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Traditional 401k vs. Roth 401k – Which is truly better?
Episode 1193rd October 2023 • Financial Life Planning for Busy Parents • Mike Morton, CFP®, RLP®, ChFC®
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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

Transcripts

Matt:

What do you mean, you can't do two cold opens in a row there's no like statutory limit like

Mike:

I thought there, we thought there was some IRS ruling about only one cold opening a week.

Matt:

I am going to, you're gonna have to refer me to the sexy new tax code we're talking about. Hey, I'm Matt Robison and that is my co host, Mike Morton, this is financial life planning, and we are talking about the world's wimpiest smackdown. Do you think our editors can put in a little echo effect where I just said this, you want to call this one, smackdown? I want to, is there like a level down from smackdown? It's sort of like a tickle fight. We're gonna have a tickle fight between a traditional IRA and a Roth IRA, a traditional 401 K and a Roth 401K. It's, it's not exactly WWE, folks. Okay, like, wrestlers, this is a tickle fight. This isn't how coded versus I don't know, I I'm losing people Triple H is that a guy? Good guy. Sure.

Mike:

Triple J, Triple P, whatever.

Matt 1:07

Sounds good but wait, why do you why do you want to have a smackdown?

Mike:

I don't know. Brackets just came, it just came to me it smacked and one versus another? Traditional versus Roth. Let's go. And this is you know, it could be the start of our brackets that we're going to eventually get to, this is a little preview.

Matt:

When when you said smackdown all I could think about was that song The Final Countdown. Did you know that we have a rule in our family that if anyone says The Final Countdown, everyone else has to immediately start going but it up duh duh.

Mike:

Even in public?

Matt:

Well, we do like to spread it on one another. If you you do want to do a little compare and contrast. This is really useful for me, because I've been doing the show with you for a while, I still kind of lose the story on traditional versus Roth. So can you start to lay it out for me, traditional vs. Roth.

Mike:

Alright, these are 401 K's. Now, this could be a 403B, those are employer retirement accounts. Okay, so we're not talking about the individual, the IRAs, we've talked about traditional Roth IRAs and stuff, we're talking today… we're talking about employer retirement accounts, 401K's, 403Bs, etc… Many times, you know you have the option between traditional contributing to the traditional side with a Roth side of that employer retirement account. So what I mean between Traditional and Roth now is this didn't used to be a thing so much, Matt, it's great that it is a thing now, when 20 years ago, you really just had the traditional, that's what everybody's used and everybody's been doing. So it's a great time to bring this up, especially for the younger listeners, or the busy parents.

Matt:

I think it's super interesting for me, because I became aware of 401K's at a time where this was not a thing, as much as you and I have talked about the concept of Roth and I'm still like I can't get it out of my mind, every time you bring up Roth, I think of Hyman Roth from Godfather Part Two, and I think of shirtless Hyman Roth sitting in… anyway, it's totally…

Mike:

I think you’re the only person on earth who does that.

Matt 3:20

What's wrong with you? Of course I think of Hyman Roth, of course. All right, of course. But anyway, so this is very useful.

Mike:

You're absolutely right. And it comes up all the time, because we didn't grow up, you know, grow up with like the Roth, sorry, it was this traditional 401k. That's great. I got a 401k, let's put money in there and then you think about it 20 years later, 30 years later.

Matt:

So I'm not sure I even knew there's an option. So what we're talking about here is you go to work, and you're given a benefit, a perk. And usually there's like a match. There's an employer match. And so we've talked before on this, like if you've got a 401k max out your contribution to the level that the employer will match, of course, free money density of arithmetic. But you're saying that there is this other option? That's, it’s sort of news to me that I think I knew this maybe, but maybe.

Mike:

The audacity of mathematics? Is that what you said.

Matt:

What I said is the audacity of arithmetic. This is like Barack Obama except a lot less inspiring.

Mike:

Okay, traditional versus Roth traditional, it's when you get taxed. Alright, when you pay taxes on the money, you put in money in the traditional 401k you do not pay taxes on that money. So your salary is $100,000 and you put in $20,000 to your 401K, so you only pay taxes on $80,000. Cool, so you just didn't pay taxes on the 20 grand that you put in there, it's just gone.

Matt:

It's now it's in the 401k.

