401k: Roth vs. Traditional

Introduction

One of the more interesting questions that has cropped up recently is whether the Roth or Traditional 401(k) is the superior savings vehicle.  Most people know that if you expect your tax rate to increase in retirement, a Roth is better, and a Traditional 401(k) is better in the case you believe it will decrease.  I would like to show you some of the considerations where this may not be the whole story.  I am not a financial planner; I just like to think through these sorts of decisions on my own. The following is my judgment of the situation, and you should discuss your own situation with a financial planner.  Hopefully you can use this information for your own purposes.  Also, if the middle is too dry, skip to the end.  Enjoy!

History

The 401(k) was first open for contribution in 1980.  With it the United States ushered in an era of personal responsibility for retirement saving, and started shifting the burden from the corporate pension.  By allowing individuals to defer the time they pay taxes on earned income, the 'traditional' 401(k) empowers a worker to provide for their own livelihood.

In 1997, legislation was signed bringing into existence the Roth IRA.  As opposed to a 'traditional' IRA (or 401(k)), contributions are made post-tax, and distributions are tax-free.  In effect, the Roth IRA is a bet that a person's tax rate will be greater (or substantially similar... which will be explained in greater detail later) when distributions are made.  The Roth 401(k), introduced in 2006, is an extension of the Roth rules to the 401(k) tax code.  Employers can allow employees to contribute post-tax money in order to allow it to compound and be disbursed without the burden of taxes.

Since many employers now offer a choice between the two plans, the question becomes: which plan should I choose?  Following is a reasoned discussion of the issues to consider in making the choice, followed by a summary of the top issues to consider.

Mathematical Considerations

For 2009, both the traditional and Roth 401(k) have a contribution limit of $16,500 for employees under 50 years old, and $22,000 for employees over 50 years old.  401(k)s of both types can avoid state and federal taxes, which must be considered in any calculations which plan to choose.

The following is a calculation of the tax burden for an unmarried under 50-year-old employee making $100,000 a year, and a married under-50-year-old employee (filing jointly) both living in California.

A single employee making $100,000 is in the 9.55% income tax bracket in California, and in the 28% federal tax bracket.

The single filer takes home an additional $6,196.03 and the couple $11,789.20.

In the absence of clear guarantees, the best way to compare the two options is to make some basic assumptions.  In this case, assume the employee's tax rate will be equivalent when the money is eventually withdrawn.  This example is used to show one clear advantage of the Roth structure - the ability to protect a greater amount of income from being taxed.  Also, assume that the money will grow 4% a year after inflation (possibly a fair assumption, although obviously not guaranteed).

An example to illustrate this (for a single employee in the 28% marginal federal bracket and 9.55% California bracket):

(Ed: As reader Dave points out below, the following numbers are only valid at the margin.  Assume that the worker is taking out other income and this income is an addition- enough to put them into the 28% bracket in retirement.  I also assumed the money was invested at the margin as well.  There numbers only make sense in that context, otherwise they are off by a bunch to the high side.  Thanks Dave!)

$16,500 invested for 30 years in a Roth 401(k) at 4% after inflation will be worth $53,516.06 in today's money when withdrawn.  Withdrawing it will incur no tax liability.  $9,921.14 in taxes was paid.

$16,500 invested for 30 years in a 401(k) at 4% after inflation will be worth $53,516.06 in today's money when withdrawn.  Withdrawing it will cause $14,984.50 in federal taxes and $5110.78 in California taxes, resulting in $33,420.78 after-tax. $20,095.28 in taxes was paid.

Considering the 401(k) only saves $6,196.03, the problem with the contribution limit is seen... unless the contribution limit is expanded to factor in the marginal rate (allowing the extra money protected in the Roth 401(k) to be contributed to the traditional 401(k)) the Roth 401(k) will be the superior savings vehicle if an employee expects to be in the same or a very similar (calculations have to be made for each case) personal tax bracket.

Political Considerations

There are a few elephants in the room that may affect the future treatment of the Roth and Traditional 401(k), of which I will mention two.  The more important one is the tax treatment of the two options.  The second is potential entitlement reform that could change the total retirement picture for a retiree.

Between the Roth IRA and Roth 401(k) there is a potential untapped source of revenue, which is growing as more people take advantage of the favorable tax treatment.  The future is uncertain, but it's possible that one day the two Roth retirement forms will be subject to some form of tax or fee.  This seems like a low risk, but considering the difficulty of taxing previous benefits, the traditional 401(k) is a safer bet of being there in its current form when the money is withdrawn.
The second potential huge political risk is if entitlements start being means tested.  If there is means testing of people applying to Social Security or Medicare (amongst other potential programs) it is possible any retirement saving you do could work against you.  Although it is impossible to know for certain if this would happen, it's best to consider the possibility.  However, the odds are that any means testing won't penalize benefits 1 to 1, and having retirement accounts will almost definitely be a net benefit.

Other Caveats

Plenty of things change the picture rendered above significantly.  The world (and your life) is not static.  One of the major events you can do to change the picture is retire (or move to in retirement) a different state than the one in which you earn the income.  Moving from a higher tax to a lower tax starts to tilt the balance to the traditional 401(k).  Income, which was protected from the first state's taxes, will be taxed at the new state's rate upon withdrawal.

Another risk is the federal tax rate.  Historically, the amount of tax collected by the federal government is low.  If the tax rate increases, money in Roth accounts was already taxed at the lower rate, and won't be subject to the newer rate when withdrawn.  If the tax rate decreases, a traditional 401(k) will benefit from the taxes paid (at a lower rate) when withdrawn.

These are by no means the only situations to consider, but should be kept in mind when trying to decide which plan is right for you.

Conclusion

In most cases, a Roth 401(k) seems the superior deal.  Any increase in tax rates or even static tax rate situations point toward the Roth solution.  The Roth's advantage can be summarized as "Any time you expect to pay more or the same amount of income taxes when you withdraw the funds, the Roth seems the better choice."

The traditional 401(k) should not be shut out of consideration however.  If you are moving to a lower tax state in retirement, the traditional 401(k) becomes more attractive the more the tax rate reduces.  The traditional 401(k)'s advantage can be summarized as "Any time you expect your income taxes to decrease in retirement, the Traditional 401(k) seems the better choice".

Again, you should consider your own tax situation before deciding.  Any questions you have should be directed to a real financial planner.  Also, you should consider other savings vehicles.  Of particular interest is the Roth IRA, which behaves the same way as the 401(k) with some key advantages such as no required distributions.  Also, it is perfectly fair to practice 'tax diversification' by splitting your contributions between the various savings vehicles.  Good luck in your decision!