Traditional vs. Roth 401(k): Which Is Better for Retirement?

today we're going to revisit our old friend catch up kathy and meet her new neighbor rachel roth our ladies are 50 years old earn the same salary and have the same amount saved both also have the same annual living expenses and want to retire at age 65. catch up kathy decides that she'll max out her traditional 401k savings including the full catch-up amount every year between now and retirement at age 65. she wants to grow her 401k as much as she possibly can rachel roth however doesn't want to pay pesky income taxes on withdrawals from her accounts in retirement after all roth accounts are better right therefore she decides that she'll instead make all her ongoing savings into the roth 401k option that her employer offers so who'll be behind at retirement stick around because i think a lot of you might be surprised the original idea behind tax deferred retirement accounts such as the 401 k was that after we stopped working we'll be in a lower tax bracket deferring some of our income taxes until then can turn into a significant tax break over the course of our retirement uncle sam gave up a little tax revenue today to encourage people to save for the future then with the passing of the taxpayer relief act of 1997 the roth ira was born this allowed for the creation of an account that could grow tax-free and was not taxed when money was distributed from it less than 10 years later the tax code was changed again to allow employers to offer a roth 401k option to employees ever since then employees have asked the same question regular or wroth and that's where we find our friends kathy and rachel today for simplicity and consistency we'll again use these same assumptions that we've made in prior videos for all our calculations inflation will be 3 and our expected portfolio returns will be 7 percent again these assumptions are round numbers close enough to historical data for the purposes of our comparison for income we'll assume they each make 120 000 per year to estimate their social security we'll simply input kathy's and rachel's income into the social security online quick calculator to arrive at a monthly benefit we'll also assume that they're both single for retirement portfolio income we'll once again use the four percent rule as always i want to acknowledge that there are some limits to the four percent rule but it's great for these kinds of back of the envelope calculations for kathy we assume she fully maxes out her 401k including catch-up contributions given the current catch-up limit of 6 500 her total savings would be 27 000 this year for rachel we assume she skips the regular 401k contributions altogether instead she'll invest entirely in her roth 401k going forward remember she'll need the exact same amount for living expenses as kathy adjusting for this and taxes put her savings around nineteen thousand one hundred dollars per year it's interesting to see the magnitude of difference between the amounts they're saving ketchup kathy is putting away seven thousand nine hundred dollars more per year than rachel roth of course all those extra savings will have an associated tax liability whenever she makes a withdrawal from her retirement accounts to determine how much kathy and rachel can spend in retirement let's make some assumptions about what they have saved today again we're going to assume that they're a little behind on their retirement savings life could be hard so let's not fault them for that let's say that they have twenty five thousand dollars in cash accounts seventy five thousand dollars in stocks and mutual funds 250 000 in retirement accounts bringing their total investments to 350 000 if kathy and rachel plan to retire in 15 years how much will they have saved at that point given their current investments we can make a simple calculation based upon their savings and projected growth let's not forget to add an employer match for rachel's and kathy's 401k contributions since that's common in the real world let's assume an employer match of 100 up to a contribution of 3 percent given these assumptions we expect rachel roth to have around 1.5 million dollars saved at retirement while ketchup kathy will have around 1.7 million dollars by the way if you want to run these types of calculations for yourself i've created an inexpensive downloadable spreadsheet that you can find at pranawealth.com resources now that we know what kathy and rachel will have saved at retirement let's determine what kind of retirement income they can expect for rachel we know she'll have around 1.5 million dollars saved at that point using the four percent rule we can expect her investments to provide approximately fifty one hundred dollars per month in retirement income adding her estimated social security brings her total income at retirement to around nine thousand dollars of course these numbers are inflated to make a fair comparison we'll have to adjust them back to today's dollars using our inflation rate of three percent we find that equates to retirement income figure of around 5 800 per month for rachel when we compare this figure to her pre-retirement expenses we find that she'll need to reduce her living expenses by around seven percent when she steps away from work to have a sustainable retirement that's certainly not a stretch so how about ketchup kathy knowing that she'll have around 1.7 million dollars saved at age 65 we can expect her portfolio to provide around 5 800 per month at that time however we'll need to make an adjustment for taxes so this is a fair comparison let's assume an effective tax rate of 12 percent for any retirement account withdrawals when we adjust for taxes and add social security ketchup kathy will have around nine thousand dollars per month for her living expenses adjusting for inflation we find that kathy's retirement income in today's dollars comes out to approximately fifty eight hundred dollars per month meaning that she'll have to reduce her living expenses by seven percent as well in retirement nearly the exact same as rachel the effect of taxes makes today's comparison an interesting one in our simplified example we assume a flat 12 percent tax rate on kathy's retirement account withdrawals but is that an accurate number using an online quick income tax calculator kathy's federal effective income tax rate alone is 12 we haven't accounted for state taxes at all so maybe this is what things look like if kathy and rachel live in an income tax-free state here in the peach state her marginal state income tax rate would be 5.75 percent adding that bumps her effective tax rate up to 17.6 percent when we re-run these calculations at this new effective tax rate she'll now need to reduce her living expenses by ten percent instead of seven percent all of a sudden tax rates become the defining variable in this comparison in other words your retirement marginal tax rate should be the driving factor in making the traditional versus roth 401k decision our example today exposes one of the limitations of the four percent rule it doesn't differentiate between different types of accounts for tax purposes if we run a monte carlo analysis for ketchup kathy and rachel roth using this same data we find that they have very high probabilities of retirement success 81 and 83 respectively of course these numbers don't factor in one-time expenses like home improvements car purchases nursing home care costs or simply changing their retirement spending as they age in today's comparison we again find that our two retirees end up in a similar place using different means for those weighing the question of roth 401k versus traditional 401k the question becomes will your taxes and retirement be sufficiently high to make the roth 401k option best interestingly it may be your state taxes that wind up being the determining factor another consideration to factor into this decision would be other sources of taxable retirement income if you're expecting to have taxable pension income or even taxable executive compensation such as defined benefit plan payments this could be a determining factor as well unfortunately there's no easy rule of thumb when it comes to deciding between traditional 401k contributions or roth 401k contributions it's best to work with your financial planner and cpa to weigh your options if you're retiring with different types of accounts i recommend that you watch this video that discusses four factors to consider when choosing which accounts to use first in retirement thank you so much for watching and i'll see you in the next video

Channel: Prana Wealth

Views: 143,995

Keywords: financial advisor in atlanta, financial planner in atlanta, fee only financial advisor, fee only financial planner, Patrick King, Prana Wealth, retirement planning, financial planning, retirement, financial advisor, financial planner, personal finance, how to retire, traditional vs. roth 401k, roth 401k vs traditional 401 k

Id: hW_3PKX7pl4

Length: 9min 43sec (583 seconds)

Published: Thu Feb 03 2022