Mike:

You didn't pay taxes, you pay taxes on 80 grand, so actually your taxes are going to be pretty good. You probably get a little bit of a refund or your or your paycheck is a little bit higher than it might have been because of that so that's great. You will pay taxes eventually, the IRS always taxes your money one time, one time only, you don't get double taxed except for if you have a C-Corp, if you’re an owner of a C-Corp, but they're probably not listening to this podcast at the moment. But if you are, you can get in touch you do get double taxed on income for your owner, your C-Corp. So IRS tax is your money once, except for what is our one of our favorite accounts Matt? The HSA is never taxed. Okay, so 401 K's you’re going to get taxed once I just told you it wasn't taxed when you put it in the traditional 401k. So it's going to get taxed when you take it out. So in retirement, you take money out of your 401k, you pay taxes.

Matt:

To me, this is like our new wrestler is going to be triple T traditional taxed, take it out, traditional taxed when you take it out.

Mike:

There you go. Did you come up with that on the fly?

Matt:

I just came up with that on the fly.

Mike:

You’re amazing, alright.

Matt:

This is why I allowed myself to be promoted to co-host.

Mike:

That's why I pay you the big bucks. Alright, the traditional is taxed when you take it out, roth is exactly opposite. You pay tax when you put it in, so you pay taxes when you put it in. And then when you take it out, it's not taxed. Now neither of them is taxed while the money's inside the 401k and grows, you have interest, dividends, growth, you change funds, all tax free when it's inside the 401k, no matter which side. So on the Roth, you make $100,000, you contribute $20,000, you're still taxed on $100,000. So your paycheck is less so here's a good thing to know about if you contribute to the traditional, your paycheck will be $20,000, you're getting $80,000. But they're taking taxes out of the Roth view to the Roth choice, you're getting $80,000, you get $200,000, but you put in 20 grand. So you get paid on $80,000, right. So either way, you're getting paid $80,000, because the other 20 is going into the 401k, but your paycheck will be more if you contribute to the traditional because you're taxed on $80,000 versus the Roth, you're going to be taxed on $100,000, even though you only get $80,000.

Matt:

All right, so Roth is right up front, traditional taxes when you take it out, there you go, there you go, this is all I literally am going to accomplish for the rest of the day.

Mike:

But look, you've already gotten something done today, you feel good, you feel good.

Matt:

But your point is, the thing to understand about your paycheck is that distinction you were just making, with traditional your paycheck is going to be higher,

Mike:

Because less taxes are taken out because you got paid as you're kicking the can down the road on taxes, and this is important, it's going to come up towards the end of this episode, that's why I kind of mentioned it up front. So either way, you're saving 20 grand for the future tax now, tax later. All right, that's the difference between Traditional and Roth. Now, of course, the natural question everyone's question, which one's better? Which one should I do? I'll give you the really satisfying answer, Matt, you know what it's going to be?

Matt:

Great. Oh, Gosh, darn it. It depends, let's get into it.

Mike:

Yeah, that's pretty good. Now, the first thing to think about, pay, we've said it before on the show, pay taxes when your tax rate is lowest. Okay? That makes sense, you want to like you'd rather have instead of having zero income and paying zero taxes for, say, three years in a row, and then having $500,000 of income and paying $500,000, which is a top tax bracket for three years in a row, you'd rather smooth it out, can I just make $200,000 a year, and pay less taxes right throughout time. So pay taxes when your tax rate is low. Alright, so keep that in mind. So typically, it would be, hey, I'm working now, I'm making really good money. So my tax rate is higher. But in retirement, my tax rate will be lower. I'll tell you, that might not be the case, alright, so we'll get to that. But let's just talk about the math to not pay tax on your tax rate. First, let's assume your tax rates the same, let's say you're in a 24% tax bracket. Now, you're going to be in the 24% tax bracket later. So Traditional and Roth are going to be exactly the same. It won't matter. Okay. That's the simple math.

Matt:

You know what's funny is I remember doing this exercise in economics class, I remember it, I remember doing it, that if if your tax rate is the same, that the math ends up the same, you know what I think we should do? This is tough for people who are doing the dishes, in the car, whatever. You know what I suggest? Let's just take Mike's word for it. Read that back, so we don't have to do any math in the course of this show. Maybe a little tiny bit but I'm taking your word for it. Let's stipulate. If your tax rate is the same now and later and the math is the same, there's no difference whether you choose traditional versus Roth 401K.

Mike:

I want to bring in some of my math.

Matt:

But if you don't want to follow now is a good time for a pee break or to really scrub that pot. Go ahead.

