More and more of us are being offered a Roth 401(k) at work. How does it differ from a traditional 401(k)? Which one is better for you?
Got a Roth 401(k) option at work? Take it!
First, let’s take a step back. What exactly is a Roth 401(k)?
To answer that, let’s review what a 401(k) is. A traditional 401(k) is a retirement savings plan that allows a worker to invest money now and defer paying income taxes on the saved money (and earnings) until withdrawal at retirement.
A Roth 401(k) is kind of the opposite. You save now through your employer’s retirement plan with money that’s already been taxed. Then you get to spend the savings and earnings in retirement tax-free.
Money expert Clark Howard has long encouraged most workers under 50 who have access to a Roth 401(k) to do it! But what was just his hunch is now confirmed in a study from Harvard.
Listen: Clark discusses the Roth 401(k) on the Clark Howard Show Podcast
The study found that something interesting happens when people select the Roth 401(k) option instead of the traditional 401(k) at work: They keep their contributions the same.
You would think they’d lower their contributions because saving for retirement with after-tax money means a slightly smaller paycheck. Yet researchers found virtually everyone kept their contribution level the same when switching from a traditional 401(k) to a Roth 401(k).
The end result then becomes that if you’re saving 10% of your pay and you convert from a traditional 401(k) to a Roth 401(k), you’ll have a huge amount more to spend in retirement.
Remember, every penny in a traditional 401(k) will be taxed at retirement, reducing effectively how much money you have by roughly close to a third. But because you kept contributing the same amount of pay in a Roth 401(k), you greatly magnify the amount of money you have at retirement.
Putting real world numbers to the findings
Here’s what the study’s lead author, John Beshears, told The Wall Street Journal about the study’s findings.
“If a worker saves $5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $120,000 in spending power, which a life annuity will translate into about $700 a month in extra spending.”