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401k Comparison: Which is Best for You?: Analysis from Cabana Institutional

7 years ago

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A common question that we run into when working with businesses and their employees is “What is the difference in a Roth 401(K) and traditional 401(k) and which one is the best choice for me?” While there are a lot of advantages to Roth 401(k) contributions, there are many puzzle pieces and strategies to sort through before making a choice. We have helped lay out some of those for you below.

Know the Facts About Contributing to a Roth 401(k):

1. This option takes contributions from the employee’s salary after taxes have been paid on those amounts. Note that if there is an employer match on the account, this creates two “buckets”, one that is the after-tax contribution, and one that is pre-tax coming from the employer match. No matter what the employer matches, whenever a distribution is taken, it will be taxed exclusively on that portion. BUT the majority will come out tax-free, because taxes should already have been paid and it helps to diversity retirement income.

2. The investment earnings on the account will also come out tax free when you begin distributions, if the distributions are “qualified”, meaning that the account must be in existence for a minimum of five years since the first contribution was made and they must be made on or after turning 59.5 years old, or after death or disability. If a distribution is taken without meeting those requirements, the investment earnings on the account (including dividends, interest, and capital gains) will be taxed as ordinary income.

3. Roth 401(k)s do not have an income limit to be able to contribute. People over a certain amount of income (varies) are not able to contribute to a Roth IRA and therefore might benefit from contributing to a Roth 401(k) instead for retirement savings diversification.

Know the Facts About Contributing to a Traditional 401(k):

1. Money will come out of the employee’s paycheck on a pre-tax basis. Taxes will be paid as ordinary income on whatever amount is distributed at retirement or when money is taken out of the account (including employee and employer contributions, and investment earnings: dividends, interest, and capital gains). The amount deferred from paychecks will not count towards current income and will not be taxed during the current year or periods when contributions are being made.

2. Many people (especially high-earners) are currently in a higher tax bracket than what they might be in when they retire, since at retirement their income might be Social Security and retirement accounts only instead of a full salary. They might not be better off paying taxes now through the Roth option and could benefit from paying taxes at a lower rate in the future (assuming current and future tax rates are the same).

3. A traditional 401(k) might be less convenient when paying taxes on the sum withdrawn instead of currently on the sum contributed (which is potentially smaller) – especially if you think you will be in a higher tax bracket later or at retirement.

Now What?

Ideally it is good to diversify, and many people opt to open another retirement account like an IRA with the opposite strategy (Roth if their 401(k) is pre-tax or vice versa) or ask their employers if it is possible to contribute to both types within the same plan. Those who believe they are not making as much money as they might in the future, and might currently be in a lower tax bracket than later in life, could consider using the Roth option to pay fewer taxes now. This is common among young people who have a long career ahead of them. Those earning higher income might consider taking the tax deduction now (by choosing traditional), so that they could pay the taxes later when their tax rate might be lower. Those of you that want to diversify, and are currently at an income level that does not allow you to contribute to a Roth IRA, might consider using the Roth option for their 401(K) – and maybe diversify through a Traditional IRA that will grow tax-deferred.

Another smart thing to do when using a Traditional 401(k), is use the money being saved now on taxes to invest and grow it to pay for the taxes that will be charged on the distributions during retirement. Often, people decide to use the traditional option, but end up spending the money they save now by deferring taxes and find themselves having to take a big cut out of their distributions during retirement later. Therefore, those who believe they will not be disciplined enough to invest the tax deductions now, and that do not want to take a portion out of the money they withdraw at and during retirement, might be better off by paying the taxes now through the Roth option.

One more thing to keep in mind is that Roth 401(k)s, just as traditional 401(k)s have Required Minimum Distributions (RMD) which force account owners to begin taking distributions when they turn 70.5. But if the account is rolled over into a Roth IRA before that time comes, there will be no RMDs. Traditional IRAs also have RMD, just like any type of 401(k).

People wanting to save the trouble of paying taxes on their 401(k) distributions when they retire and are not worried about tax rates, or don’t want a portion of that income during retirement to be diminished by taxes and don’t plan on using the tax deductions they get when using a Traditional 401(k) to invest and pay for those taxes in the future, might want to opt for a Roth 401(k) option.

-Santiago Munoz, Dave Mersky and Adam Smith

 

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Holeman, Nick. “Traditional or Roth 401(k)? Decide with This 401(k) Calculator.” Betterment. N.p., 27 Apr. 2017. Web. 18 May 2017. <https://www.betterment.com/resources/retirement/401ks-and-iras/traditional-or-roth-401k-decide-with-this-401k-calculator/>.

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Schwab-Pomerantz, Carrie. “Roth vs. Traditional 401(k)—Which Is Better?” Schwab Brokerage. N.p., n.d. Web. 18 May 2017. <http://www.schwab.com/public/schwab/nn/articles/Roth-vs-Traditional-401-k-Which-Is-Better>.

Taylor, Carolyn. “Do I have to wait the 5 years to withdraw money from my Roth 401k tax-free if I was over 59 1/2 when I started contributing?” BrightScope. N.p., 12 Feb. 2016. Web. 18 May 2017. <https://www.brightscope.com/financial-planning/advice/question/3957/do-i-have-to-wait-the-5-years-to-withdraw-money-from-my-roth-401k-tax-free-if-i-was-over-59-12-when-i-started-contributing>.

Tepper, Taylor. “401(k) vs. Roth 401(k): Which is Better? | Money.” Time. Time, n.d. Web. 18 May 2017. <http://time.com/money/4258994/traditional-401k-roth-401k-retirement/>.

“Traditional or Roth account-two tips for choosing.” Roth IRA or Traditional IRA or 401k – Fidelity. N.p., 31 May 2016. Web. 18 May 2017. <https://www.fidelity.com/viewpoints/retirement/spender-or-saver>.

Udo, Joe. “4 Reasons to Save in a Roth 401(k).” U.S. News & World Report. U.S. News & World Report, 12 Sept. 2014. Web. 18 May 2017. <http://money.usnews.com/money/blogs/on-retirement/2014/09/12/4-reasons-to-save-in-a-roth-401-k>.

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“Which is better for me.” CNNMoney. Cable News Network, n.d. Web. 18 May 2017. <http://money.cnn.com/retirement/guide/401k_Roth401kplans.moneymag/index2.htm>.

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January 17, 2024

This material is prepared by Cabana LLC, dba Cabana Asset Management and/or its affiliates (together “Cabana”) for informational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This material may only be distributed in its original format and may not be altered or reproduced without the prior written consent of Cabana. The opinions expressed reflect the judgement of the author, are as of the date of its publication and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Cabana to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Cabana, its officers, employees or agents.  

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