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Roth or Traditional 401(k)s and IRAs?

Roth or Traditional 401(k)s and IRAs?

Taxes are a large cost when it comes to investing. In the United States long term investments (held 366 days or longer) are taxed at 15% for most people. For those in lower tax brackets long term capital gains are taxed at 0% and for those in the top tax bracket the IRS calls for a 20% cut.

So, if one has $20,000 in gains 15% would be $3,000. In another example $100,000 in gains would be $15,000 paid to the IRS. It’s not an inconsequential amount. Furthermore that amount of gains is very realistic, particularly over a long period of time, $10,000 invested over a period of 40 years with an 8% interest rate would grow to over $217,000.

Fortunately there are ways to shield long term retirement savings from these destructive taxes. One way is a 401(k) and another is an individual retirement account (IRA).

Traditional 401(k)s and IRAs

Many employers offer 401(k) plans. A 401(k) allows pre-tax money (money for which income tax hasn’t been paid) to be invested. Unfortunately the medicare and social security payroll taxes are still due. One can start taking money out of a 401(k) at age 59 and 1/2. Any distributions from a 401(k) (with some exceptions) prior to age 59 and 1/2 will result in taxes being due plus a 10% penalty.

No capital gains taxes are owed when the investments are sold and distributions are made but the money is taxed as ordinary income at the state and federal level.

The main advantage to a traditional 401(k) or IRA is that the money grows tax deferred and it is only taxed once. If one were to simply invest money from a paycheck without a retirement vehicle it would be first taxed at the Federal and State level and then any capital gains would be taxed as well.

For example, if one were to allocate $10,000 from a paycheck to an IRA or 401(k) it would not be subject to any state or federal taxes. It would hopefully grow (lets say at 8% over 30 years). After 30 years it would have grown to $100,626.57 and all the money is withdrawn from the 401(k). At this point (assuming the person is over 59 and 1/2) the money would be taxed as ordinary income. Let’s assume for the purposes of this example it is taxed at the 25% tax bracket, and thus the IRS would be expecting $25,156.64. The total proceeds would be $75,469.93.

A traditional IRA would work the same way with an important caveat. Your employer isn’t aware of the IRA so you will be overpaying in your federal and state withholding taxes in each paycheck (and get a larger refund which I think is a BAD thing), because the income reduction won’t come until you file your taxes the following April. But you can compensate for this by increasing withholding allowances.

This brings up the secondary advantage of IRAs and 401(k)s: they allow you to reduce your taxable income. This can be particularly helpful if one is on the cusp of a tax bracket. For example, lets say you made $40,000 in otherwise taxable income in 2016. If you contributed $4,000 to a 401k, instead of having to pay 25% on the amount over $37,651, you’d be taxed no more than 15% on any earnings that year.

Roth 401(k)s and IRAs

Traditional 401(k)s and IRAs are not taxed initially, but are taxed when money is withdrawn. Roth IRAs and Roth 401(k)s work in reverse. You don’t get any tax benefits initially with a Roth 401(k) or Roth IRA. You use after tax money to save for retirement but you don’t have to pay any taxes on distributions.

If your tax bracket is the same when you put money in the IRA as when you withdraw the money, it doesn’t matter if you have a Roth IRA or a traditional IRA, the tax savings is going to be the same.

However, if you’re in a higher tax bracket later in life as compared to earlier in life, the Roth 401(k)/IRA is better because you can pay taxes at say 15 or 25%, invest the money, it grows tax free, then if you’re in a 35% tax bracket because you’ve made it big and you’re still working at age 59 and 1/2 you can withdraw that money and you don’t have to pay any additional taxes.

Conversely, if you’re in a lower tax bracket when you retire the traditional IRA or 401(k) is going to be better.

But because of the move towards a more socialized society and given the monstrous debt in the US I anticipate taxes will only go up in the future. So I’d rather pay them now when tax rates are lower.

The Advantage of an IRA or 401(k)

Let’s compare a Roth IRA/401(k), to a traditional IRA/401(k), to simply investing the money without a retirement savings vehicle in a regular taxable account. Let’s say you earned $10,000 of W2 income and want to invest all of it. I’m ignoring social security and medicare taxes because there is no way to avoid those on W2 income in the US, for all three scenarios they are due up front.

As you can see, if one is in the same tax bracket when the investment was made, as when the distributions are made, it doesn’t matter if one has a Roth or traditional 401k/IRA. But there is a $10,000 advantage over a non-tax advantaged brokerage account.

Roth or Traditional?

I prefer after-tax, Roth IRAs/401(k)s in general but in specific circumstances using a pre-tax vehicle makes more sense. I like Roths because I can check the balance of my Roth IRA or Roth 401(k) and I know that is how much I would have access to when I achieve an age of 59 and 1/2. I don’t have to figure in taxes. I also hope to be making more when I’m 60 than I am now. Plus, I think taxes are going to be going up in order to pay for unfunded entitlement programs and to pay the national debt (not that I think it is repayable).

I also generally prefer IRAs versus 401(k)s of any kind because with an IRA you can choose a broker that has more investment options than the limited range of choices employer sponsored plans typically allow. Pretty much all the investment options I’ve seen for company sponsored 401(k)s are very limited and are focused in the US.

But I will use a traditional 401(k)/IRA under certain circumstances. 1) If I can use it to get to a lower tax bracket. 2) If my employer offers a 401(k) with company matching–I will contribute to the 401(k) until I’ve maxed out the employer match. 3) If I’ve already maxed out the Roth IRA contribution for the year ($5,500 for a single person under 50 years old in 2017) then I would consider contributing to a 401(k).

Wether you go with a Roth IRA or traditional IRA you can only contribute up to a combined total of $5,500 in 2017 if you’re under 50. If you’re 50 or over you can contribute $6,500.

For 401(k)s the 2017 contribution limit is $18,000 but goes up to $24,000 if you’re 50 or over.

So if you contribute to both a 401(k) and an IRA you could save a total of $23,500 in tax advantages funds ($30,500 if you’re 50 or older).



So in general I prefer Roth to traditional, and I prefer IRAs to 401(k)s. However, if my employer offers matching I take advantage of that.

SEPs, solo 401(k)s

There are other tax-advantaged ways to save for retirement, like a SEP or a solo 401(k). I haven’t taken advantage of these options but it is something I’m researching.

I think saving and investing for retirement is important. But there are some strong headwinds working against folks planning for retirement in the US: taxes reduce income and gains, pensions are becoming a thing of the past, Social Security is woefully underfunded, inflation ravages savings.

Tax-advantaged retirement savings vehicles like IRAs and 401(k)s provide needed advantages when it comes to investing for retirement. It’s important to understand how they work and to make use of the tax-advantaged benefits they provide when suitable.