Understanding The Differences Between A Roth 401k And Your Traditional 401k
Most physicians will get paperwork sent to them during open enrollment to either continue with their Traditional 401k contributions or to switch to a Roth 401k. The Roth option is also available if you have 403b or 457 contributions.
In this post I would like to talk about how to choose between a Roth or a Traditional option.
The IRS has a decent table comparing a Traditional 401k to a Roth IRA and to a Roth 401k.
If you hate numbers and just don’t want to be bothered by this crap then the ideal option for you is to likely stick to a Traditional 401k, if you have a conventional doctor income and lifestyle. This is the option I have picked for myself as well.
Traditional 401k Overview
If you have your own business then there is a way to have an Solo 401k, for the rest of us a 401k is something offered to us by our employer. It’s one of the shiny benefit packages they use to recruit us. A 403b and 457 is fairly similar and for the purpose of this post you can read them to be the same.
The advantage of offering a 401k is that it is a retirement tool which allows you to funnel money away from your gross income thereby reducing your taxable dollars.
This pre-tax money then sits in the 401k accounts and grows tax-free until you reach age 60. At this ripe age you can take it out without any penalties, otherwise a 10% slap is applied if taken out sooner.
And since you didn’t pay taxes on this when you set it aside in your working years, you will pay income taxes upon withdrawal.
In 2016 the IRS allows you to contribute no more than $18k to a 401k account. So, if you make $118k in 2016 and contribute $18k to your Traditional 401k then you will only pay taxes on $100k. This is why we say a 401k is a good tax deduction.
Your company can even match your 401k contributions. Whatever they match doesn’t count towards your $18k limit. Which means that with a nice match you could have quite a bit more than $18k in your 401k every year.
A Traditional 401k account has money that can be invested in all sorts of investments. Most of us invest it in stocks/bonds where the money grows for many years without incurring any tax at all. Even if you bought and sold within your 401k account you would pay no taxes on gains – very nice.
Finally, once you are ready to use the money in these account, at say age 61 or 70 or whatever, you have to pay taxes based on whatever tax-bracket you fall under at that time.
If you are retired and don’t make any money from a job then your income in retirement is considered whatever money you pull from a retirement account. If you pull $100k out that year then you will pay state and federal income taxes on that $100k. At what rate? Whatever the tax code will be at the time.
A Roth 401k is a little different in that you don’t contribute pre-tax dollars to it but instead after-tax dollars. So if you made $118k and contributed $18k to your Roth 401k you would still be taxed on $118k. Meaning, the downside to a Roth 401k is that it doesn’t lower your taxes.
The advantage to a Roth 401k is that once you withdraw money from the account at the age 60+ you would owe no state/federal income taxes since you already paid that back in your working years.
Otherwise everything about a Roth and Traditional 401k is the same. The matching works the same. The contribution limits are the same. They both grow tax-free, so no taxes owed on any gains you make while they are being invested.
What Will The Tax Code Be In The Future?
If we knew for sure that in 2040 income taxes would be a lot higher then it would make sense to take the hit now and switch to a Roth 401k.
But we don’t know what they will be. Most economists suspect that the US will maintain its progressive tax code with the various tax brackets though of course they will change from year to year.
The U.S. income tax system is considered progressive.
It’s likely that in the future there will still be a tax break for those with lower incomes. Translation: once you’re retired you could still enjoy lower tax rates by simply taking less out of your retirement.
If You Expect To Make More In Retirement
Most of us won’t have as much income as we do now come retirement time. The average doctor still spends a good deal less than $100k in retirement while they make on average $250k in their working years.
But what if you are making less money now and are planning to either make a lot more in retirement or spend a lot more in retirement.
You see, if you spend a lot more, then you are likely withdrawing a lot more from your retirement accounts. If you withdraw $300k every year from your retirement accounts then you are essential earning that much every year as far as the IRS is concerned.
Which is why it makes sense for medical residents to use the Roth option while they are in training. With their petty income during residency they are better off using a Roth 401k because they are in very low tax brackets.
Being in a low tax bracket means that only a small percentage of your $18k would be tax-deductible if you opted for the Traditional 401k.
A resident who is in the 15% tax bracket would be able to write off 15% of their $18k if they chose a Traditional 401k. That’s a savings of $2,700. And since they are likely to be taxed in the 25%+ bracket in their retirement (because they are spending what the average doctor spends in retirement) then they would have lost money going the Traditional route.
The best online calculator I found to help you decide was here at CalcXML. You can play around with it in order to figure out if a Roth or Traditional is better for you. The factors that will affect it are as we discussed:
- tax bracket during accumulation phase
- how much money you make in your working years
- tax bracket during retirement age
You Can Do Both
In some circumstances it can make sense for you to partake in both a Traditional and a Roth 401k simultaneously or consecutively. You could contribute $9k to your Roth 401k and $9k to your Traditional 401k.
However, maybe you started with a Traditional 401k and are nearing retirement age. You are perhaps toying with the idea of early retirement. Furthermore, you have cut back on your work so you are at an even lower tax bracket. In this case it would make sense to switch over to a Roth 401k moving forward.
You Can Access A Roth 401k Early
Because your contributions to your Roth 401k were made with after-tax dollars then you can access the contributions at any age, as long as the account has reached maturity, meaning it has been around for at least 5 years.
However, any gains the account has made would not qualify for early withdrawal unless you paid the 10% penalty on it. If you contributed $45k to your Roth 401k account over the years and you have a gain of $5k from your investments then you may only access the $45k of this $50k account, the $5k would be taxed and penalties owed for trying to access it early.