Roth vs Traditional 401(k)s: Which Is Right For You? (EP.150)

0:28We all need to make smart decisions with our money. how you save, but also how your money grows and is taxed over time. Given the ever-changing landscape of tax laws and financial strategies, understanding which option best aligns with your financial goals is more crucial than ever. Welcome to The Long-Term Investor, proud member of the Retirement Podcast Network. As a reminder, you can find show notes and links to all sorts of great resources at thelongterminvestor.com. Now, let's start with the fundamentals of these two types of 401k plans. Both Roth and traditional 401k accounts allow you to grow your investments tax-free, which is a fantastic benefit, but the way they handle taxes on your contributions and withdrawals is quite different.

1:17First, the traditional 401k plan allows you to make contributions before any taxes are taken out of your paycheck, hence the term pre-tax. It reduces your taxable income now, meaning you pay less in taxes today. So, for example, if your income is in a bracket taxed at 35 % and you contribute$10 ,000 to a traditional 401k, your taxable income is reduced by that$10 ,000 because every dollar you contribute to a traditional 401k reduces your current tax bill. However, when you retire and start withdrawing the money, those withdrawals are taxed as ordinary income. And this includes both the money you initially contributed and any of those gains the contributions have earned.

2:06On the flip side, we have the Roth 401k. Here, you contribute after-tax dollars. So continuing with the previous example, if you're in that 35 % tax bracket and you want to contribute$10 ,000 to your Roth 401k, you need to earn about$15 ,385 to have$10 ,000 left after taxes. The benefit is that once that money is in your Roth account, it grows tax-free and you don't owe any taxes on it when you make withdrawals in retirement. That means both your initial investment and the gains it has earned are yours to keep. Tax-free. So which is better? When it comes to deciding between a Roth and a traditional 401k, there are a couple factors to consider.

2:56The first, of course, being tax implications. If you expect to be in a higher tax bracket when you retire, paying taxes now on a Roth might save you money down the line. Conversely, if you anticipate being in a lower tax bracket in retirement, deferring those taxes with a traditional 401k could be the way to go. But this isn't just about predicting future tax rates, which is already a challenge, but it's also understanding how your income and deductions might change over time. For example, you're going to eventually have income from Social Security or required minimum distributions or maybe even a pension if you have a defined benefit plan.

3:38Whereas maybe you're no longer going to have mortgage interest to deduct, or your charitable contributions change, or the education or retirement savings accounts that you've been contributing to and getting deductions no longer are going to have those contributions and related deductions. So it's all very difficult to predict. Another essential factor in making this choice between Roth versus traditional is the power of tax-free growth. So with Roth accounts, since you've already paid taxes on your contributions, both the contributions and the gains they generate are entirely free from tax when you withdraw them in retirement.

4:18And this is a significant advantage if you expect your investments to grow substantially over the years, either because of higher returns, which can be hard to predict, or easier to predict, multiple decades of compounding. And that's where your career stage can play a pivotal role in choosing the type of 401 contribution. For professionals in their 20s and early 30s, the raw 401k is often the more appealing choice. Why? Well, because you likely have decades ahead for your investments to grow, the tax-free withdrawals on potentially higher future balances can be hugely beneficial. Plus, younger workers are often in a lower tax bracket now than they will be later in their career or at retirement.

5:05As you move into your late 30s and 40s, the decision becomes a bit more nuanced. You see, this is a time when many individuals approach their peak earning years and move into those higher tax brackets. And here, the immediate tax deduction offered by a traditional 401k can be particularly valuable. because reducing your taxable income at this stage could save you significant money on taxes each year. But where things get less clear is whether the amount of time your savings have to compound will offset the current tax benefit versus a future tax benefit. Then, as you approach retirement in your 50s and 60s, your accumulated wealth and impending retirement plans become key factors.

5:49If you've been primarily investing in Roth accounts up to that point, you might enjoy considerable tax-free income in retirement. However, this might also put you in a lower tax bracket than expected, which could shift the advantage back towards having some traditional tax-deferred savings. But at all career stages, there can be a case for a mix of Roth and traditional contributions, a strategy known as tax diversification, to help manage future tax liabilities. The idea is that by maintaining both types of accounts, you provide yourself with more flexibility to manage withdrawals and taxes based on the tax rules and your financial situation when you retire.

6:33Now, while tax diversification sounds appealing, it's not diversification in the traditional sense. Instead of reducing risk by spreading it across uncorrelated investments, tax diversification links outcomes. What benefits a Roth hurts a traditional account when tax rates rise, and vice versa. It's a bit like taking all the potential for market movement off the table, akin to almost holding cash. With this in mind, instead of a fixed diversification strategy, consider a tax timing strategy that adapts your contributions to your tax bracket over time for potentially better outcomes. Contrary to trying to time the market, timing our tax situation can be far more predictable and beneficial.

7:22Our tax brackets change due to life events and career progression, offering opportunities to optimize our contributions. So you'd consider allocating more to Roth accounts in low-income years or after retirement and favoring traditional accounts when in higher tax brackets. Now, this approach doesn't guarantee success, but it can lead to a significantly greater accumulation of wealth over time. So how do you make the right 401k choice for your financial future? To summarize, whether you opt for a Roth or a traditional 401k depends on multiple factors. Your current and future tax rates, your career stage, and your retirement goals.

8:06Both account types offer significant advantages, but the best choice for you will hinge on your specific financial situation as well as how you anticipate it to evolve over time. Knowing when to contribute to each type of account can be a delicate balance, but it's not the account type alone that will secure your financial future. Remember, a good savings rate can offset a lifetime of poor financial decisions. And what this means in the context of Roth versus traditional 401k is that making consistent contributions is often more important than the fine details of tax optimization. Yes, choosing the right account type matters, but the act of saving diligently, no matter the account, is what truly builds wealth over time.

8:54And so for those looking to refine their saving strategy, I have a number of links up on the longterminvestor.com with some practical tips, but just to rapid fire, I think if you start early and contribute regularly, the compounding of gains over time is a really powerful ally. And then adjust as you go, because as your income and tax situation change, so too should your retirement saving strategy. And lastly, consulting with a professional is always helpful, given the complexities of predicting future financial landscapes. Working with a financial advisor can provide personalized advice tailored to your specific situation.

9:33As always, thanks for listening. And if you found today's discussion helpful, please consider subscribing to our podcast on your favorite platform and share it with your friends or colleagues or whoever you think might benefit. We're here to help make complex financial concepts accessible and actionable for everyone. And don't forget, for more in-depth analysis and practical tips, visit the long-term investor.com.

10:26informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.