Learn about one of the most powerful tools that savvy young investors use to generate serious wealth. Early in your career, the Roth 401K provides a great way to minimize your future tax bill and maximize your future net worth. Consider this your one-stop-shop for Roth 401K questions, concerns, and strategy.
What is a Roth 401K?
I know. Another seemingly nonsensical name for one more retirement account that you never knew you needed. Just what you were hoping for! To complicate matters further, this one sounds almost the same as two different types of accounts: the Roth IRA and traditional 401K. Fear not. We’ll break it all down today.
The Roth 401K is a tax-advantaged account offered through an employer. It’s a unique hybrid account that mixes benefits from both the traditional 401K and Roth IRA. We’ll dig further into the distinctions between these accounts below.
Like the traditional 401K, the Roth 401K allows contributions up to $19,500 per year as of this writing (excluding catch-up contributions). These contributions may also be split between a traditional and Roth 401K as long as the aggregate amount falls under the annual limit.
While the Roth 401K is less widely offered by employers than the traditional option, it’s gaining significant traction. Employee adoption, however, seems to be lagging. Data indicate that ~70% of employers offer Roth 401K’s, but under 20% of employees choose this alternative.
Should I Invest in a Roth or Traditional 401K? (Quick & Dirty Answer)
This is one of the most common questions that I receive from new workforce entrants. I will provide detailed analysis and example case studies throughout the remainder of this post regarding this topic. But some of you are probably unconcerned with the details. You want the quick answer. And that’s fine, here it is:
- If you expect that your future tax bracket will be higher than your current tax bracket, invest in a Roth 401K
- If you expect that your future tax bracket will be lower than your current tax bracket, invest in a traditional 401K
Much more detail and nuance below.
Comparing a Roth 401k with a Traditional 401K
Similarities
Both a traditional and Roth 401K are types of tax-advantaged retirement accounts. This means that investors are rewarded with tax benefits simply for prioritizing their retirement savings. These accounts are both offered by employers. In other words, do not log in to an account on Charles Schwab or Vanguard and expect to find an option to create a 401K. Enrollment in these programs is handled through an employer’s HR department or a third party provider enlisted by an employer.
Furthermore, both accounts carry the same maximum annual contribution limit ($19,500 at the time of this writing). This cap prevents higher earners and ambitious savers from shielding even greater portions of their income from taxes. Finally, the investment options available within a Roth 401K and traditional 401K are made up of the same set menu of choices. Typically, these will include a variety of mutual funds and target date retirement funds. Try to stick with the lowest-cost passively managed index funds offered.
Differences
While both accounts offer powerful tax advantages, these benefits manifest themselves in different ways. The traditional 401K allows investors to kick the proverbial tax can down the road. All traditional 401K dollars are contributed pre-tax, meaning that the contributions lower an investor’s taxable income in the eyes of the IRS. This is especially beneficial for high-earners due to the progressive tax system that the US employs.
Sound too good to be true? It is. Remember that regardless of which type of account you utilize, Uncle Sam always takes his cut sooner or later. Traditional contributions grow tax-free, but withdrawals are taxed as ordinary income in retirement.
Conversely, the Roth 401K allows employees to invest for retirement with after-tax dollars. These investments then grow tax-free for the rest of an investor’s life. To emphasize, all future growth and withdrawals in retirement are exempt from any future tax expense. In effect, pay Uncle Sam now and never pay him again.
Comparing a Roth 401k with a Roth IRA
Similarities
These are also both types of tax-advantaged retirement accounts. From a tax perspective, the Roth 401K and Roth IRA are almost identical. When you hear Roth, I want you thinking “pay taxes now…avoid taxes later.”
Investments in both of these accounts are made with post-tax dollars. While they don’t provide any near term tax relief, all gains, dividends, and interest grow tax-free while in the account and aren’t taxed upon withdrawal in retirement either.
Differences
Put simply, the Roth IRA offers greater flexibility than the Roth 401K.
A Roth IRA is opened by an individual rather than through an employer. As a result, there are no set menus of investment options to limit investors like we see in a Roth 401K. Roth IRA investors can open an account with a brokerage firm and invest in just about any type of security. With a Roth IRA, investors are also able to avoid required minimum distributions. Conversely, a Roth 401K requires an individual to start taking distributions at age 72.
[Cash Snacks Note: There is a convenient way to capture the benefits of a Roth IRA if you initially invest into a Roth 401K. By “rolling over” a Roth 401K into a personal brokerage account after you leave an employer, you can effectively transform a Roth 401K into a Roth IRA and enjoy enhanced flexibility.]
Additionally, the Roth IRA account allows investors to withdraw contributions at any time. With a Roth 401K, investors incur a penalty / tax to withdraw funds in advance of retirement. Note that any gains on Roth IRA investments are still subject to penalty / tax if withdrawn prematurely (excluding certain special circumstances).
There is one more critical difference between the two: eligibility requirements. Here, the Roth 401K shines. It allows individuals to contribute regardless of annual income whereas Roth IRA eligibility phases out for high-earners above certain thresholds.
