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VTEngineer2001 (< 20)

Standard 401k Versus Roth 401k (more choices, more confusion)

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October 18, 2007 – Comments (6)

A standard 401k allows and individual to put funds in tax free, while a Roth 401k makes this same individual pay taxes on the funds going into their 401k. When a person retires with a standard 401k, the funds can be withdrawn and taxes paid, however on a Roth 401k the funds can be withdrawn tax-free. In otherwords, with a standard 401k you pay in the rear, and with a Roth 401k you pay upfront. So far, this is easy....but...

Which is better?

Tough question, but it seems to depend on the expected rate of return and years till retirement. Great, two variables....

Individual 1: Standard 401k value of $100k and he puts 10% of his $75k salary in every year (no salary increase for ease of calcs) equals $7.5k every year. Assuming an 8% rate of return for 25yrs yeilds $1.233 million. Since taxes must be paid and assuming 33% in taxes, the net windfall is around $826k.

Individual 2: Same numbers except he has a Roth 401k. His monthly investment shrinks to $2475 assuming 33% in taxes. Again compounding this for 25yrs at 8% annually yeilds $866k, but since taxes were paid up front, the net windfall is $866k.

A difference of $40k, or $1.6k every year. Big deal, right? 

Now, keeping everything the same and using the S&P's historic average of 11% yeilds a difference of over $150,000! Okay, this is a good chunk of money.

Now, change the rate of return to 5% and the standard 401k earns more by approximately $10k. What the.....?

Personally, I'd take a chance at getting $150k more and losing $10k. So, it looks as if there is potentially more upside with a Roth 401k versus a standard 401k. Solving for the break even rate of return (where the net return of a standard and roth 401k are the same), I get roughly 5.87% using the parameters above. For other time frames the break even rate of return is approximately:

20yrs ---> 4.56%

25yrs ---> 5.87%

30yrs ---> 6.59%

35yrs ---> 7.00%

40yrs ---> 7.26%

The reason why the rate of return creaps up with the years till retirement seems to be that the standard 401k has compounding strength on its side, since an individual is initially putting in more money. Therefore, if you think that you can walk away with a year over year return greater than what is shown, you should switch to a Roth...

...at least this is my understanding...I need a drink! 

[financial wizards reading this, please eliminate my confusion] 

6 Comments – Post Your Own

#1) On October 18, 2007 at 7:21 PM, QualityPicks (22.57) wrote:

To complicate things further, you have to consider your current income and your income at retirement. If you earn a lot now and might not earn much when you retire, you are better off with the regular 401k. The average person in this boat, so the regular 401k is a better option generally speaking. Your case might be different.

Since it is difficult to know you how your investments will perform, and what your tax bracket will be when you retire, another thing to consider is blending a standard 401k with a Roth IRA. Say, put $5,000 in your 401k and $3,000 in your Roth. That way, when you retire, you can blend your income, by taking as much out of your 401k while still staying in the 15% bracket (for example), and then take the rest from your IRA, which won't impact your income for tax purposes. That way, you are putting money in the 401k tax deferred (at 33% tax rate), and then when you pull it out, you pull it out at 5 to 15% tax rate.

 

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#2) On October 18, 2007 at 7:37 PM, dbhealy (32.85) wrote:

thanks for doing some of the grunt work for me - i'm going to be faced with this exact scenario in the very near future, and your blog post reminded me that i need to figure out what kind of 401(k) i'm going to use!!

fyi, here's a good article on contribution rules around 401(k)'s - i wasn't aware you could contibute to both types until i read it:

http://www.bankrate.com/brm/news/sav/20050518a1.asp

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#3) On October 18, 2007 at 10:28 PM, MakeItSeven (31.82) wrote:

The calculation is wrong on the tax rates.  With the correct tax rates, the 401K plan is almost always better.   Also, compounding will help the 401K plan.

Let's  assume the 2006 tax rates will be used.

Assuming the scenario for Individual 2 is correct and the 7.5K he contributes is taxed at 33% tax rate.  That means he is living in a state with almost 8% income tax (for amount of  income above 50K, say).

 At retirement, let's say Individual 1 only withdraws the 8% yearly profit and leaves his $1.233 million alone.  That gives him an income of $98,640.  Using the 2006 tax rates, he will have to pay about $21,727 in federal income tax and roughly 6% in state tax (since the 8% tax rate does not apply to all of his income, only amount over 50K).  His after tax income will be around $70,995.

If Individual 2 does the same thing then he can get $66,080 in income, almost 5K less each year or 100K less in 20 years.

Other factors which might affect this calculation:

- High medical expenses (which might be common at retirement) will help Individual 1 deducting his tax.

- If the two retirees withdraw large amount of money each year, much more than their income before retirement then Individual 1 will be hit with the high tax.  However, normally, they would want the 401K to last at least 20 years, in that case, Individual 1 will do better.

- If you can count on it, SS will push Individual 1 into paying more taxes.

In most cases, a retiree will have lower income than when he is still working, so Individual 1 will come out better.

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#4) On October 18, 2007 at 11:11 PM, Imperial1964 (98.29) wrote:

Obviously, it gets very complicated given that you don't know your tax rate for the rest of your working years or your retirement.

The reason I chose a Roth 401k is the same reason I chose a Roth IRA.  The figures for the IRA are simpler:

I can stuff $4k into either type of IRA.  With a Roth, I have already paid the taxes, so the $4k taxes-paid is much more valuable than $4k tax-deferred.  Also, with the Roth IRA I can withdraw the principal at any time, penalty free!  That is especially important if you, like me, want to retire early.

Does anybody know if you can withdraw the principal early from a Roth 401k without penalty? 

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#5) On October 19, 2007 at 7:10 AM, MakeItSeven (31.82) wrote:

Imperial, 

Yes, it will be very complicated but it all boils down to how much money you're making now vs how much you will withdraw each year when you retire.  For example, saving earlier or saving more will leave you with a bigger 401K account (i.e. bigger retirement income) and end up paying more taxes when you retire.

But, assuming you save in such a way that your retirement income is slightly less than or equal to your working income (the usual advice) then traditional 401K has a slight edge since not all of the money you withdraw each year in retirement is taxed at the top tax bracket (relative to your income level) whereas all of the money you put into a Roth 401K is.

BTW, if you are really rich when you retire then you might want to give money to charity if you don't really need that much money.  In that case, the 401K-based donation will be truly tax-free whereas the Roth 401K-based donation is already post-tax :).

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#6) On October 19, 2007 at 8:48 AM, VTEngineer2001 (< 20) wrote:

MakeItSeven:

I already have a Roth IRA that is (knock on wood) doing well. So, if I understand what you are telling me, I should stick with a standard 401k? It seems to me that there must be some break point (rate of return) where the taxes pulled out at payment will cancel out the benefits of compounding (as I tried to show above) for the standard 401k. Similarly, there must be some point where the benefits of not paying taxes in the rear outweighs paying them upfront. Do you know where I can find such information?

Thanks,

-Scott.  

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