The question we're addressing today is one of the most common questions I get as a financial advisor. Should I make Roth 401k contributions or Traditional 401k contributions?

Getting this right could be worth hundreds of thousands of dollars in retirement, so it's worth careful consideration. Fortunately, I think there's a simple rule to follow. that will lead most people down the right path.

​The Difference Between Roth and Traditional 401ks

So first, let's review the main difference between a Traditional 401k and a Roth 401k.

With a Traditional 401k, the amount you contribute is not taxed today, but it is taxed when you withdraw that money in retirement.

A Roth 401k is the opposite. Your contribution is taxed, but your withdrawals in retirement are tax-free.

How Your Tax Rate Impacts The Roth vs. Traditional Decision

One really important thing to know about Traditional and Roth 401ks is if you have the same tax rate at contribution and at withdrawal in retirement, then Roth and Traditional 401ks are going to end up with the same after tax amount in retirement, so it wouldn't matter which one you contribute to.

Tax Rate Impact Example

All right. So let's look at an example to show this. So we're going to assume that you have the same 20% tax rate at contribution and at withdrawal. And then you've got $5,000 here, pretax to invest. So you can invest that full amount in the Traditional 401k. And remember, there's no tax on your contributions so you can invest the full $5,000. 

As opposed to the Roth 401k. If you invest that $5,000, you're going to have a 20% tax. You're going to pay your 20% tax rate then. And so you end up getting $4,000 invested. Now we're going to assume that you have 100% growth, your account value doubles between now and retirement. Then in retirement, in the Traditional 401k, you're going to pay your 20% tax when you withdraw that money. And so you have $8,000 after tax. Whereas with the Roth 401k, you're going to pay no tax on the withdrawal. And so your after tax value on the Roth, 401k is also $8,000. 

So remember we had the same 20% tax rate at the time of contribution and at the time of withdrawal. Now if your tax rate wasn't the same at contribution and withdrawal, then obviously you want to pay taxes whenever that tax rate is lower. So if your tax rate at contribution is lower than the tax rate at the time of withdrawal, then you want to pay taxes at contribution. And so you'd want the Roth 401k. But if your tax rate is lower in retirement, then you'd want to pay taxes in retirement. And so you'd rather do a Traditional 401k.

So if we know our tax rate at contribution and at withdrawal, we'll know whether we should contribute to Roth or Traditional.

Now how do we know those rates?

The Difference Between Tax Rates and Tax Brackets

Before we get into that, notice that we're talking about tax rates here and not tax brackets. There is a difference and understanding that difference is the key to making the best decision.

So let's look at tax brackets for a second, because it's going to be crucial to understand this.

The way the US federal income tax system works is that your income builds up from the bottom of the tax brackets. So, whether you make a million dollars a year or $50,000 a year, if you're married filing jointly in 2023, the first $22,000 of your income is going to be taxed at 10%.

Then the next $67,450 of your income is going to be taxed at 12% and on and on up the tax brackets.

Tax Rate vs. Tax Bracket Example

So let's look at an example, a couple making $150,000 of annual income. They're going to end up in this 22% tax bracket. Now if they made a Traditional 401k contribution, that contribution is going to come off of the top of their income. Meaning, whatever their marginal tax bracket was, in this case 22%, they're going to avoid paying 22% on that 401k contribution.

So we can say that the tax rate at the time of contribution for this couple would be 22% because that's the tax that they're avoiding paying.

Now in retirement, their withdrawals are going to build up from the bottom of the tax brackets again. And so even if they still had $150,000 of income that they were pulling out of their 401k. That $150,000 withdrawal is going to start at the bottom and build back up the tax brackets. So they're still going to end up in the 22% marginal tax bracket, but a lot of that income is going to be taxed at 12% and at 10%. And they're even going to have some that's not taxed at all through the standard deduction.

And so if we were to do the math and figure out, okay, what's the average tax rate paid on that withdrawal. We would find that the average tax rate paid on $150,000 withdrawal is going to be less than 12%. Assuming they take the standard deduction.

So we just said that the tax rate at the time of contribution was 22%, but at the time of withdrawal in retirement, that tax rate was less than 12%. So there's a significantly lower tax rate at the time of withdrawal compared to the time of contribution. So, again, we'd rather pay taxes when our tax rate is lower. In this case, it would be at the time of withdrawal in retirement.

And so this couple would be better off contributing to a Traditional 401k as opposed to a Roth 401k.

The Key Insight In the Roth vs. Traditional 401k Debate

This is the key insight in the Roth versus Traditional 401k debate.

At contribution, you're taking that contribution off the top of your income and avoiding paying your marginal tax rate.

In retirement, your withdrawal builds up from the bottom of the tax bracket. So even if you end up in the same marginal tax bracket in retirement that you were in in your working years, your average tax rate paid is going to be less than your marginal tax bracket.

Which is why a traditional 401k often makes sense over a Roth 401k for many people.

Caveats

There are a few caveats to this.

First, I'm assuming tax brackets in the future are the same as tax brackets today.

In reality, we don't know how tax brackets are going to move around in the future, and they probably won't be the same that they are today.

With that being said, tax brackets could actually increase quite a bit in the future, and a Traditional 401k would still be the better choice.

Second, I'm assuming that a 401k is the only source of income in retirement.

In reality, there could be social security income or a pension that's taking up some of the room in those lower tax brackets, which would bump up the average tax rate a little bit.

Lastly, I'm assuming a similar standard of living today and in retirement, but if you expect to have a significantly higher standard of living in retirement compared to today, then that could actually change the math in favor of a Roth.

Traditional vs. Roth 401k Rule of Thumb

As a general rule of thumb on Traditional versus Roth 401ks, I think most people in the 10% and 12% federal income tax brackets should make Roth contributions and people in the 22% tax bracket and above should favor Traditional 401k contributions.

Of course, there are a lot of factors that go into this Roth versus Traditional decision that we didn't touch on today. So ultimately I would recommend talking to a financial professional before making any changes to your contributions.