Roth vs. Traditional 401(k)/403(b) - Which is Better?

Recently a client of my approximate vintage asked if he should start contributing to his employer’s Roth 401(k) rather than the traditional 401(k). Roth 401(k)s and Roth 403(b)s are retirement account options commonly offered by employers, such as the University of Kentucky. The difference is that you put after-tax dollars into a Roth rather than pre-tax dollars and, when you take a withdrawal in retirement, you won’t pay income tax on that amount. In other words, the earnings growth is tax-free. Cool, you say, gimme some of that. But, the real question is, which account option will produce the most money in the long run?

As always, different circumstances can result in different strategies but we almost always advise clients to take the pre-tax route – pronounced rout, not root, by the way – because every dollar contributed to a pre-tax retirement account reduces your taxable income by that same dollar. That not only reduces your tax obligation but it frees up cash flow for other things. Furthermore, this strategy reduces taxable income at it’s peak – during your working years – and defers the income tax until retirement when your earnings will be lower.

But, since the earnings growth on that contribution isn’t ever taxed through a Roth account, would you ultimately pay less tax and accumulate more investment assets by investing that way? To answer that question, we turn once again to our loving couple, Monica and Chandler to see what’s right for them.

If you remember, Monica and Chandler are both 43, earning $75,000 a year apiece. They both contribute to the 401(k)’s offered by their employers – 6% pre-tax which is matched 6% of their salaries by their employer. Their current account balances are $100,000 each. So, which method – Roth 401(k) or Traditional – results in more money for them in the long run?

Roth 401(k)

Chandler and Monica both contribute 6% of their salaries to their 401(k)s. That same contribution to a Roth 401(k) will actually cost them about $210 more per month since they will pay income tax before contributing. So, first, they must determine if their cash flow can manage that.

Results:

• At age 65 their 401(k) assets will total $491,564;
• At the same age, their total investment assets will total $3,041,891 (This includes their 401(k)s, Roth IRAs and a regular investment account described in a previous blog post)
• At age 85 their total investment assets are projected to total $4,915,056.

Traditional Pre-Tax 401(k)

To compare apples to apples, one must account for the extra $210 per month Monica and Chandler pay in taxes by contributing to a Roth. So, we take that $210 per month and invest it and compare.

Results:

• At age 65 their 401(k)s will total $587,514;
• At the same age, their total investment assets total $3,128,408 (This includes their 401(k)s, Roth IRAs and a regular investment account);
• At age 85 their investment assets total $4,987,597.

Conclusion

Now that we’ve completely wonked-out, here is the conclusion:

• At age 65, they will have accumulated $95,950 more in their pre-tax 401(k)s;
• At age 85 they will have $72,541 more total investment assets with the pre-tax option.

This makes sense for the reason we spelled out initially. If you’re going to pay income tax on that contribution either way, it makes more sense to pay it in retirement when your taxable income is lower and, presumably, your tax rate is lower too. In fact, a Roth account only wins relative to a traditional one if your tax rate in retirement is higher than when you make the contribution. But, individual circumstances deserve individual scrutiny so give us a call if you want personalized advice.

Steve Byars