Everyone is puzzled whether Roth 401k is better than Traditional 401k. Usually financial advisors will not give a good explanation why one or another is better. They tend to compare the same amount invested in one and another, which is wrong amount of investment, because IRS limit works differently for Traditional vs Roth. For Traditional it's pre-tax and for Roth it's after tax. Same amount invested in Roth is actually a larger investment.
To make things fair, I compared Roth 401k with a combination of Traditional 401k plus regular investments, so that we would look at the same amount spent pre-tax. The code below does the modelling. It assumes your current marginal tax rate is 50% (pretty common for software engineers in SF Bay Area), you'll invest up to Roth maximum every year for 15 years, make 10% annually less 3% inflation, have 6K company match limit (it actually doesn't matter for comparison! thanks
rezkiy for pointing that out, which led to discovery of bugs in the original version of this post). All that matters is expected average tax rate at retirement, and it seems that breakeven point is around 20%. avg tax Roth401k Trad401k+Inv
10% 875588 941751
15% 864363 896849
20% 853137 851947
25% 841912 807045
30% 830686 762143
35% 819461 717241Here is the source:
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 | # initial constants class const: def __init__(self, retirement_effective_tax_rate): self.irs_cap = 18000 self.company_match_limit = 6000 self.current_marginal_tax_rate = 0.5 self.retirement_effective_tax_rate = retirement_effective_tax_rate self.long_term_capital_gain_tax_rate = 0.2 self.inflation_rate = 1.03 self.investment_growth = 1.07 self.years_before_retirement = 15 # money made with Roth 401k def roth401k(const): roth401k_account_value = 0 roth401k_company_match_value = 0 current_irs_cap = const.irs_cap current_company_match_limit = const.company_match_limit for i in range(const.years_before_retirement): roth401k_account_value *= const.investment_growth roth401k_company_match_value *= const.investment_growth roth401k_account_value += current_irs_cap roth401k_company_match_value += current_company_match_limit current_irs_cap *= const.inflation_rate current_company_match_limit *= const.inflation_rate after_tax_available_at_retirement = roth401k_account_value after_tax_available_at_retirement += (roth401k_company_match_value * (1 - const.retirement_effective_tax_rate)) return after_tax_available_at_retirement # money made with traditional 401k + investments # if the same amount after tax is kept for spending. def trad401kAndInv(const): trad401k_account_value = 0 investment_account_value = 0 investment_cost_basis = 0 current_irs_cap = const.irs_cap current_company_match_limit = const.company_match_limit for i in range(const.years_before_retirement): trad401k_account_value *= const.investment_growth trad401k_account_value += current_irs_cap trad401k_account_value += current_company_match_limit investment_account_value *= const.investment_growth equivalent_roth401k_contribution_pretax = current_irs_cap / (1 - const.current_marginal_tax_rate) extra_investment = ((equivalent_roth401k_contribution_pretax - current_irs_cap) * (1 - const.current_marginal_tax_rate)) investment_account_value += extra_investment investment_cost_basis += extra_investment current_irs_cap *= const.inflation_rate current_company_match_limit *= const.inflation_rate after_tax_available_at_retirement = (trad401k_account_value * (1 - const.retirement_effective_tax_rate)) after_tax_available_at_retirement += investment_cost_basis after_tax_available_at_retirement -= ((investment_account_value - investment_cost_basis) * const.long_term_capital_gain_tax_rate) return after_tax_available_at_retirement def printAll(): print "%12s %12s %12s" % ("avg tax", "Roth401k", "Trad401k+Inv") for retirement_tax in [0.1, 0.15, 0.2, 0.25, 0.3, 0.35]: r = roth401k(const(retirement_tax)) t = trad401kAndInv(const(retirement_tax)) print "%12.0f%% %12.0f %12.0f" % ((retirement_tax * 100.0), r, t) print printAll() |
