Deciding between the Traditional and Roth 401k depends on your current tax rate, estimating your future tax rate and your preference for having a tax deduction now or later. Here is a simple scenario comparing the tax treatment for both options. The scenarios assume the same tax rate throughout. Results can change if you move to a state that has higher or lower state income tax rates.
Scenario 1 - Traditional 401k
Start with $10,000 in IRA/401k
Tax Bracket 28% gives a $2,800 savings.
Assume that $2,800 savings is invested in a taxable account.
The $10,000 grows to $100,000.
The $2,800 grows by same multiplier of 10 to $28,000.
Assume all investments accounts are sold, withdrawn and put to taxable cash account.
When the $100,000 is withdrawn it is taxed at 28%.
This leaves $72,000 from 401k
The capital gain from $2,800 taxable account is $25,200 and taxed at capital gains rate of 15%.
This leaves $21,420 + initial $2,800 for a total of $24,220.
The total amount from both accounts is $96,220.
Scenario 2 - Roth 401k
Start with $10,000 in Roth 401k
No deduction. This causes you to take $2,800 from savings to pay taxes.
$10,000 grows to $100,000
All investments sold and withdrawn.
No tax on withdrawal.
Receive full $100,000
This all assumes the same tax rate throughout. A person would come out the same in both Scenarios if they invested the tax deduction savings in Scenario 1 into a Roth IRA. But that is only if the person qualifies for the Roth. They would be worse off if they used a Traditional IRA because the IRA contribution is not deducted if you participate in an employer sponsored retirement plan, income is above certain IRS limits and gains are taxed at the potentially higher income tax rate.
