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.

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:

 

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