So…should I Invest in a Roth or Traditional 401K? (Detailed Answer)
It depends. We could include a lot complexity, math, and scenario analysis to answer this question precisely for each individual situation. But let’s try to boil it down in simplified terms that you’ll actually remember. As mentioned above, it all comes down to evaluating your current tax bracket versus your future tax bracket. Generally speaking, if your future tax bracket will be higher than your current bracket, invest in a Roth 401K. If not, invest in a traditional 401K.
For young professionals just starting careers, this often means the Roth 401K wins. Think about it. Most people toil near the bottom of an organization’s totem pole in the first few years of their careers. They accept lower wages and more demanding schedules in the hopes of earning more attractive titles and compensation down the road.
There are, however, exceptions to every rule. Research your career path and trajectory. Map out a loose plan to evaluate your income today compared to your expected income in the future. There are also a variety of unique life events, situations, and decisions that may drastically alter your tax bracket over time. Below, we’ll dive into some real world examples and special considerations that may impact your Roth versus traditional 401K decision.
Real World Examples
Example 1 – Billy goes to Business School
Billy is a high-earning young consulting professional who plans to attend business school. He’s only a year out of college, and will likely earn a much higher salary in 10 years. Given this fact pattern, you might be tempted to say that Billy should prioritize Roth contributions since his tax bracket will be much higher in the future.
But there’s actually a compelling case for Billy to maximize his pre-tax contributions. Here’s why. Billy will generate no or limited income if he pursues his MBA full time.
This provides a unique tax arbitrage opportunity. He can convert pre-tax accounts such as a traditional 401K into post-tax accounts such as a Roth IRA. While this will require a tax payment today, it is an attractive time to incur this tax hit because Billy’s income is artificially deflated during school. This same framework could be extended to other unique family situations. For instance, individuals planning to temporarily leave the workforce to raise newborn children.
Example 2 – Trish Retires in Texas
Now consider Trish. She’s a couple years out of school and works at a reputable tech firm in New York City with lots of room for future compensation increases. Trish has enjoyed her time on the East Coast and plans to continue working there in the near future. But she’s also decided that she’d ultimately like to retire close to where she grew up in Texas to be closer to family.
Despite the fact that her income will likely rise substantially, it might still make sense for Trish to contribute to a traditional 401K versus a Roth 401K. Why?
In doing so, Trish minimizes hefty state and city taxes that would have been incurred in New York. Then, she can withdraw these funds in Texas where she’ll face no state or city taxes. This strategy can be utilized as part of a larger geographic arbitrage plan if she’s particularly motivated to capitalize on discrepancies between living expenses across different areas.
This concept could be applicable for anyone temporarily working in an area with high local taxes that plans to retire in a low or no-tax region.
Example 3 – Freddie First Year
Freddie graduates from college in May and starts his first job in July. This means that during his first calendar year as a full-time employee, Freddie will only show a half year of income. Even if he’s crushing it with an $80k starting salary, the IRS can only tax the $40k of wages he earns this calendar.
Here, a Roth 401K almost always wins. Freddie’s tax bracket will likely never be lower. Assuming he avoids getting fired, the odds are quite high that he’ll earn more next year and into the future.
[Cash Snacks Note: The same theory applies to summer internships. While you won’t have access to a 401K plan as an intern, you may still open an individual retirement account at a brokerage. You’ll most likely be better served contributing post-tax dollars to a Roth IRA rather than pre-tax dollars to a traditional IRA since you worked for such a small portion of the year.]
Creating a Tax Strategy that Mitigates Regulatory Risk
This is a more advanced concept, but it becomes increasingly relevant as your retirement accounts grow.
Many tax / public policy experts hypothesize that elevated government spending and a widening deficit will lead to increased future tax rates across most or all brackets. As a result, investors who subscribe to this line of thinking might favor post-tax retirement contributions regardless of what future tax bracket they see themselves occupying. They’d rather get tax payments out of the way ASAP since they assume all rates will be higher in the future anyway.
The catch? No one actually knows what will happen. In an unlikely (but theoretically possible) scenario, Roth accounts could ultimately be subject to additional taxation if the government finds itself in dire straits.
Recognizing this uncertainty, many savvy investors hedge their bets. For instance, you could split retirement contributions by putting 50% in a traditional 401K and 50% in a Roth 401K.
I tend to fall somewhere within this camp. I think of diversifying my tax strategy similar to the way I embrace a diversified investment portfolio. It may not lead to the most optimal outcome, but I think the cap that it places on downside is worth the trade-off.
Key Roth 401K Takeways
The Roth 401K is an extremely powerful tool for young investors. Its tax efficiency is perhaps matched only by the Health Savings Account. If your employer offers one, it likely makes sense to begin contributing early and often!
Additionally, remember that your tax and investing strategy will not remain static over the course of your life. Special circumstances (some of which we discussed above) will dictate your unique action plan. Tax optimization can be a complex and technical topic, and I would always suggest consulting with a professional tax expert when making any of these decisions.
No matter if you choose a Roth 401K or an alternative tax-advantaged retirement vehicle, realize that you’re making more progress than most young professionals. Try not to get overwhelmed by the nuance. As Winston Churchill once said, “perfection is the enemy of progress.”
Don’t let perfection be your enemy. Pick a direction and take action today!