Should You Save for Retirement in a 401(k) or Roth IRA?
All things being equal, saving the maximum into a Roth option provides the greatest chance of high, after-tax income during retirement.
Q: My son is 23 and is working full-time for what I consider to be a pretty decent salary. He’s always been a bit of a saver, and he recently asked me if I thought he should contribute to his employer’s 401(k) plan, or if he should instead save in a Roth IRA? What is your advice?
A: Your son is wise to start saving at such a young age. For most of us, it’s difficult to get into the habit of putting money away, so it’s great if we can begin when we have our first “real” job.
The question of whether to use a pre-tax savings plan, such as a 401(k), 403(b), 457, or a traditional IRA, or to use a Roth option, is not an easy one to answer. That’s because there are so many variables that it’s impossible to predict future outcomes.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Your son’s employer-sponsored retirement plan will provide him with a current tax deduction on whatever he contributes, up to a maximum of $18,000. The money invested within the plan will grow tax-deferred for decades, but when he reaches retirement age, everything he withdraws will be taxed as ordinary income, and at whatever the rate that ordinary income is being taxed at in the future.
These tax-deductible retirement plans have been around for decades and have been endorsed by many experts based upon the premise that most people will find themselves in a lower tax bracket once they retire. With that in mind, it would seem to make sense to take that tax deduction today and defer paying the government its share until later.
The problem with this argument is that many of the best savers actually find that they are not in a lower tax bracket during retirement. The fact is that, because they’ve saved and invested well, many retirees end up paying much more in taxes once they leave the workforce than they did during their working years.
The Roth option—whether it’s a Roth 401(k) through his employer or a Roth IRA funded outside of work—takes a different approach. A saver receives no tax break for the funds deposited today, but the money is withdrawn tax-free during retirement.
All things being equal, saving the maximum into a Roth option would provide the greatest chance of high, after-tax income during retirement, and here’s why: The problem with traditional retirement plans that offer a tax deduction is not the plan itself, exactly, it’s with the behavior of the person who is contributing to the plan. That’s because the tax savings provided by the plan is rarely set aside for the future. Instead, human nature, being what it is, means that the higher take-home pay usually gets spent.
Here’s an example: Two people work for the same employer. One contributes the maximum into the traditional 401(k), while the other contributes the maximum into the Roth 401(k). Both amass $1 million in their plans and then retire.
So who is better off? The person who used the traditional 401(k) had a larger paycheck each month because of the tax break (but as mentioned earlier, she will, in all likelihood, spend that extra take home pay), and so she now has $1 million that will be fully taxable when she withdraws and spends the money. With that in mind, that million-dollar plan may be worth “only” $750,000 once the taxes have been paid.
The person who used the Roth 401(k) may not have had as large as a paycheck while working, but she now has a retirement plan that will be free of taxes. The $1 million in retirement savings will not be degraded in any way.
So, to answer your question, because your son has begun to save so early in his career, I think the Roth is a better option.
The caveat is that no one can predict what tax rates will be like in the future. Will we move to a flat tax? Will Congress adopt a lower income tax burden along with a national sales tax? Will Roth withdrawals be taxable for higher income retirees?
Because it’s impossible to know what will happen, I believe it’s prudent to diversify tax strategies in the same manner one diversifies investments. Ideally, it would be great to reach retirement with some funds in a traditional 401(k) or IRA, some money in a Roth, funds in a brokerage account, perhaps some real estate, and so on. (Of course, this level of diversification is the reason why a good saver will likely find his or herself in a higher tax bracket once they retire: more income from more sources.)
So, given all of the uncertainties of the future, rather than choose one retirement plan option, I would recommend your son contribute equally to both the traditional 401(k) as well as a Roth IRA. He has roughly 40 years until he reaches retirement age and, no doubt, a lot will change by then. With that in mind, having some diversity with his tax-advantaged retirement plans seems the best route to follow.
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit www.MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.
To continue reading this article
please register for free
This is different from signing in to your print subscription
Why am I seeing this? Find out more here
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit HansonMcClain.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.
-
Stock Market Today: Nasdaq Soars Ahead of Tesla Earnings
The EV stock rose nearly 2% ahead of its highly anticipated Q1 earnings report, due after tonight's close.
By Karee Venema Published
-
GM Stock Accelerates After Earnings Beat
General Motors beat expectations for the first quarter and raised its outlook for the year. Here's what you need to know.
By Joey Solitro Published
-
Pros and Cons of Waiting Until 70 to Claim Social Security
Waiting until 70 to file for Social Security benefits comes with a higher check, but there could be financial consequences to consider for you and your family.
By Patrick M. Simasko, J.D. Published
-
How to Stop Boredom From Ruining Your Happy Retirement
Retirees who explore new interests and have an active social life are more likely to find joy — and even greatness — in the newfound freedom of retirement.
By Richard P. Himmer, PhD Published
-
The Life-or-Death Answers We Owe Our Loved Ones
How our life ends isn’t always up to us, but that question too often must be answered by loved ones and health care workers who don’t know what we would want.
By Joel Theisen, RN Published
-
Is 100 the New 70?
Eating well, exercising, getting plenty of sleep and managing chronic stress can help make you a SuperAger. Funding that long life requires longevity literacy.
By Phil Wright, Certified Fund Specialist Published
-
Nine Lessons to Be Learned From the Hilton Family Trust Contest
Disclaimers, good communication, post-marital agreements and more could help avoid conflict in a family after the owners of a wealthy estate pass away.
By John M. Goralka Published
-
Strategies to Optimize Your Social Security Benefits
To maximize what you can collect, it’s crucial to know when you can file, how delaying filing affects your checks and the income limit if you’re still working.
By Jason “JB” Beckett Published
-
Don’t Forget to Update Beneficiaries After a Gray Divorce
Some states automatically revoke a former spouse as a beneficiary on some accounts. Waivers can be used, too. Best not to leave it up to your state, though.
By Andrew Hatherley, CDFA®, CRPC® Published
-
Charitable Remainder Trust: The Stretch IRA Alternative
The SECURE Act killed the stretch IRA, but a properly constructed charitable remainder trust can deliver similar benefits, with some caveats.
By Brandon Mather, CFP®, CEPA, ChFEBC® Published