In 2006, the IRS made provisions under the 401(k) tax code allowing employees whose company provides a 401k, to make their contributions as either “traditional” pre-tax contribtuions, which are deducted from their income taxes, or to make a Roth contributions, which trades the tax deduction received from the traditional contribution for completely tax free withdrawals from their retirement account when they retire. For Example:
1) Employee A makes $75,000 a year contributes of $7,500, or 10% of his income during the year. Because it is regular contribution, when the employee files his income taxes his gross pay is 75,000 – 7,500 = a net income of $67,500 which is what he will owe taxes on less deductions (mortgage interest, number of dependents, etc.) The contribution to his traditional 401k lowers the amount of taxes he will pay for the year. When Employee A retires and starts to draw income out of his 401k account (usually at retirement employees will “rollover”/transfer their 401k into an Rollover Individual Retirement Account with a borkerage firm, bank or some other financial institution) he will pay normal income taxes on each withdrawal.
2) Employee B also makes $75,000 a year, but instead decides to make a Roth contribution of $7,500, also 10% of his income during the year. Because this is a Roth contribution, Employee B does not get to deduct his contribution to his Roth 401k – he pays taxes on the full amount of his salary. However, the Roth 401k which will eventually be rolled over into a Roth IRA when he retires, will provide completely tax free withdrawals during retirement. Keep in mind any growth above his contributions to the Roth 401k is never taxed! By the way, the Roth 401k does not have any eligibility restrictions the Roth IRA carries – anyone may contribute to a Roth 401k regardless of their income. And the contribution limits are the same as for a traditional 401k!
So the question becomes which type of 401k is better, and the answer is – it depends. Before I go into the example below which will illustrate in general, which type of 401k is the better for a particular person, a good rule of thumb is the younger you are (in other words the longer you expect to work before you retire) the better the Roth 401k will benefit you. Put simply, the decision usually boils down to which type of account will save you the most in taxes over the life of your retirement account. Let’s look at an illustration below:
I would highlight the following points this chart dramatically illustrate:
- As you can see above, the younger you are the more the Roth makes sense from how much you will save in taxes when you retire vs. the amount of taxes you save from the tax deduction you receive each year you make a traditional contribution. If you started contributing $7,500 a year at age 25, you would save a total of $75,000 in taxes over 40 years in a traditional pre-tax 401k. Under the assumptions above, in the first 10 years you start taking distributions from the Roth 401k you would save $218,821 in taxes.
- Looking at the above in a different way the accumulated growth of $1,726,127 in the 25 year old’s account is never taxed!!!
- The older you are the less you receive in terms of tax benefits from a Roth vs. a Traditional 401k – for a example a 45 year old starting a Roth 401k would save $37,500 in tax deductions from traditional contributions vs. saving $38,654 in income taxes from withdrawals from the Roth during the first ten years of retirement.
- Lastly, the above exercise emphasizes how important it is to start saving money in a 401k (or an IRA if your company does not provide a 401k) as soon as possible. The amount of time you have to allow those savings to grow has the most impact on what you will end up with when you finally decide to retire or decide to slow down work less to devote time to do things you enjoy.
Please keep in mind I am not a tax expert, and each of you will have your own set of unique circumstances. Consult your tax expert as well as your investment advisor to determine what’s best for you.
If you have any questions please give me call at 760-755-7799 or email me at email@example.com! Also, check out my Facebook page Ward Capital Management and like the page! By the way, for those of you who are self – employed, you can set up an individual 401k to increase the amount you can put away for retirement.