Mike:

It's just fun, because if you have kids, you know, you've been reminded of the commutative property recently, which you can switch around.

Matt:

Depends on how good your kids school is. But that's right.

Mike:

So it's all multiplication, it's the amount you save $20,000 times the compounding over 20 years times the tax rate. And now whether you put the tax rate at the start, or at the end of the equation, multiplying those three things together gives you the final number. So the commutative property, that’s the same exact same number.

Matt:

That actually makes sense, because it's like a PEMDAS thing, right? It's like, your multiplication is going to work out what's inside the parenthesis.

Mike:

Alright, I can cut right through, there you go. Okay, so that's why if the tax rates are the same it won't matter. Now, that's the simple math version. But that's not the way the world works. Because of taxes, taxes are not easy, they're very complicated. So what really happens, this goes back to the paycheck, you're going to put in the same $20,000, whether you put in the traditional side, or the Roth side. So it's not like you're putting less money into the Roth, that would be the commutative property, hey, I pay taxes now. So I only put in 16 grand, I had to pay 20% taxes, but that's not the way it really works in the real world. In the real world, you see, I'm putting in $20-$22,500 is the max for this year, that you can do into one of these accounts, if you're under the age of 50. So you put in $22,500, the difference is, when you go to file your tax return, I told you your paycheck is going to be less when you go file your tax return, you're going to owe an extra $5,000 of taxes. So that's where you pay the taxes. Does that make sense? I think so, I think so. So in either case, you're going to have $22,500, inside the 401k, then it's going to compound and it's going to compound exactly the same over 20 years, then when you take it out your Roth, you don't pay any taxes and the traditional, you're going to pay a bunch of taxes, because you pay taxes at the end. Okay, so how do we do the math, then, because it's not what I just told you, you're not putting less into in the compounding. Alright, and the way you do it is actually your paychecks higher, if you put money in the traditional, you might have more savings that you can do there. So that's how we have to do the apples to apples comparison, I'm putting $22,500 in each of them. But in my Roth version, I have to pay extra taxes, I have to pay an extra five grand of taxes from my taxable savings. And so therefore, the Roth wins, and this is where you're going to have to trust me, because I don't want to go through the numbers, you can go to the webpage when the episodes up, I'll have a table of how the numbers work out. And you can see there, but in other words, you have to pay more taxes, so you have less in your savings account. And then that savings account has a tax drag, we talked about that in the last episode, it's got a tax drag, because it's taxable account. So that's where the Roth wins, you end up with an extra $6,000 bucks in your Roth, if you go to the website, check out the tables. That's what it comes out to.

Matt:

I see. Alright, well, let me, can I kind of take this upper level, because what you said before, I thought was a really helpful shorthand, which is the reminder, pay taxes when your income is low.

Mike:

Salary isn't when you get your tax rate or income is low. Right, when your tax rate is lowest, right.

Matt:

And the kind of like the simple version I was thinking about was, I always tried to figure it out by taking things to extremes, it makes it a lot clearer for me, right. And if I were making a million dollars a year, right now, then presumably, my tax rate is high. And if I assume that when I'm retired, I'm going to live simply, and then I'm going to assume that my tax rate is low. So I would want to pay my taxes later therefore, I would want to be in a traditional 401k.

Mike:

Boom that’s it 100%.

Matt:

But if the reverse is true, if I'm young in my career, and I'm taking like that, that first, second job out of college, I'm building but I'm in an industry where I anticipate that my income is going to be much higher later and therefore I might establish a standard of living where when I retire I'm going to be in a higher tax bracket then is the reverse true, I know that my tax rate is low now so I should be doing Roth 401K right now get in while the getting as good.

Mike:

100% you got it.

Matt:

Well, then why isn't this more straightforward?

Mike:

I mean, the reason the reason why it's not more straightforward is because you're you got the extremes there, but most people are in the middle. Hey, I'm not like I'm in that 24% tax bracket, am I going to be higher or lower? I'm not sure. So I'm setting the stage here, we're going to talk about some of the extremes and some of the other stuff, but I want to set the stage that even if your tax rates exactly the same now, and in the future, Roth is still better. So it tips the scales towards using your Roth 401K. So it's not as simple as the first math. I told you the simple math. Oh, no, they're the same. Not true. Because we have taxes. Okay. So even if your tax rate is exactly the same now, and in the future, the Roth wins. Are you ready to create your ideal lifestyle? Let's discover what's most important to you and design a plan to have more of that in your life? Go to meet Mike morton.com. All one word, meet Mike morton.com.

