“If you contribute to a Roth 401k, all the money can be withdrawn at a later date completely tax-free.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- investing after-tax money into a Roth 401k and not paying any tax when it’s withdrawn.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:
…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:
- 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.
- 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.
- 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?
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?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.