I Should’ve Gone With Roth 401k!
TL;DR: You can effectively contribute more by using a Roth 401k.
As a refresher, when it comes to your 401k, traditional means contributing pre-tax (you get taxed on all your withdrawals) and roth means contributing post-tax (you get taxed before you can contribute). If you read online, it seems like the only factor considered when thinking about Traditional vs. Roth 401k is whether you think you’re in a higher tax bracket now or in the future. While that’s still true, there’s one more detail when you’re maxing out your contributions.
When you contribute to a Roth 401k, you’re effectively able to contribute more!
What do I mean? To see this clearly, here’s the example. Say Alice and Bob both earn enough to invest $100k a year, and taxes (for simplicity’s sake) is always a flat 25% both now and at retirement. They are buy and hold investors, and they invest in the same portfolios. For simplicity, their investments will double by the age of retirement, and long-term capital gains taxes are a flat 15%. They both contribute the maximum of $19500 to their 401k. There is only one difference – Alice contributes to a Roth 401k, and Bob contributes to a Traditional 401k.
Bob then has $19,500 in his traditional 401k, and $60,375 (rest of his income after taxes) in his normal brokerage account. By retirement, both accounts double – Bob has $39,000 in his 401k and $120,750 in his normal brokerage. When Bob withdraws all his cash, he gets taxed on his 401k at his income level (leaving him with $29,250) and pays capital gains tax on his gains in his brokerage (leaving him with $111,693.75), for a total of $140943.75 at retirement.
Alice contributes $19500 to her Roth 401k, and $55,500 (rest of her income after taxes) to her normal brokerage account. By retirement, both accounts double – Alice has $39000 in her 401k and $111,000 in her normal brokerage account. When Alice withdraws her cash, she doesn’t get taxed on her 401k (leaving her with $39000) and she pays capital gains on her normal brokerage (leaving her with $102,675), for a total of $141,675 at retirement.
Woah what, an extra $700 for no reason?? Where did that come from? That’s some forbidden magic right there! And remember – this is just from one year’s contributions, this adds up every year.
(It’s a fun little exercise to figure out what happened).
Of course, you may protest that your tax liabilities can be different now vs. at retirement, and you’d be right. That’s something you gotta figure out on your own. But if you have no opinion on what tax trends for yourself might be, and you would want to get as much value as possible from your 401k, this is just something else to consider.
Happy Roth’ing!
TheJKW