Standard 401k Versus Roth 401k (more choices, more confusion)
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 When a person retires with a standard 401k, the funds can be withdrawn and taxes paid, however on a Roth 401k the funds can be withdrawn tax-free.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]