Why I Believe Traditional 401(k) is Better than Roth 401(k)
When it comes to planning for retirement, most people have heard about 401(k) accounts, but deciding between a Traditional 401(k) and a Roth 401(k) can be confusing. In this post, I’ll explain why I believe the Traditional 401(k) is the better choice for most people, especially if you're focused on building the largest retirement nest egg possible.
What Is a 401(k)?
A 401(k) is a retirement savings plan that gets its name from a section of the U.S. tax code. It was originally the responsibility of employers to handle retirement, but over time, companies have shifted that responsibility to employees. Now, it’s up to us to take charge of our retirement savings, and a 401(k) is one of the most popular ways to do that.
Traditional 401(k)
Pros:
Tax-deferred contributions: You contribute pre-tax income, lowering your taxable income today.
Bigger initial investment: You can contribute more upfront since you're not paying taxes immediately, leading to potentially faster growth.
Tax breaks now: You get an immediate tax break, which is beneficial if you are currently in a higher tax bracket.
Potential for lower taxes in retirement: If you expect to be in a lower tax bracket in retirement, you could pay less in taxes when you withdraw.
Employer match grows pre-tax: Any employer match also grows tax-deferred, potentially leading to faster compounding.
Cons:
Taxable withdrawals: You will pay taxes on withdrawals in retirement, which could be higher if you're in a higher tax bracket later.
Required Minimum Distributions (RMDs): After age 73, you are required to take distributions whether you need the money or not, and those distributions are taxed.
Less control over future tax rates: If future tax rates go up, you could end up paying more in taxes than expected during retirement.
Roth 401(k)
Pros:
Tax-free withdrawals: Since you pay taxes upfront, all withdrawals in retirement (including earnings) are tax-free, assuming you follow the rules.
No taxes on growth: All growth is tax-free, which can be a big advantage if your investments perform well.
No RMDs if rolled into a Roth IRA: If you roll your Roth 401(k) into a Roth IRA, you aren’t required to take RMDs, offering more flexibility.
Cons:
Smaller initial investment: Contributions are made with after-tax dollars, so you have less money invested upfront compared to a Traditional 401(k).
No immediate tax benefit: You won’t get the benefit of lowering your taxable income today.
Uncertain future tax rates: If tax rates decrease in the future, you may have paid more in taxes upfront than you would have with a Traditional 401(k).
My View: Why Traditional 401(k) is Better
1. Bigger Seed Money = Bigger Snowball
When you contribute to a Traditional 401(k), you’re using pre-tax dollars. This means that every dollar you contribute can go directly into your investment without being reduced by taxes. Think of it like starting with a bigger snowball that can grow larger over time. With more money invested from the start, your savings have a better chance to grow through the power of compounding.
In contrast, with a Roth 401(k), you’re investing money that has already been taxed. That means, right off the bat, your “seed” is 22% smaller (or more, depending on your tax bracket). A smaller seed means a smaller snowball, even though your withdrawals later in life are tax-free.
2. Longer Lifespan = More Growth
As people are living longer, it’s important to make sure your retirement savings last. By investing in a Traditional 401(k), your pre-tax dollars are working harder for you over a longer period. When you eventually retire and start withdrawing, you may be in a lower tax bracket, allowing you to keep more of your money. Even though you pay taxes when you withdraw, the larger initial investment often outweighs the tax burden later on.
3. Leveraging Tax Efficiency
Thanks to the way social security and pension taxes are structured, you can only make so much with your taxable income. If you’re smart about your tax planning, you can strategically withdraw from your Traditional 401(k) during low-income years, which may result in lower taxes on your withdrawals. This strategy can extend the longevity of your retirement savings even further
My Own Investment Tips for 401(k)
Diversify Early
If you're young, I recommend a 90:10 stock-to-bond ratio. Taking more risk in your younger years can lead to higher rewards, as you have plenty of time to recover from any downturns. Stocks typically offer higher returns over the long term compared to bonds.Adjust Over Time
As you age, you might want to reduce your stock exposure and increase your bond allocation by about 10% each decade. For example, in your 20s, you might have 90% stocks and 10% bonds, but by the time you're in your 50s, it might be closer to 60% stocks and 40% bonds.Consider S&P 500 Investments
If your 401(k) provider allows it, think about putting your stock investments into the S&P 500. As I discussed in a previous post, the S&P 500 is a simple, diversified way to invest in 500 of the largest companies in the U.S. You can even apply a Dollar Cost Averaging (DCA) strategy that we covered on the last post to ensure you’re buying shares consistently, regardless of market highs or lows.
Conclusion
In the end, I believe the Traditional 401(k) offers more flexibility and growth potential for most people. By contributing pre-tax dollars, you're maximizing the amount of money you can invest, which leads to bigger returns over time. While the Roth 401(k) has its benefits, especially for those who expect to be in a higher tax bracket later in life, for the average person, the Traditional 401(k) is the smarter choice.
Remember, the key to success with any retirement plan is to start early, invest wisely, and adjust your strategy as you age. The sooner you begin, the more time your money has to grow into that snowball you’ll need in retirement.
