Traditional vs Roth 401K: Which Retirement Investment Is Better

February 12, 2020
by Matt

One of the most frequently asked questions when it comes to retirement investments is whether a Traditional vs Roth 401K investment fund is best for my future. The challenge here is that there isn’t a one size fits all answer.

There are a few primary factors that you can use to determine whether to invest in a Traditional vs Roth 401K:

Understand the key differentiators between Traditional and Roth investments
Consider your future earning potential
Evaluate all future factors
Ease your emotions

It’s All About the Taxes…Now or Later

The primary difference between Traditional and Roth investments is when you pay taxes on your investment.

Traditional 401K: You are contributing pre-tax money directly to your 401K, meaning your taxable income will be lower come tax season. You won’t pay taxes on the money invested and the growth until you are ready to pull out funds from your 401K account in retirement.
Roth 401K: You are contributing post-tax money directly to your 401K, meaning that your taxable income is not affected. Since you paid taxes when you contributed money to your Roth, your take-home pay will be lower because taxes are applied to your contribution amount. However, you will not pay any more taxes on either the growth or when you pull out funds in retirement.

Pull Out Your Crystal Ball

One of the most challenging elements of deciphering the right investment strategy comes down to guessing whether your future tax bracket will be more or less favorable than your current one. Typically, as a young worker just entering the workforce, you will not earn as much as you will 10-15 years down the line, so the standard advice is to contribute to your Roth while you are in a lower tax bracket. Based on this, it is more favorable to pay taxes now (Roth). However, only you know your personal financial situation.

Beyond trying to predict your future earnings, you also need to consider what the political climate will be 20-40 years from now. This is an important factor to consider because governing politics will influence the tax brackets. Given the unpredictability and polarization in politics, this is a difficult task only looking 10 years out, let alone 40 years.

Professor’s Notes

Looking at my personal approach, up until recently I’ve only had a Traditional 401K available to me. Because of this, I’ve been able to build a modest pre-tax investment fund and plan to continue to grow it. However, now that I have a Roth 401K available, I am now electing to put a larger percentage into a Roth 401K while also adding a smaller percentage to my Traditional 401K.

There are two main reasons this is my current approach.

The first reason is that by diversifying across Traditional and Roth investments, I am protecting myself against the uncertainty of future tax implications. Should my future tax situation be lower than it currently is, my Traditional 401K proved to be the proper investment. Should my tax situation be the opposite, then I know I have post-tax funds that are available to me through my Roth 401K and no additional taxes are owed.
The second reason I have started bolstering my Roth investments (401K and IRA) is my EMOTIONS. While I nearly always recommend removing emotions from any financial decision, the truth is that it’s not always possible. In this case, I have an emotional comfort in knowing exactly what my retirement funds will be as well as knowing that I won’t need to pull taxes out later. It’s probably because of where I am in my life currently, but taking the taxes out now does not feel as damaging as I think it will in 30 years. Beyond this, I am comforted by having a clear outlook on my retirement savings and it allows me to be more bullish in my shorter-term investments.

At the end of the day, you will need to take a look at your personal finances, career trajectory, and emotions to determine which investment is best for you. If you’re not sure, you can consider following what I do and invest in both Traditional and Roth 401K. Before determining whether Traditional or Roth 401Ks are best for you, make sure you have a firm grasp on what a 401K is.