Saturday, December 22, 2007

Traditional 401K vs. Roth 401K

As the new year approaches, my employer has updated their benefits package to include the option of contributing to a Roth 401K. Ever since I have been working, I have always contributed pre-tax dollars in the Traditional 401K to take advantage of (i) starting to save early and (ii) of the healthy company match.

Since I have been contributing to my 401k, I never felt the need to start a Roth IRA. With that said, I never took the time to understand the benefits of the Roth. So with this available option, I need to ensure I am making the right choice for the long-term....

So here is what I have learned so far, using a simple analysis that I have created to help me understand the differences...

Initial Contribution of $1000
Assuming 7% growth for 30 years
Effective Tax of 28%
Withdrawal rate of 10% after year 30

Traditional 401k Results:
After 30 years at 7%, the balance would be $7,612
At the same tax rate of 28%, you will receive post-tax amounts of $5,481

Roth 401k Results:
After 30 years at 7%, the balance would be $5,418 with no tax liability.

Neutral at the same tax rate pre and post retirement.
Advantage Trad. 401k when you assume your tax rate in retirement will be lower.
Advantage Roth 401k when you assume your tax rate in retirement will be higher.

In summary, one of the most critical assumptions is your tax bracket differential now vs. retirement. To provide you some more data for your analysis, here are the historical income tax rates in the US.

After looking at the variability of the tax rates among other assumptions about potential career success or not, I am not going to try and guess and put all of my funds in one type of account. I am deciding to employ a hedged strategy and will plan on having both a Traditional and a Roth 401k. I will need to assess what percentage of my retirement accounts I would like in each account, but my initial reaction is a 50/50 split.

Here are some additional website and articles that have helped me in this analysis:
Fool Article

Hopefully this simple analysis helps you in your financial quest. Please feel free to comment if you feel I am missing some significant advantages and disadvantages between the two.

Author Disclosure: I am not a Certified Financial Planner. Please read the disclaimer and consult your financial advisor.


Anonymous said...

One definite advantage of the ROTH is that you can pull out your contributions anytime for anything w/o penalty or taxes. It's not a financial gain, but definitely a liquidity issue and makes a compelling argument to max out the ROTH before going into pre-tax territory, especially if you are in a lower tax-bracket or have a lot of tax write-offs right now. Also, you can use it for more things like a down payment on a house for you, or your kids - up to $10,000 last time I read. Just it check, though. I'm not a CFP either, but I did carry a series 6 and 63 for awhile.


I cannot get to excited about the Roth IRA'S. Watch out for the cash strapped states to look upon the tax excempt status of Roths as a Piggy Bank of potential revenue.