The Verus Team

The 401K or the 401K Roth?

Written by: Derek Majkowski. Any opinions are those of Derek Majkowski and not necessarily those of RJFS or Raymond James.

Every financial advisor has to disclose that they do not give tax advice, and I don’t.  That said, every financial advisor also has to be aware of the tax features when it comes to a particular investment or investment strategy.  

One of the more frequently asked questions that I get is around the features and benefits of different retirement accounts or plans.  Often I am asked to explain the different tax trade-offs of each, and which I happen to prefer as a saving and investing tool.  

Over the years, my opinion has shifted a bit around how I look at the features and benefits afforded those that invest in traditional IRA or 401K retirement accounts when compared to those of investing in a Roth IRA or 401K Roth.  I have long been an advocate for savers to try and maximize their annual limit into their respective employer sponsored plan, or retirement account, and for years my instinct and advice would often be to maximize the current day tax deduction by maximizing one’s 401K contribution.  More recently however, I have started changing my tune, or at least become more balanced and thoughtful on the topic.

To understand this shift, it is important to put some context around this subject.  To begin, the original thought with traditional IRAs, or more importantly 401Ks (introduced in 1978), was to reduce your taxable income today in order to withdraw from the account at a later date.  The idea was that you were operating in a higher tax bracket today, so reducing your taxable income made sense, and then your money would grow tax-deferred and be withdrawn later in life when your tax rate was theoretically at a lower tax rate.

In addition, the limits that one is able to contribute to a 401K has grown over the years, and after age 50, people are able to add catch-up contributions.  While this does reduces someone’s current present day income, what we are finding is that the size of many of these traditional 401K accounts are getting quite large in size.  In fact, a large percentage of individual’s savings are in these tax deferred accounts, and once the income needs to, or must be turned on at age 70 1/2, the size of the distribution is relatively large, and does not provide much of the tax benefit that one may have expected.

With the introduction of the Roth IRA in 2001, and later (2006) employers were able to offer a combination of the features of a Roth IRA with that of a 401K.  The difference being that the contributions, like a Roth IRA, would be from after tax income, but the contribution limits would work like a 401K.  An individual did not have an income limit with an employer sponsored 401K Roth plan.  Once invested, the funds could grow tax-deferred, and ultimately be distributed later in life (post 59 ½) tax-free.  

The obvious trade-off is that the individual would be taxed on the additional income as received, and the net would go into the investments.  This distinction cannot be ignored.  If you assume an individual over 50 maxing out a 401K at 24K pre-tax, that would be the equivalent of approximately 37K of pre-tax income if you assume a max 401K Roth contribution (assuming a 35% tax rate).  For someone over 50, you could see a 10-20K a year difference depending on your personal tax rate.  This is an assumption, but you can see that it would require more to make that contribution.

That said, if you assume that $24K grew at a compounded annual rate of 5%, then that 24K in either account (all else remaining constant), would be worth approximately $63.6K in twenty years.  Assuming you needed to take the full distribution at the end of twenty years and your tax rate is lower (assume 25%).  The net proceeds from a traditional account would be $47,700 vs. that of $63,600 from the Roth.  

In this example, a difference of almost 16K, the tax hit is even higher if your rate does not drop, or the future tax code (always a possibility) is different.  Assume also, you don’t want to take the distribution.  The IRS doesn’t mandate a withdrawal from a Roth, but it does from a traditional retirement account when you are no longer working or contributing to a 401K plan.
So which is better, pay the tax now or pay the tax later?  

The ultimate answer obviously lies with someone’s unique and personal situation.  It also depends on how much time someone has to let their money grow.  I tend to think that the longer the runway, the more likely the 401K Roth looks advantageous.  

Lastly, and perhaps one of the main reasons my opinion has charged on the traditional 401k vs. the Roth 401K, is that there is less flexibility with the traditional 401Ks.  While we are all looking for ways to save money on taxes, when we are working and earning money, we are generating an income that we live off.  The tax bite, while noticeable as we look at w-2s each year preparing for our tax filing, is not really as impactful to our daily life and spending habits.  Later in life, when it may be more important to utilize those funds for actual support, the tax impact may be more detrimental.  

When assisting clients with financial planning and reviewing assets, everyone is proud of the nest egg that they built up over time with their retirement funds.  It is worthy of praise, and a discipline that has been committed to over a long period of time.  When reviewing the balances inside a traditional 401k or IRA, it is important to highlight that in real terms, those funds are actually a lot less than what we see.  The reason is because of the fact that taxes still need to be paid in order for someone to use those funds.  

In other words, what you see is not what you get..

Unfortunately, that is a reality that is sometimes lost when we review all of our assets, and a big reason why I’ve been taking a closer look at the 401K Roth.  


This information has been obtained from sources considered to be reliable, but we do not guarantee that the material is accurate or complete.
Unless certain criteria are met, Roth account owners must be 59½ or older and have held the account for five years before tax-free withdrawals are permitted. The examples provided are hypothetical and have been included for illustrative purposes only. The examples provided are not intended to reflect the actual performance of any particular security, future investment performance cannot be guaranteed and investment yields will fluctuate with market conditions.