Matt:

Can I just point out that this is exactly why this isn't a smackdown and it's a lot more of a tickle fight. It is very ticklish, very tricky. Okay, explain this to me, then, when I retire the IRS is going to treat the money I take out from my various accounts as income, right? So that's what's going to set my tax bracket at the time, right?

Mike:

Yes, now here. So this is let's go back to the thing I said earlier, it's oh, when I'm retired, I won't have any income, I'll be in super low tax bracket, of course. So I always want to do traditional, here's the thing to think about, you're saving money for the future, you just said, Hey, I should be in traditional saving money for the future or pay tax in the future. If your standard of living is spending $100,000 a year, then when we get to retirement, you still want to spend $100,000 a year, you might be in the same tax bracket, you still need $100,000 A year. So that would all be income, I still need $100,000 of income to support my lifestyle. So I still have $100,000 of income, it's coming from your traditional accounts, maybe from your social security, which is taxed at various rates. And so you still have $100,000 of income, so your tax rate might not be that different in retirement.

Matt:

I see. Okay, well, that's a very helpful distinction. So then, alright, so then let's get to why does Roth win?

Mike:

Well, Roth doesn't win, I was just pointing out that even in the case of tax rate, it stays exactly the same, the Roth wins, that goes along with complicated math, I don't really want to be on the podcast, but it's because you're saving in your after tax, which is a taxable account versus getting the money into a Roth where 100% of it grows tax free. Alright, so even if your tax rate would be the same, the Roth is a better place to be. Now it gets even more complicated that we said you're I don't know what your income is going to be in retirement, but probably not as little as you think it might be. Because you've built up like you and I, we've been putting in traditional accounts for decades. So they've grown very large, and we're going to have to take money out of them. And so you got these RMDs and other stuff where you know, you're going to have quite a bit of income and be paying taxes on that, there's other reasons that it gets even more complicated. What about inheritance? Are you going to leave this money to somebody else? If you do, the Roth definitely wins because if you leave this to your kids, and they're in the prime working years, then they have to pay their high tax rate, you know, they were making that million dollars, guess what, all that money, they have to take it out during that 37% tax rate. And so the Roth definitely wins in that case, if you plan on leaving some money behind and then also the Roth 40K for high earners. Remember, you can't put into a Roth individual retirement account, so you can't save directly into a tax free account. So the Roth 401K might be a great place just to get more money into a tax free account, because there's no income limits for contributing to a Roth 401K. But there are income limits for contributing to the Roth IRA. So there's a lot of factors to really think about traditional versus Roth. It's not, it's definitely not easy. And it gets even more complicated. The more you start thinking about it.

Matt:

All right. How about this Einstein? What do I do? Alright, I just call you every time I've got a problem, you know what to do with it.

Mike:

I'd be inundated with phone calls. You know, when people listen to this, they'd be calling me up, man, don't do that.

Matt:

Go to your website. I'm sure you've explained it all there. All right, so what do we actually do?

Mike:

So how do we sort through this? Yes, it can be complicated. I will say sometimes it's worth hiring an advisor, like if you get to a stage, it's like, geez, I'm not really sure. There's a lot of moving parts here. Yeah, this is complicated, alright, but let's break it down. You mentioned a couple of them, when you're young, you're probably in one of those lower tax brackets. Go Roth. All right, you're never going to be sad having tax free forever money, that you've paid the taxes that happened two years ago, you've already pulled the band aid off and pay taxes. And now that money is growing tax free forever. So I love that. If you're young, you find yourself in a little bit lower tax bracket, go 100% Roth. And on the flip side, that seems that seems pretty, pretty low or no regrets.

Matt:

It would be the rare person who's young, making a ton of money now and then somehow in a low tax bracket later.

Mike:

Yeah, I mean, that's the most likely the case. Alright, but we'll get to some of those other ones if you find yourself young, making a ton of money. I'll tell you another form that you can think about, and the flip side is true, Matt, you already mentioned it. What about those sorts of right towards the end of their career, mid to late career making really good incomes? Yeah, that's the time that you want to be more in tradition, you're probably in those higher tax brackets. Now, I will say we're in historically low tax brackets. Now, no one likes to hear this, because no one likes taxes and their pay so much in taxes between federal and state and everything else. And it's true, okay, but if I show you a graph, historical tax brackets, we are in by far the lowest bracket. Now, if you go with the Roth, you're paying taxes, now. It's getting rid of that tax rate risk, one of the risks you have is that tax brackets all go up, they are going up in a couple of years with the top the tax cuts, job acts, I can never get the the right acronym, but it's going back up in a couple of years. And it might even go higher if the government wants more money, they're just going to raise tax brackets. So just be aware of that by paying in the Roth, now, you're getting rid of some of your tax rate risk.

