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Traditional 401k vs. Roth 401k – Which is truly better?
Manage episode 378650663 series 2910154
Sisällön tarjoaa Mike Morton, CFP®, RLP®, ChFC® and Mike Morton. Mike Morton, CFP®, RLP®, ChFC® and Mike Morton tai sen podcast-alustan kumppani lataa ja toimittaa kaiken podcast-sisällön, mukaan lukien jaksot, grafiikat ja podcast-kuvaukset. Jos uskot jonkun käyttävän tekijänoikeudella suojattua teostasi ilman lupaasi, voit seurata tässä https://fi.player.fm/legal kuvattua prosessia.
Traditional vs. Roth 401k - Which is truly better?
This week Matt Robison and I put the Traditional 401k and the Roth 401k in a head-to-head battle of the retirement accounts. If you’ve been following this podcast for a while, you are well aware of what a 401k account is a tax-advantaged way to help fund your retirement. Just in case you need a refresher, a 401k, or 401(k), is a retirement savings plan offered by many employers in the United States. It's a valuable tool that allows you to save for your retirement while enjoying potential tax benefits. There are two types of these accounts, a Traditional and a Roth. Which is right for you? Follow the fight to find out.🥊 Round One:Traditional vs. Roth - The Taxes
First up in the ring, the two accounts swap jabs with regard to taxes. One of the primary distinctions between these two types of 401(k) accounts is the timing of tax payments.- Traditional: Contributions are made with pre-tax dollars, which means you don't pay taxes on the money you invest until you withdraw it in retirement.
- Roth: Contributions are made with after-tax dollars, so you pay taxes upfront, but your withdrawals in retirement are tax-free.
So what’s the score? At first glance, it might seem like a wash when it comes to Traditional vs. Roth 401(k) accounts. The math appears to work out the same if your tax rate remains constant throughout your life. If you pay 24% on your contributions now or in 20 years, there is no difference. Math nerd alert - it’s the commutative property: tax x $dollars x compounding = $dollars x compounding x tax. However, there's an important factor to consider: tax drag.
🥊 Round Two: The Sucker Punch - Tax Drag
Unfortunately the simple math above doesn’t work in the real world. Why? Tax Drag! Let’s see how. Warning: The following section might explode your brain. 🤯 Let’s say that you contribute $22,500 to a Traditional 401(k) in 2023. On top of that, you save an additional $10k from your paycheck. Awesome! If instead, you contribute $22,500 to a Roth 401(k) in 2023, you owe more in taxes (this year). Recall that you pay tax in 2023 on that $22,500 of income to enjoy tax-free withdrawals in retirement. This tax, taken out of your paycheck, is 24% x $22,500 = $5,400. Since your paycheck is lower, you can only save $4,600 ($10k - $5,400) So now let’s compare those two examples:- Traditional: Contribute $22,500 and have $10k of savings in your brokerage account
- Roth: Contribute $22,500 and have $4,600 of savings in your brokerage account
- All the money grows at 8% (6% increase + 2% dividends) each year.
- In the Traditional and Roth accounts, it grows tax-free!
- In your brokerage account, the 2% dividends are taxed each year plus the gain is taxed (capital gains tax) when you sell.
- After 20 years, you withdraw all the money from the Roth (tax free) or Traditional (pay taxes on the account balance at 24% tax rate)
| ROTH 401k | Traditional 401k | |||
|---|---|---|---|---|
| Year | Brokerage | Roth 401k | Brokerage | Traditional 401k |
| 0 | $4,600 | $22,500 | $10,000 | $22,500 |
| 1 | $4,946 | $24,300 | $10,752 | $24,300 |
| 2 | $5,318 | $26,244 | $11,561 | $26,244 |
| 3 | $5,718 | $28,344 | $12,430 | $28,344 |
| 4 | $6,148 | $30,611 | $13,365 | $30,611 |
| 5 | $6,610 | $33,060 | $14,370 | $33,060 |
| 6 | $7,107 | $35,705 | $15,450 | $35,705 |
| 7 | $7,642 | $38,561 | $16,612 | $38,561 |
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