High-income earners often face a dilemma when it comes to retirement savings: Traditional 401(k) or Roth 401(k)?
What Traditional 401(k) is
A Traditional 401(k) is a type of retirement account where contributions are made with pre-tax dollars, reducing your taxable income for the year. For example, if you contribute $10,000 to a Traditional 401(k) and you are in the 24% tax bracket, you will save $2,400 in taxes (24% of $10,000). The money grows tax-deferred, meaning you won't pay taxes until you withdraw the funds in retirement. This is based on the concept of tax-deferred growth, where the 4% rule (withdraw 4% of your portfolio per year, indexed to inflation) and 25x rule (save 25 times your annual expenses) are often applied for FIRE (Financial Independence, Retire Early) planning.
The Traditional 401(k) is a popular choice among high-income earners because it provides an immediate tax benefit. However, it's essential to consider the tax implications in retirement, as withdrawals will be taxed as ordinary income. This can impact your marginal tax rate and effective tax rate in retirement, potentially affecting your overall FIRE plan, including Coast FIRE (a type of FIRE that involves stopping work, but not fully retiring) or LeanFIRE (a type of FIRE that involves living frugally) strategies.
What Roth 401(k) is
A Roth 401(k) is a type of retirement account where contributions are made with after-tax dollars, meaning you've already paid income tax on the money. The money grows tax-free, and withdrawals are tax-free if certain conditions are met. This can be beneficial for those who expect to be in a higher tax bracket in retirement. The Roth conversion ladder is a strategy that involves converting a Traditional 401(k) to a Roth 401(k) to minimize taxes in retirement, often used in conjunction with the SWR (Sustainable Withdrawal Rate) to optimize retirement income.
Roth 401(k) contributions are subject to the same income limits as Traditional 401(k) contributions. However, there are no required minimum distributions (RMDs) for Roth 401(k) accounts, which can be beneficial for those who want to leave money to their heirs. This can be an important consideration for those pursuing BaristaFIRE (a type of FIRE that involves working part-time in retirement) or FatFIRE (a type of FIRE that involves maintaining a high income in retirement) strategies.
Pros and cons at a glance
| Factor | Traditional 401(k) | Roth 401(k) |
|---|---|---|
| Fees | Typically lower fees | May have higher fees |
| Minimums | No minimum contribution | No minimum contribution |
| Tax features | Tax-deferred growth, taxed as ordinary income in retirement | Tax-free growth and withdrawals |
| Target user | High-income earners who expect to be in a lower tax bracket in retirement | Those who expect to be in a higher tax bracket in retirement |
| Where it shines | Provides immediate tax benefit, reducing taxable income | Provides tax-free growth and withdrawals, beneficial for those who expect to be in a higher tax bracket in retirement |
Better for X: when Traditional 401(k) wins
Let's consider an example: John, a 35-year-old software engineer, earns $150,000 per year and expects to be in a lower tax bracket in retirement. He contributes $10,000 to a Traditional 401(k) and saves $2,400 in taxes (24% of $10,000). If he expects to withdraw $40,000 per year in retirement and be in the 12% tax bracket, his Traditional 401(k) withdrawals will be taxed at 12%, resulting in $4,800 in taxes per year. Using the Freedom Calculator, John can run the FIRE math behind his retirement plan and determine the optimal contribution strategy.
Better for Y: when Roth 401(k) wins
On the other hand, let's consider Emily, a 30-year-old doctor, who earns $200,000 per year and expects to be in a higher tax bracket in retirement. She contributes $10,000 to a Roth 401(k) and pays $2,400 in taxes upfront (24% of $10,000). However, her Roth 401(k) grows tax-free, and she can withdraw the funds tax-free in retirement, resulting in no taxes on the withdrawal. This can be a significant benefit for those who expect to be in a higher tax bracket in retirement, such as those pursuing FatFIRE or BaristaFIRE strategies.
Bottom line: how to choose
Ultimately, the choice between a Traditional 401(k) and a Roth 401(k) depends on your individual circumstances and tax expectations in retirement. If you expect to be in a lower tax bracket in retirement, a Traditional 401(k) may be the better choice. However, if you expect to be in a higher tax bracket, a Roth 401(k) can provide tax-free growth and withdrawals, making it a more attractive option. It's essential to consider your marginal tax rate, effective tax rate, and overall FIRE plan when making this decision, and to consult with a financial advisor if needed.
New to FIRE? See our primer at https://freedomcalc.app/what-is-fire.