Traditional 401(k) vs. Roth 401(k) Calculator

This Traditional 401(k) vs. Roth 401(k) Calculator helps you evaluate which retirement savings option might provide a greater after-tax balance at retirement. By comparing a Traditional 401(k), which offers tax-deferred growth and immediate tax savings, against a Roth 401(k), which grows tax-free after post-tax contributions, this tool considers the impact of reinvesting the tax savings from the Traditional 401(k) option. Using your input on contribution amount, investment growth, and tax rates, the calculator projects balances at retirement to highlight the potential benefits of each plan and determine which yields better after-tax savings at retirement.

Instructions for Using the Traditional 401(k) vs. Roth 401(k) Calculator

Inputs

• Annual Retirement Plan Contribution: Enter the amount you plan to contribute each year to either a Traditional or Roth 401(k) account.
• Years to Invest Until Retirement Plan Withdrawals Begin: Specify the number of years until you expect to start withdrawing from your retirement plan.
• Expected Annual Return (%): Estimate the average annual return rate for your investments (e.g., 8 for 8%).
• Current Federal Income Tax Rate (%): Enter your current federal income tax rate, which affects the Traditional 401(k) tax-savings reinvestment.
• Estimated Federal Income Tax Rate in Retirement (%): Enter the anticipated federal income tax rate during retirement, which will apply to Traditional 401(k) withdrawals and gains on tax-savings investments.

Outputs

• Traditional 401(k) Balance at Retirement: The total pre-tax amount in a Traditional 401(k) at retirement.
• Tax-Savings Investment Balance at Retirement (from Traditional 401(k) option): The total balance from reinvesting the tax savings from Traditional 401(k) contributions.
• After-Tax Total Traditional 401(k) and Tax-Savings at Retirement: The combined after-tax amount from the Traditional 401(k) balance and the tax-savings reinvestment at retirement.
• Roth 401(k) Balance at Retirement: The total amount in a Roth 401(k) at retirement, tax-free.
• Comparison Result: Indicates which option, Traditional or Roth 401(k), may result in higher after-tax retirement savings based on the inputs provided.

Traditional 401(k) vs. Roth 401(k): Choosing the Right Strategy for Better Retirement Savings

Selecting between a Traditional 401(k) and a Roth 401(k) is a significant decision that can impact your retirement savings. Each option has unique tax benefits, but they work differently depending on your current tax rate and anticipated tax rate at retirement. Here, we’ll examine when each option makes sense, how tax rates influence the decision, and the potential benefits of a hybrid approach that combines both.

1. Roth 401(k) is Ideal for Lower Current Tax Rates

If your current tax rate is relatively low (around 15% or less), a Roth 401(k) is often the best choice for maximizing your savings:

• Paying Taxes at a Lower Rate: Contributions to a Roth 401(k) are made after taxes, so you pay taxes upfront. With a low tax rate now, the tax cost on your contributions is minimal, allowing you to “lock in” today’s low tax rate and avoid any taxes on withdrawals during retirement.
• Tax-Free Withdrawals in Retirement: With a Roth 401(k), your savings grow tax-free. This means that when you make qualified withdrawals in retirement, you won’t pay any taxes on your contributions or their growth. This can be especially valuable if you anticipate being in a higher tax bracket when you retire.

For younger professionals or those early in their career, a Roth 401(k) often has the highest chance to outperform because income (and tax rates) are likely to increase over time.

2. Traditional 401(k) Benefits Higher Current Tax Rates — But Roth May Still Be Beneficial

If your current tax rate is higher, such as 20% or more, choosing a Traditional 401(k) might seem like the best choice because:

• Immediate Tax Savings: Contributions to a Traditional 401(k) are made pre-tax, reducing your taxable income for the year and resulting in immediate tax savings. This is valuable if your current tax rate is high, as it allows you to defer taxes until retirement.
• Deferring Taxes: In a Traditional 401(k), taxes are deferred until you withdraw funds during retirement. If you expect to be in a lower tax bracket in retirement, this can reduce your overall tax liability.

However, our analysis shows that if your tax rate in retirement is likely to be close to or higher than your current rate, a Roth 401(k) is often the better choice, as it allows you to avoid taxes on withdrawals. This can be especially advantageous if tax rates rise over time or if you expect substantial income in retirement.

3. Added Advantage of Pre-Tax Savings with Traditional 401(k)

An additional benefit of a Traditional 401(k) is that the tax savings you gain by choosing pre-tax contributions can be reinvested in other assets, providing:

• Additional Growth Opportunities: The tax savings from a Traditional 401(k) can be reinvested in taxable accounts, providing more growth over time. While these reinvestments don’t benefit from tax-deferred growth, they give you more flexibility to diversify your investments.
• Liquidity of After-Tax Savings: Unlike Roth 401(k) funds, which have strict limitations on withdrawals, reinvested tax savings in a Traditional 401(k) are more liquid. This flexibility can be advantageous if you encounter an unexpected expense and need to access some of your savings before retirement. Examples include home purchase, weddings, kids education etc. This liquidity provides additional financial security outside of your retirement accounts.

4. The Hybrid Approach: Combining Roth and Traditional 401(k) Contributions

For those who are uncertain about their future tax rate or who want to maximize tax efficiency, a hybrid approach can be a strategic solution:

• Tax Diversification: By contributing to both a Roth 401(k) and a Traditional 401(k), you diversify your tax exposure. This provides you with tax-free withdrawals from the Roth 401(k) and taxable withdrawals from the Traditional 401(k) in retirement, giving you more options to manage your income and taxes.
• Maximizing Employer Match: Employer matching contributions apply to both Roth and Traditional 401(k) contributions, so you won’t miss out on matching benefits by choosing one over the other. Employer contributions are made pre-tax and treated as Traditional 401(k) funds, allowing for tax-deferred growth on the match portion.

This hybrid strategy offers flexibility, as you can withdraw from the Roth 401(k) during high-tax years and the Traditional 401(k) in low-tax years, helping you optimize taxes on your retirement income.

Summary

• If you have a low current tax rate (15% or less): A Roth 401(k) is typically favorable, as the upfront tax is manageable, and you’ll benefit from tax-free growth and withdrawals.
• If your current tax rate is high (20% or more): A Traditional 401(k) offers immediate tax savings, but a Roth 401(k) may be beneficial if your retirement tax rate is expected to be similar or higher.
• Hybrid Approach: A combination of both Roth and Traditional 401(k) accounts can provide tax flexibility, liquidity, and options to manage taxes on withdrawals in retirement.

Ultimately, the Roth 401(k) provides a powerful option to “pre-pay” your taxes and lock in tax-free income in retirement, offering peace of mind about future tax liabilities. However, as with many financial decisions that require predicting the future, a more balanced or hybrid approach may also be a good option to consider.