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There are many good articles describing 401(k)s
online (e.g. this one).
We won't try to duplicate them here.
However, we've received questions from readers wanting to quantify the difference between using a traditional 401(k), Roth 401(k) or investing outside a 401(k) plan.
In this article, we provide an example comparing those 3 options.
We base the calculations on a person who works from age 30 until 65, consistently investing a percentage of his/her income.
At age 70, after taxes, he/she ends up with 70% more money using the 401(k) plans!
The traditional and Roth 401(k) options return the same, assuming the same tax rate
when working and in retirement (the distinction between these two is purely based on tax rates—lower
tax rate in retirement favors a traditional 401k).
The Scenario
Let's call our investor Bob.
To make the comparisons fair, we adjust his contributions/savings so that he receives the same net (take-home) pay each working year in all three cases.
That amount is shown in the third column of the table below.
In the traditional 401(k), Bob contributes the standard 10% of his salary before taxes.
For the Roth and no 401(k) cases, Bob must pay more income tax—the traditional 401k lowers his income tax).
Bob therefore makes smaller contributions in order to receive the same take-home pay each year.
The contributions Bob makes in all 3 cases are included in the table below.
We assume Bob earns 90k USD at age 30 and receives 3.5% raises each year thereafter.
His gross annual income is shown in the second column of the table.
We assume he earns 7% annual returns on his investments, regardless of the option.
We assume he pays no short-term gains in the no 401(k) option (he reduces his taxes by holding all investments until retirement).
His 401(k)/savings balances are shown in the table.
We assume he pays a flat 25% income tax rate (including retirement, in the case of the traditional 401(k)), and a
15% long term capital gains tax (in the case of the no-401(k) option).
Some Details
It's important to note that comparing the balances in any particular year is misleading.
The Roth 401(k)
appears to be less than the traditional 401(k), but since it's not subject to future taxation
it's worth the same as the larger traditional 401(k) balance.
Similarly, the no-401(k) balance appears overly small compared to the traditional
401(k) balance.
Bob will only need to pay capital gains taxes in the no-401(k) option, which are normally smaller
than the income taxes due on the traditional 401(k).
Let's say taxes increase to the extent that Bob will pay 30% (instead of 25%) on his traditional
401(k) in retirement.
In this case, he would lose over 200k in the traditional 401(k) and the Roth 401(k) would be unchanged, and hence superior.
On the other hand, if taxes drop to 20% in retirement the traditional 401(k) will result in over 200k extra cash, above the unchanged Roth.
What if Bob found a super investment that could return 9% (instead of 7%) in the no-401(k) option?
In this case he'd end up with 3 million in the no-401k option, and still underperform the 7% 401(k) options.
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