Which is better a 401(k) or Roth 401(k)?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
OpenAI’s ChatGPT tool responds to an investor question and Certified Financial Planner™ professional, Joe O’Boyle, fine tunes the AI response (in italics). This should be fun!
“Which is better a 401(k) or Roth 401(k)?”
Both 401(k) and Roth 401(k) are types of employer-sponsored retirement savings plans. They both have their own set of advantages and disadvantages, and the one that is best for you will depend on your individual circumstances.
In general, we typically recommend that our clients contribute to an after-tax Roth 401(k) over a pre-tax 401(k) due to the potential for 100% tax-free growth for retirement and for the added flexibility of optimizing your taxable income in retirement with a tax-free retirement income source (such as a Roth 401(k) or Roth IRA).
A traditional 401(k) is a pre-tax retirement savings plan. This means that the money you contribute to your 401(k) is deducted from your taxable income, so you can reduce your tax burden in the year you make the contribution. However, when you withdraw the money in retirement, it is taxed as ordinary income.
Your pre-tax 401(k) helps to reduce your taxes today, with the understanding that you will be taxed when you withdraw your money in retirement. For example, let’s say you earn $100,000 in income, contributing $22,500 to your pre-tax 401(k) will reduce your taxable income to $77,500. That $22,500 in your 401(k) may now grow tax-deferred until you retire. When you ultimately withdraw the money in retirement, the withdrawal amount is treated as taxable income and you are taxed based on your tax bracket at that time. The idea is that you may be in a lower tax bracket in retirement because you are no longer working.
A Roth 401(k) is a post-tax retirement savings plan. This means that the money you contribute to your Roth 401(k) is not tax-deductible when you make the contribution, but the money grows tax-free and you can withdraw it tax-free in retirement as long as you meet certain requirements.
Your after-tax Roth 401(k) contribution does not help to reduce your taxes today, but the compounded growth you may achieve over time provides you with a tax-free income source for withdrawals in retirement. Ultimately, for a retirement account that you hope will grow meaningfully over time, many investors prefer to pay taxes on the small contribution amount today, rather than paying taxes on the potentially significantly larger amount in retirement.
There are a few factors to consider when deciding between a traditional 401(k) and a Roth 401(k). One factor is your current tax rate versus your expected tax rate in retirement. If you expect to be in a lower tax bracket in retirement, a traditional 401(k) may be a better choice because you'll get the tax deduction up front. On the other hand, if you expect to be in a higher tax bracket in retirement, a Roth 401(k) may be a better choice because you'll pay taxes on the money when you contribute, but you won't have to pay taxes on it when you withdraw it in retirement.
Another factor to consider is the flexibility of your retirement savings. With a traditional 401(k), you are required to start taking required minimum distributions (RMDs) at age 73 (due to passage of the Secure 2.0 Act). With a Roth 401(k), you are not required to take RMDs, so you have more flexibility in terms of when you withdraw the money.
In general, financial planners love Roth 401(k)’s for the potential for tax-free growth for retirement. For retirees, starting in 2024 due to the Secure Act 2.0, they also love that Roth 401(k)’s are not subject to Required Minimum Distributions (RMD’s), so your Roth 401(k) balance may continue to potentially grow tax-free in retirement.
For retirees, having to make taxable withdrawals (such as a Required Minimum Distribution) from a pre-tax 401(k) can have the unintended consequence of making your Social Security income taxable. You pay tax on up to 85% of your Social Security benefits if your taxable income exceeds a certain threshold. In addition, for estate/legacy planning purposes, both Roth 401(k)’s and Roth IRA’s can be a great tool for passing along a potentially tax-free inheritance to your loved ones.
On paper, you can compare the benefits of investing your tax savings from making annual pre-tax 401(k) plan contributions over the long run and treat it like a math problem. However, in practice, this tax savings may not actually be invested and is often spent when it is not intentionally set aside. In 20 years of working as a financial planner, we have found that retirees value not having to pay taxes on their retirement nest egg (whether in the form of a Roth 401(k) or Roth IRA) that much more when they no longer have the benefit and comfort of receiving a regular paycheck.
It's important to consider all of these factors and discuss your options with a financial advisor or tax professional before deciding which type of 401(k) is best for you.
What did you think? How did AI do?
About OpenAI’s ChatGPT tool:
GPT (short for "Generative Pre-training Transformer") is a type of language model developed by OpenAI that is trained to generate human-like text. ChatGPT is specifically designed for generating text in a conversational style. It is a machine learning model and has been trained on large datasets of real-world conversations in order to learn the patterns and styles of human communication.
Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.