The Truth About the Roth 401k and the Traditional 401k

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Roth 401k and the Traditional 401k“If you contribute to a Roth 401k, all the money can be withdrawn at a later date completely tax-free. If, however, you put that same amount of money into a Traditional 401k, it will be taxed and you’ll only end up with 2/3 of your nest egg. This is why you should contribute to a Roth 401k every time.”

What a crock of bull.

I’ve heard Dave Ramsey say this about a hundred times and it still ticks me off. This statement actually bothers me so much that I’ve decided to dedicate this entire post to prove it wrong and to educate all of you readers on the actual facts of the Roth 401k and the Traditional 401k.

I’ll teach you:

  • what makes them different, and
  • what the benefit is of having one vs. the other

The Truth About the Roth 401k and the Traditional 401k

The Roth 401k was first introduced in 2006 and was modeled after the Roth IRA. The benefit of course, is that you’d be able to invest your money directly from your paycheck into your retirement account, PLUS you’d be able to invest a greater amount since it’s under the 401k designation and not the traditional Roth IRA (as of 2017, you can contribute a maximum amount of $18,000 into the 401k vs. just $5,500 into a Roth IRA).

Ugh, this is already getting boring isn’t it?? Hang with me! 

So what Dave is saying in the quote above is that the Roth is better because you can withdraw it tax free. Well that’s great and all, but you still have to pay taxes on that money FIRST, which means that you’re putting less into your investments in the first place.

In other words…

  • instead of investing pre-tax money into a traditional 401k and paying tax later, you’re
  • investing after-tax money into a Roth 401k and not paying any tax when it’s withdrawn.

The Interesting Math of the Roth 401k and the Traditional 401k

So what’s the real difference in the end? Does it really matter if you choose the Roth 401k over the Traditional 401k?

For most of us….probably not.

And here’s why:

Roth 401k and the Traditional 401k

…there is absolutely no difference between after-tax growth and the tax-free growth of the Roth 401k and the Traditional 401k . Your $500 a month will still net you $2.4M after 40 years whether you pay taxes on it now or pay taxes on it later.

I told you it was interesting!!

3 Reasons Why I Invest in the Roth 401k

So, if the dollars are the same in the end, what’s the big deal about the Roth 401k? And why do people (like me) choose to invest in them over the Traditional 401k?

I can’t speak for the entire human race, but I know that I actually have 3 reasons why I invest in a Roth 401k instead of a Traditional 401k:

  1. My company matches my contribution and puts the money into the Traditional 401k, so I figure it’s best to diversify my tax position and make sure that roughly half of it goes into the after-tax Roth 401k bucket.
  2. I’ll probably earn more in my retirement than I do right now, so I may as well pay the taxes while I’m in the low end of the tax-table.
  3. This country’s finances are messed up, so I figure taxes as a whole are going to go up when I get older (I mean, how else do we expect to get out of the $20 trillion hole we’re in…?). And, if that’s the case, I may as well pay the lower percentage now!

Contrary to Dave Ramsey’s belief, there really isn’t that big of a difference between the Roth 401k and the Traditional 401k in the end, but the reasons above move the needle just enough for me to invest into my Roth 401k.

The Most Important Takeaway

When you looked at the table above, did you notice what $500 a month turned into after 40 years?

….$2.4 million!!

Cha-Ching!!

It didn’t matter whether Jim or Suzy (or Bob or Billy or Harry…) put their money into an after-tax or before-tax investment account. What mattered is that they started! If you want to have big bucks in your retirement, then start investing ASAP!!

What did you learn from this article?  And what do you have to add?

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13 comments to The Truth About the Roth 401k and the Traditional 401k

  • We favor a traditional 401k and use Ruth’s for diversification, but you hit the nail on the head. It’s all about your tax bracket when you plan to touch the money. Diversification is also important as you never know if the government will change the laws at some point,

  • Derek, nice start, I have a number of points on which The David and I disagree, and this is one as well.

    But. The conclusion about can use some scrutiny. I have little issue with the assumption that deposits go to the retirement accounts while one is in the 25% marginal rate.

    (Although, to be fair, I often start the discussion by figuring that one starts their savings while at 15% or lower. Why? Keep in mind, for a couple, it takes a gross $96,700 in 2017 to have the next $100 taxed at 25%. So this assumption, 25%, means we’re talking to the top 26% of earners (2014 census data). I also don’t want to miss that we should help encourage teens to start saving young. My daughter’s Roth was opened when she was 13. Now, almost 19, she has over $25K in her account.)

