Roth 401(K) Vs. Traditional 401(K) And What Is The Best Option

With the advent of Roth 401(k) in the workplace, many individuals are wondering if they should contribute to Roth 401(k) or a traditional 401(k). While focusing on tax strategies is a great idea, deciding on contribution to Roth 401(k) vs. a traditional 401(k) involves predicting your income levels and tax brackets in retirement.

In an ideal world, if tax brackets and income at the time of contribution and withdrawal stay the same, investing in Roth 401(k) vs. traditional 401(k) yields identical results. However, given a choice, picking the conventional 401(k) is the better option.

Traditional 401(k) accounts are funded with money on a pre-tax basis, meaning it comes out of your paycheck before you pay any taxes on it. Your adjusted gross income (A.G.I.) is lowered by the amount you contributed, which could put you in a lower tax bracket.

In a Roth 401(k), you contribute money after paying your taxes. Contributions to the Roth 401(k) also do not reduce your adjusted gross income.

What Is A Roth 401(k)

Why 401(k) Is Better Than A Roth 401(k)

In an ideal world the difference between the 401(k) v/s a Roth 401(k) is just the timing of when you receive the tax break. With a 401(k), you receive it immediately while with a Roth 401(k) you receive the tax benefits later.

Lower Retirement Income Levels

Your income should be lower in retirement compared to when you are working. When you are working, you need money to fund your lifestyle and to save for retirement. Assuming a 30% Savings Rate, your income is 30% higher than your actual lifestyle spending needs. You are only using the income to fund your retirement lifestyle and don’t need extra money to save for retirement. Hence your income needs are lower in retirement.

Upfront Tax Benefit. With a traditional 401(k), you receive the tax benefit upfront. Remember both 401(k) and Roth 401(k) yield the same results only if the rule stays the same. You never know when the government might change taxation rules for Roth 401(k). A bird in the hand is better than two in the bush.

The most common argument I’ve heard in favor of the Roth 401(k) is that tax rates are lowest now. Considering the increasing deficit and our inevitable path towards Modern Monetary Theory (MMT), many folks worry that the tax rate would be higher in retirement.

I’m afraid I have to disagree with that viewpoint. Even if tax rates increase, your tax bracket will be lower in retirement. If you are worried about the government changing the tax rates, a bigger worry could be that the tax break you deferred by opting for Roth 401(k) could be restricted, and you might not get to use it.

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