The Investment Scientist

Roth 401k vs Traditional 401k

Posted on: April 14, 2011

Many companies now offer employees the option to contribute to a Roth or traditional 401k. For a long while, I have advised my clients to go for the traditional 401k; they are all high-income earners and the tax deductions can be substantial. Besides, what’s not to like about taking money out of the clutches of the IRS?

The other day I googled “US tax rate history.” I was shocked to learn that out of the last 100 years, there were 48 years when the top rate was above 70%. There was even a period when the top rate was 94%! For heaven’s sake, that’s not taxation, that’s deprivation!

At this rate, I wonder why nobody thought of a “simplified” 1040 Form like this:

1. How much did you earn last year? _______

2. Send it in.

Joke aside, this gives me a new perspective on Roth vs. traditional 401k: our current top rate of 35% is relatively low, and a future rate of 40%, 50%, even 60% is not unthinkable. It is much preferable to pay your tax now and get Uncle Sam off your back once and for all.

Besides, since both types of 401k plans have the same contribution limit, but the Roth 401k holds after-tax money, effectively you can contribute more.

On both accounts, Roth is clearly preferable to traditional. What do you think?

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2 Responses to "Roth 401k vs Traditional 401k"

In the face of uncertainty it’s a good idea to hedge. I would go 50-50 Roth/Traditional. This would provide more flexibility with your withdrawal strategy. For example you could use your traditional 401k up to the 15% tax bracket and then use your Roth for the rest of your income needs. Plus if like most high-earners you live in an area with high city/state taxes you could avoid paying those taxes altogether by moving to a no/low income tax state when you start to withdrawal. I would definitely go 50-50.

Sound like a great strategy. Thanks for commenting. Come back often.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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