Traditional 401k vs ROTH 401k/IRA : Battle of pretax vs posttax ...

When thinking about starting to save for retirement, the first question most of the young investors have is ?Should I invest in traditional 401k or a ROTH 401k?? ?There are many variation of the question ? ? Should I continue investing in traditional 401k even after the company match or start a ROTH IRA?? Or ?Should I invest in traditional IRA or ROTH IRA?? All of these boils down to ? is pretax retirement savings more lucrative or posttax savings? Which is better for the bottom line?

Standard advice on 401k vs ROTH 401k/IRA

Most people?s blanket recommendation is to go for the ROTH because you will never be taxed again. ?Is ROTH always the better option? The advice inherently assumes:

• The person is not earning much and therefore is paying less in taxes now.
• The tax code is definitely going to change and it will only go up.
• Everyone will have tons and tons of money in their nest egg, so the taxes will be high when they retire.

But the tax advantage of the traditional 401k is too substantial to ignore. And no personal finance advice is one-size-fits-all, so let?s see if ROTH IRA is?really?the better deal for an average young investor.

My assumptions :

1. Start to save for retirement when @ 25.
2. Retire at 60.
3. Average annual growth of 8% (Let me know where I can get this )
4. Contribute $5000 after tax every year.
5. I have calculated the traditional 401k contributions based on 3 marginal rates (25%, 28% & 35%). That equates to contributions of $6666,$6944,$7962 respectively pretax. ?Use this spreadsheet to check your own numbers based on your own tax rate.
6. It is based on marginal tax. (Why? ?Here is a short primer on?how taxes are calculated in the US)
7. Post retirement life span of 20 yrs. ?I examine two cases for post retirement:
1. Move all the savings to cash equivalent, super safe investments like a CD which doesn?t grow the principal. So the total savings is equally divided by 20 yrs to get the withdrawal amount for each year.
2. Move the savings to safe, but low yield savings. I have assumed a growth rate of 3% every year.
8. Inflation isn?t considered.

If I have missed anything, please point it out or ask me, I will add to this list.

401k vs ROTH : The tale of two portfolios

All the 4 portfolios ? $5000 after tax (ROTH 401k), $6666 (traditional 401k with 25% tax bracket), $6944 (traditional 401k with 28% tax bracket, $7692 (traditional 401k with 35% tax bracket) grew at the same rate of 8%/year for 35 yrs. This is how they ended up when that person turned 60 -

ROTH 401k	Traditional 401k with 25% tax bracket	Traditional 401k with 28% tax bracket	Traditional 401k with 35% tax bracket
$935511	$1247348	$1299320	$1439347

The traditional 401k portfolios grew to much more than the Roth 401k portfolio because we put more money into it, thanks to the tax deduction upfront.

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401k vs ROTH withdrawal (pretax vs posttax?play-outs)

So now comes the fun part, the actual retirement. It?s time to enjoy the fruits of our labor. The ROTH 401k portfolio is straight up yours to enjoy. For the other traditional portfolio, Uncle Sam wants his cut. ?As I mentioned previously, I now look at two scenarios.

Scenario #1 : Money is moved from growth funds to a cash vehicle. So it won?t grow any further. Every year the person withdraws an amount equivalent to total portfolio/# of years during retirement.

As you can see from the graph below, traditional 401k still wins. There are two major reason for this

(the withdrawal amount is per year and same for every year because there is no growth)

Scenario #2 : Money is moved from growth funds to a bond/CD fund. So it will grow at a slower, 3% rate. Every year the person withdraws an amount equivalent to [Whatever is left over in the portfolio]/# of years left in retirement.

As you can see the traditional still gives better retirement income even after taxes.

BUT, I have made a lot of assumptions about the tax rates. I?have assumed it will be the same (or very similar) to today?s rate. The #1 argument for ROTH 401k/IRA is that the taxes will go up. There is no way to prove or disprove this claim, which brings us to -

Gamble with taxes

We cannot predict the future tax rates. The only thing we have is the history. ?Here is the historical tax rates for all the income groups -

?

?

As you can see the highest bracket has changed a LOT in the last 50 years, but the rest were relatively stable, esp. the highest earning 20% and below. So it doesn?t look like the statement that ?taxes will go up a lot? is always true.

Taxes can go up, in which case people who had a ROTH heavy portfolio will do better, or it can stay the same/go down, in which case the traditional portfolio would give more retirement income.?

Don?t forget state taxes. We live in CA right now and the state tax rate is up to 9.3%. During retirement, I can control where I live as I don?t have to live in a place where I could find easy employment. So if I move to Washington state or Texas, I can get a 9% savings right there.

Our approach : Hybrid

So why do I have a ROTH IRA in addition to a regular IRA?

• ROTH gives me?liquidity to take my ?contribution out?in case I need it. In fact, I opened a ROTH IRA just to keep my ?emergency fund in (read about it here ? ROTH IRA for an emergency fund ).
• No Required Minimum Distribution.
• Pass ?it on?without having our beneficiaries worry about taxes.
• Your employer provided 401k might not be good.
• Finally, I like?diversification.

So, Should you invest in 401k or ROTH IRA/401k?

There is a problem in the ROTH is always better advice. You will have to decide what is better for you. And that decision is not set in stone either. Each year evaluate what your situation is for that year.

• If you are going to take an year off, will have very little income and travel the world, contribute to ROTH that year. You could even rollover?your Traditional 401(K) to a Roth IRA that year and pay the low income tax rate.
• For someone who is looking to max out their 401(k), they essentially can put away more money in a tax efficient account by investing in a Roth 401(k).?Even though the limit is the same, doesn?t mean the value is the same because Roth 401(k) contributions are made with after-tax dollars.
• If you are just little over to fall into a lower tax bracket, you can contribute enough in traditional to let you fall in the lower bracket and then contribute to a ROTH IRA.
• If your income is a over the limit for some deductions, contribute to traditional IRA/401k to bring it down to the level where you can take the deduction.

The worst thing you can do is nothing. So don?t let this question stop you from investing. Even if you picked one randomly, you will do better than not saving for retirement. Both the ROTH and the traditional 401k/IRA are great investment vehicles. Use my spreadsheet, do the math, pick what works for you best.

What do you currently do? Do you maximize the pre-tax potential or want to be tax free during retire, so go all the way with posttax retirement plans or a mix of both??

Source: http://www.wealthinformatics.com/2012/02/08/invest-in-roth-ira-401k-traditional-pre-tax-post-tax/

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