Roth 401(k) versus Traditional 401(k)
The Conclusion: Traditional 401(k) is usually the winner… with some caveats
Tax Savings > Lump Sum
If you're currently working, you are likely familiar with the 401(K) and how you may benefit from investing in a one given your company's matching policy and tax-related advantages.
Often times, you are presented with the choice between the traditional 401(K) - pre-tax contributions, or the Roth 401(K) - post-tax contributions.
Some important distinctions arise at this point - electing to commit pre-tax contributions mean you are effectively netting a tax shield. Your investments will continue to grow tax free until you retire, where you will then be taxed on the gains of the investment.
Consider the following example:
Electing to contribute the max annual amount (set by the IRS) of $19,500 reduces your pretax income and can save you $4,095 in cash a year, because you are effectively being taxed on a lower income despite retaining the contribution as part of your net worth.
In reality, these tax savings are incremental bi-weekly savings as opposed to annual, given how often you are paid by the company. However, conceptually, they are equivalent.
Now let’s talk about the Roth 401(k). This investment vehicle is principally the same as the traditional 401(k) except for one key difference, contributions are made post tax. In essence, you elect to pay taxes on your earnings now, instead of pre-tax with the traditional. Upon retirement, you can withdrawal your full portfolio tax-free. However, you forego the tax-shield benefits with the traditional 401(k).
Consider this example below:
Because contributions are made post-tax, you are effectively pre-paying for your retirement. In other words, you pay taxes on your contributions now so you may withdraw them completely tax free on retirement. If we conceptually compare the two vehicles, we would think that if we expect to retire in a higher tax bracket, we would favor the Roth IRA that elects to pay taxes earlier. However, many articles and calculations fail to calculate one crucial component. Reinvested tax savings. The $4,095 in annual tax savings highlighted in our example can be invested into the market every year and compound until retirement.
Consider this example below.
This model is a hypothetical scenario where you start investing at age 23, and contribute the max amount to your 401K ($19,500). Assuming an annual return of roughly 7%, your portfolio will grow to $3,588,214 (highlighted in Red - Age 64. You can consider this the value of your 401K on retirement. Upon withdrawing this for your Roth 401(k) , you will be taxed at your older tax rate as you made post-tax contributions.
Now consider this scenario where your average current tax rate was 21%, rising to 32% in your retirement years. If we use the same numbers as above, ($3,588,214), you will notice your actual portfolio value is significantly less for the traditional 401(k) because of the higher tax rate. However this is excluding the idea of reinvesting your annual tax savings each year.
Consider the this example further: Taking the $4,075 in annual tax savings we calculated before, we can run a simulation where we invest the money each year back into the stock market, effectively compounding it at the same ~7% rate we were using prior. In the end, the highlighted red value of $1,056,048 represents a possible value of the reinvested tax savings on retirement.
With all considerations taken into account, we can now reach our conclusion. In this scenario, despite moving to a higher tax rate in retirement, the traditional 401(k) is worth more if you invest the annual tax savings each and every year until retirement, totaling to a total benefit of ~$500,000. This will be in the case in almost every scenario, but the cash savings have to be invested consitently and timely, or the added benefits will not compound to a degree that is greater than the lump sum tax benefit from the Roth 401(k). Luckily, this is neither hard nor time-consuming to do.
The ultimate conclusion is that the Traditional 401(k) often nets a more positive ending value than Roth 401(k) when including reinvested tax savings