Matt:

Got it? Okay, so far in this tickle fight, it really feels like Roth is winning.

Mike:

I tend to really like Roth accounts. Again, the biggest reason that I like Roth accounts is getting rid of the tax rate risk, and also that it makes people feel good. Like I pulled the band-aid off, I paid five grand of extra tax taxes now to never have to pay taxes on that again, the other reason is Matt, a lot of people in our situation, we've already mentioned this have a large tax deferred account, hey, it's been great, I've been a great saver, it's been compounding it's grown to a million bucks in my 401k. And you have nothing in the Roth. One of the reasons I like Roth also is more tools in the toolbox. When it comes down to that retirement, we want to pull out you mentioned it paid pay taxes when taxes are low. If we have tax deferred accounts, tax free accounts, taxable accounts, if I got some money in each of those, I can pull each of those levers at the right time to maintain a nice tax bracket. So it's more tools in the toolkit later on to manage that stuff.

Matt:

I see. So if you if you have all of that you could decide their minimum distributions and whatnot. But you could at various times distribute more from traditional more from Roth et cetera. And that just gives your future self a better ability to manage your tax situation.

Mike:

That's right. Let's talk about that for a second, we're gonna have a future episode on Roth conversions. And this is what really comes in, I have so many clients that are about to retire, there was no Roth account, when they're growing up, they've got $2 million in their traditional account, and they've got a few $100,000 in their brokerage account, but like nothing in Roth, okay, so you got 2 million that's tax deferred, you owe taxes on the $2 million dollars. Well, when you retire, typically you have some years before those RMDs kick in required minimum distributions where you have to take money out. So we do as we manage it, we take out, we convert maybe $100,000. And then you have $100,000 of income at 12% or 20-22% tax bracket really low kind of tax bracket. So that's where we can use the tools to help maintain and keep that nice tax rate. So we can talk more about that in a future episode. But again, having the tools in the toolkit, like you just said, we get to decide how much to take from the Roth IRA, how much to take from the traditional 401k when you're in retirement to manage your tax brackets.

Matt:

Got it? All right. I think this is giving me a hazy picture at least. As much as I would like to say there is a clear winner raise a hand, there really isn't a clear winner here. It is complicated, but there are at the very least what I'm taking away from this is you should have a Roth account. And you should give yourself that option value and you should think heavily especially if you're on the younger side, the lower earning side. Now, just think heavily about getting some money in there.

Mike:

Yep. I'll give you a couple of takeaways. You're young, go with a Roth. Okay. If you're older and you're in those max earning years, really consider the traditional with the caveat that if you don't have much Roth, I would really think about that. I also use the 24% tax bracket, I'll throw this out as the kind of not a rule of thumb. But something to think about 24% per tax bracket is a pretty, not that high of a rate 24%. So if you're right around there, that's where I think it becomes more complicated, sort of in there less than that Roth, you're going to feel really good about it. If you're in a 35% tax bracket, you're blown through the 24% bracket, traditional is probably going to be the way to go for you.

Matt:

Got it. All right, and I'm gonna give my contribution takeaway here. Roth, remove right away, traditional, taxed when you take it out, Triple R, triple T. I might even remember that and that's my big one. Anything else?

Mike:

We didn't even get to after tax contributions. It's a whole other topic, Matt.

Matt:

Let's, let's save it for a whole nother topic. Alright. Well, on that Mike Morton, I’m Matt Robison, we will see you next time.

Mike:

Thanks, man. Thanks for joining us on financial planning for entrepreneurs. If you liked what you heard, please subscribe to and rate the podcast on Apple, iTunes, Google Play Spotify, or wherever you get your podcasts. You can connect with me at LinkedIn, or Morton financial advice.com. I'd love to get your feedback. If you have a comment or question please email me at financial planning pod@gmail.com. Until next time, thanks for tuning in. This recording is for informational purposes only and should not be considered for investment advice. Opinions expressed as our of the date of recording. Such opinions are subject to change. We do not guarantee the accuracy or completeness of the data presented here.