your future tax rate will be lower favors the Traditional 401k.

Our View

Our recommended approach depends on the level of before-tax dollars that you plan to allocate to your 401k. We have 3 categories. Is your level:

  • Below the level of contribution receiving the maximum match from your employer, or
  • Between the level for receiving the maximum match and the maximum amount you are allowed to contribute to your 401k, or
  • Above the maximum amount you are allowed to contribute to your 401k?

Here is our advice for each category:

a.  Your contribution is below the level for receiving the maximum match from your employer.

We really like matching funds. If your allocation of before-tax dollars is below the level for receiving the maximum match, any allocation to the Roth 401k will reduce the amount of matching funds you receive from your employer. So in this category, the benefits of more matching funds usually dominate the other factors, favoring a full allocation to the Traditional 401k.

b.  Your contribution is between the level for receiving the maximum match and the maximum amount you are allowed to contribute to your 401k.

In this category, some advisers recommend a balanced approach – splitting your allocation between the Roth and the Traditional. We would note that the employer’s contribution is put into a Traditional 401k so you will automatically have some splitting if you receive matching funds.

The driving factor for this category is your view on your future tax rate — whether your future tax rate will be higher or lower than your current rate.  If you are currently in a low tax bracket, this would favor the Roth since the future rate would have to be even lower for the Traditional to be the better choice.  If you are currently in a high tax bracket, you might consider contributing enough to a Traditional account to bring you down to a lower tax bracket and contributing the remainder to a Roth (incurring taxes at the lower rate on the Roth contributions).

We generally favor the Roth because it removes the risk of encountering significantly higher tax rates later. Our reasoning has two parts:

1.  We’re not very optimistic about future tax rates being lower, and

2.  From an ease-of-mind standpoint, we think removing all worry about future tax rates outweighs the possible increased return we could achieve if tax rates were to fall.

If you decide to allocate some of your contribution to the Roth, we recommend that you first contribute those funds to a Roth IRA up to the maximum you are allowed. The Roth IRA is much more flexible than the 401k – you can choose your own low-cost provider and you can withdraw your contributions at any time.

c.  Your desired contribution (of before-tax dollars) is above the maximum amount you are allowed to contribute to your 401k.

In this category, our recommendation is to use the Roth because it will allow you to contribute more funds to your 401k. Again, you may consider splitting your allocation between the Roth and the Traditional. But, as we note in part b) above, we generally favor the Roth because of its protection against tax rates being higher when you withdraw the funds. And you will have some splitting as a natural consequence of the employer’s match going into a Traditional 401k.

Finally, as we noted in part b) above, a Roth IRA is much more flexible than a Roth 401k. So, if you decide to allocate some of your contribution to the Roth, we recommend that you first contribute those funds to a Roth IRA up to the maximum you are allowed.