    Now, at the back end. Unless we assume there’s also a huge pension coming (which opens up a different discussion), retirement withdrawals start at 0%, the combined standard deduction and exemptions, then 10%, 15%, etc. $2.5M would provide a $100K/yr income. And due to the rate structure, a tax bill of $11,278. Barely in the 25% bracket, but an average rate of 11.3%. Not the forecast $25K in the graphic above. I’d also suggest that this same couple would have used the Roth for any 15% income or below, and so the $2.5M becomes a too-high estimate. They’d end their a savings with a nicer mix.

    As a TL:DR I’d say “don’t assume withdrawals at 25%. It takes a high income from pretax accounts to get that high a marginal rate. Deposits go in at the marginal rate, but withdrawal flow out starting at dollar ‘zero’.”

    • Good points, JT. So this might sway the favor slightly into the Roth 401k court, but not by much. I may up my contribution at some point, but for now I still like the idea of being heavy in real estate. Once the market corrects, then maybe I’ll up my Roth 401k allocation.

  • I’m doing a mix – Roth 401k, Trad 401k and Roth IRA. At the end of the day, it probably doesn’t matter…

  • Kathy

    I have great respect for Dave Ramsey’s advice on how to get out of debt. I have NO respect for his investment advice. He totally fails to take into account someone’s personal situation. For example, my mother lived through the depression and was/is highly suspicious of the stock market. She put money in treasury bonds and CDs which Dave call certificates of depression. She would have gone crazy with worry about any money in the stock market, even through mutual funds, of which Dave is a big fan.

    • Right?! Dave definitely has just one blanket investment advice statement… That is all. But yes, I have great respect for Dave as well, but you know what? Not everyone knows everyone.

  • […] This week in the blogosphere, I came across a few great posts on a popular topic, Roth IRAs. Life and My Finances walks through the differences and benefits in “The Truth About the Roth 401k and the Traditional 401k”. […]

  • Craig4871

    Derek – I always understood Dave to mean to invest the SAME NET AMOUNT (not sure why I am shouting) in a Roth 401k vs a Traditional 401k when you have the option. Instead of $375 Net in the Roth 401(K) I understand him to mean for you to put in the entire $500…so $625 would have to come out of you pay(assuming 25%). In your example, each Investment Balance Total would be the same at $3,162,039.79 at the end of 40 years but the Traditional 401(k) would owe $790,509.95 in taxes whereas the Roth 401(k) would have only paid $60,000 in taxes up front ($125 x 12 months x 40 years). T401(k) = $2,371,529.84 Net, vs R401(k) = $3,102,039.70 Net. That’s just shy of 3/4 of a million more dollars in your Roth 401(k). Am I not understanding Dave correctly or is my math way off?

    • Hi Craig. Thanks for the comment. Your math is a little bit off, but we’ll roll with it.

      You’re right, Dave does mean that you should put in the same amount after tax, but he just never says it. The way he makes it sound is that you don’t have to pay anything more out of pocket today and you can end up with a much bigger pot of money in the end. BUT, if you DO put in $625 a month and contribute a net $500 a month after taxes, then absolutely you’ll have the same amount invested in the end and owe no taxes!

      It’s a beautiful thing. All you have to do is part with the money now and let it GROW!

      • Craig4871

        Me again – since you seem to know what you are talking about and respond so quickly perhaps you can answer me a question that led me to your blog in the first place. Hypothetical scenario: I contribute $10,000 to my Roth 401(k) this year, my employer match is dollar for dollar (also $10,000) but they are required to put that in traditional 401(k) account…if I understand it correctly. My question is, can I convert my employer contribution to my Roth side? Can I somehow bring A) all $10,000 employer match over and pay the $2500 outright on my taxes so my Roth will now be $20,000 or would I B) only be allowed to convert $7500 to Roth because $2500 taxes would be withheld and my Roth account would now be $17,500 or C) Other, or D)this is a stupid idea just let them grow independently and don’t over think it Craig?

        • Hi again Craig. That’s an AWESOME question. I’ve heard it only a handful of times and I’ve heard it answered differently each time. It’s my understanding that the 401k match could potentially be converted to the Roth 401k, but that it’s company dependent. In other words, you might get a different answer from one company to the next. If you can move it, you’ll be taxed on the conversion based on your income tax rate.

          Ha, just so you know, I’m in option D. I’m not overthinking it and I’m just letting them grow independently of one another. There may be times in my retirement where I’m earning practically no money, so then I’ll draw from my traditional 401k (since I probably won’t have to pay tax with the low income). If I have an amazing income year, then I’ll draw from the Roth. It will (in theory) give me some flexibility in my retirement draws.

          Thanks for the awesome questions, Craig. Keep on reading, and tell your friends!! 😉

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