Why Roth 401 (K) Is (Almost) Always Better Than Traditional 401 (K) [update]
Everyone loves a Roth IRA , but there is one drawback: there are income limits starting at $ 189,000 for a couple and $ 120,000 for an individual, which means higher income people must use the traditional IRA or the Roth backdoor. However, it turns out that these restrictions do not apply to Roth 401 (k) s – which means that you can get all the benefits from the employer’s plan and not have to worry about your income ceiling.
But not only those who have high earnings make a profit. Roth 401 (k) – attractive options for everyone. As with the Roth IRA, contributions to the Roth 401 (k) are made after the money is taxed, making withdrawals tax-free and free of penalties, provided you are 59½ and have an account for at least five years. But the bonus is that, just like the traditional 401 (k), you can save up to $ 18,500 in 2018 and up to $ 24,500 if you’re 50 or older, which is significantly higher than $ 5,500 and $ 6,500 allowed in the IRA.
You say it’s great, but investing in Roth means you lose your tax credit now, making it more beneficial for young workers. And it’s true that young workers, who tend to earn less, can get more from decades of tax-free growth than from upfront deductions. But take a look at this graph from T. Rowe Price:
The chart makes many assumptions, including that each investor contributes $ 1,000 to Roth or a traditional IRA, that they are in the 25 percent tax bracket, and that the annualized rate of return is seven percent. And in almost all cases, Roth performs better than traditional, even for older workers.
“The benefits of tomorrow’s tax-free retirement with a Roth IRA far outweigh the benefits of today’s tax deduction and other potential benefits with a traditional IRA,” said Stuart Ritter, senior financial analyst at T. Rowe Price, in the report . … “Even though a Roth IRA contribution does not qualify for an income tax deduction, decades of tax-free accumulation can generate more retirement income.”
The same is true for 401 (k) s, as this example from Kiplinger shows:
Tom and Elaine, 45, are contributing $ 5,000 to their 401 (k) plans. Tom participates in the traditional 401 (k) plan and Elaine contributes to Roth. They continue to work for up to seventy years and do not withdraw until they are 75. If their tax rates and investment income remain equal, Tom will end up with $ 27,404 after taxes on withdrawals, and Elaine will have tax in the amount of 38,061 dollars. free (this example assumes an annual rate of return of seven percent and a tax rate of 28 percent). Even if Tom invested $ 1,400 in tax savings by investing pre-tax money in a taxable account, he would still be $ 2,616 behind Elaine.
And it’s not just that you can get more later using Roth; In addition, traditional withdrawals are considered income, which can further push you into a higher tax tier, which will have a large impact on your Social Security check and Medicare premiums.
Plus, given the low tax rates that are likely to be in the foreseeable future, Roths is more attractive than ever .
You can split the difference and contribute to both Roth 401 (k) and traditional 401 (k) if your employer permits (note that you can contribute in aggregate $ 18,500 or $ 24,500, depending from your age). Check with HR to see if this makes sense.
Correction: Tuesday 10 June 2018 5:50 pm: We have corrected the above story to reflect that you cannot withdraw contributions from your Roth 401 (k) without penalty. This is only true for Roth’s IRA.