Make Your Choice: Roth vs Traditional 401k

When you're planning for your financial future, one big decision is choosing between a Roth and a Traditional 401(k). It's a common question - don’t worry - especially for medical professionals who are looking to maximize their retirement savings.

Let's break it down in a way that’s easy to understand and apply to your own situation.

The Basics

1. Traditional 401(k): Contributions are made with pre-tax dollars, which means you get a tax deduction now. However, you will pay taxes on the withdrawals during retirement at your ordinary income tax rate.
2. Roth 401(k): Contributions are made with after-tax dollars, so there is no immediate tax benefit. But, the withdrawals during retirement are tax-free.

It's All About Taxes

Remember, choosing between Roth and Traditional doesn’t change the actual investments you make. It only affects how your contributions and withdrawals are taxed.

A Simple Guideline

Here's a quick rule of thumb:

• Choose Roth if your current tax rate is lower than what you expect it to be in retirement.
• Choose Traditional if your current tax rate is higher than what you expect it to be in retirement.

However, there are more layers to consider:

• Tax Diversification: Having a mix of tax-deferred (Traditional), tax-free (Roth), and taxable (brokerage accounts) gives you more control over your finances in retirement. This flexibility helps you manage your withdrawals based on market performance and your tax situation at the time.
• Control in Retirement: Different tax treatments for your retirement savings give you options to optimize withdrawals based on your needs and external factors. This can help you minimize your overall tax burden.

Use Online Calculators

To get a more personalized answer, use online calculators. A good one is from Citizens Bank, which helps you visualize your after-tax returns based on whether you choose Roth or Traditional contributions. It can be a handy tool to see how your choices play out over the long term.

Key Considerations for the Future

While you may have a reasonable anticipation of your own future income, predicting the future of all tax brackets is much more uncertain. Historical trends show that tax brackets have fluctuated significantly over the decades and we are currently nowhere near historical highs in the US. This is highly political and difficult to predict. For instance, if you believe that tax rates are likely to be higher in the future, a Roth 401(k) could be more advantageous since it utilizes taxation your current tax rate.

If you play with calculations, you will find that there are very few scenarios when traditional contributions win in the absence of an extremely high income. One of the few scenarios where pre-tax contributions (Traditional 401(k)) might show a significant benefit is when you invest the tax savings in an after-tax account. If you invest the tax savings from a traditional contribution, you will see enhanced benefits due to the compounded growth in a taxable account. This calculations also ignore the potential added benefit of traditional contributions for AGI reduction in those pursuing PSLF or even taxable loan forgiveness.