Which is better, Traditional 401k or Roth 401k?

Inflatable Dividends

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Also near the bottom of that page is the PayPal button to subscribe to the service. The first month is always free because we don’t think you should pay for something unless you find it valuable.

Anyone that signs up before June 1st, 2008 will receive the subscription price of $4.95/month for the life of the subscription. On and after June 1st, the price will be going up to $19.95/month. As one of our beta testers pointed out, this service is too valuable to give away for so cheap.

Traditional 401k vs. Roth 401k

I was asked not too long ago which retirement account, Roth or non-Roth, is better to contribute to. My knee-jerk reaction was to say the Roth because I don’t like paying taxes. But really that wasn’t a fair answer because it was completely based on emotion and not facts. And emotion and investing do not mix well. So I resolved to create a spreadsheet to prove my point and show conclusively which type of account is better. (Turns out my gut emotional reaction was wrong.)

To cut to the conclusion for any that don’t care about the particulars, if you assume that your after tax spendable income now will be roughly the same as your after tax spendable income in retirement, then you want to go with the regular 401k because you will end up with about 10% more years of retirement income over the Roth 401k. The reason is that when you put $30k into a regular 401k versus $30k into a Roth 401k, you end up with more spending money in the non-Roth situation. So to make the two situations equal, and end up with the same amount of spending money, you have to take that extra and invest it in a taxable account.

This finding of the regular 401k being better only holds true if the tax rates in the future stay below 30% for earned income and 47% for capital gains. If they go above those rates then the Roth 401k becomes the better option. (Although, what it really means is that the government is taxing away your retirement money because the Roth 401k doesn’t change, its just that the Traditional 401k gets worse.)

To help with your decision on whether or not earned income tax rates will go that high take a look at the following link.

http://www.moneychimp.com/features/tax_brackets.htm

You’ll notice that for the last 7 years the 15% tax rate stays at about the same standard of living after inflation. But I’m not prepared to believe that congress and the fed will keep their hands out of my pockets, so I’m investing in my 401k and in my Roth IRA in case tax rates do rise. That way I’ll have the option when the time comes. (I’ll address the fallacy of inflation and the silent theft of your savings by the Fed in a later rant.)

For those of you that are interested in the particulars and that want to check my work, below is the spreadsheet that details my calculations along with an explanation of the columns and lines. (This spreadsheet will open in Microsoft Excel, but you may need to resize the columns to see the numbers correctly.)

401k vs. Roth Spreadsheet

– Column B is money invested in a regular 401k.
– Column C is the extra money from the regular 401k tax savings invested in a taxable account to match the same spendable income as the other columns.
– Column E is money invested in a taxable account using a strategy that requires annual buying and selling (this was to show the effects of paying taxes every year).
– Column F is a taxable account using a buy and hold strategy.
– Column G is a Roth 401k.
– Line 2 is an assumed amount of $100k income. Changing this number would affect the tax calculations.
– Line 3 is the FICA tax which you pay no matter what on earned income (up to a point) so it doesn’t really matter for this expirement.
– Line 4 is the deposit of $30k to the regular 401k. Again this amount is just assumed, it could be more or less.
– Line 5 is your resulting taxable income at that point.
– Line 6 is your income taxes. This is where things would change if you had a higher or lower income. The equation used assumes that you are in the current 25% tax bracket, given the $100k income.
– Line 7 is your income after the taxes are taken out. (Sorry you had to see that. Painful, I know.)
– Line 8 is the deposit of $30k to the Roth 401k.
– Line 9 is the income remaining after the Roth 401k deposit.
– Line 10 is the amount that has to be placed in a taxable account to make all of the columns match in spendable income. Here is where the 401k gets an extra $7500 that the Roth column paid to taxes.
– Line 11 is the amount of spendable income left after the investments are made. Notice that it is equal so we are now comparing apples to apples. Meaning you will have the same standard of living now for all columns.
– Line 13 is the return earned each year on the investments. This number really doesn’t matter. The answer comes out the same for the Roth vs non-Roth 401k even if it is zero or for that matter negative.
– Line 15 through 45 are the years of returns. I have separated out the taxable and non-taxable parts of the non-Roth 401k into columns B and C with C being the taxable account. Again the amount of time (30 years) doesn’t affect the outcome, it could be zero years or 100.
– Line 47 is the total savings and earnings after the 30 years of investment.
– Line 49 is the top tax rate paid on earned income in retirement. If this number goes higher than 30% or you have a higher income in retirement than in your working years, I expect that this will change the outcome.
– Line 50 is the top tax rate paid on capital gains in retirement. If this number goes higher than 47% or again if you plan a higher retirement income than in your working years, the Roth might be the better option.
– Line 52 is the amount of income desired in retirement. Notice that this is the same across all columns to again continue comparing apples to apples.
– Line 53 is the amount you will need to withdraw from this account to end up after taxes with $40k of spendable income in retirement.
– Line 54 is the taxes you will pay on the amount withdrawn. (Notice Column E doesn’t have taxes because they were already withdrawn for the year on Line 45.)
– Line 55 is the check to make sure we calculated the taxes correctly and that all columns still match in spendable income.
– Line 57 is the number of years (assuming no more growth) that you could live on the money. For me this is the best method of comparison. Note that cell B57 is the sum of the number of years for the 401k and the taxable account that is paired with it.
– Line 58 is the percent more financially free life over the buy and sell option.

Again the calculations bear out that the regular 401k is the better option in the current tax environment. But the Roth 401k is not too far behind depending on tax law changes in the future or if you decide to have a higher income in retirement, so it might be prudent to put money into both types of accounts.

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