Taxes on growth - Traditional vs Roth 401K

Both 401(k) and Roth 401(k) grow tax free. Any dividends or capital gains paid out by your investments, or gains you have from trading inside the account, are not taxed. If you take money out of these accounts too soon, though, you will have to pay taxes and penalties. The below assumes you leave the money in the account until retirement age and only make allowable withdrawls.

With a traditional (non-Roth) account, however, withdrawals are taxed - and they are taxed as ordinary income. The entire amount you withdraw is subject to tax. So if you withdrew the entire $100k all at once, you would pay tax on all of it. If you only withdraw a little bit, you only pay taxes on that. It gets counted with all your other income for tax purposes. If you have a high income while you withdraw, you'll pay a higher tax. If you have little or no other income, you will pay a much lower rate (possibly 0, if the total amount subject to tax is below the standard deduction).

With a Roth account, you pay taxes on the money now, at your current income tax rate. Then you are done paying taxes on this money. Withdrawals, unlike in the non-Roth case, are not subject to tax. You could withdraw the entire $100k at once if you wanted without having to pay tax. However, if you then leave it to grow in a non-tax-advantaged account, you'll have to pay taxes on dividends and gains, so you should only withdraw money you actually need to use.

Note that in the non-Roth case, when the tax is levied (on withdrawal), you are receiving the money that is being taxed, and can use it to pay the tax. In the Roth case, the money is subject to tax when it goes into the account; you need to have other cash on hand available to pay the tax that year.

Technically, yes the ROTH's gains grow tax free, while you have to pay taxes on both the contribution and the gains of the traditional account. However, that can be misleading because if all else is equal, both accounts end up performing exactly the same.

Let's look at two examples to see the full picture. First some assumptions:

• You currently have 10,000 (pre-tax) available to invest.
• Your marginal tax rate is currently 25%.
• Whatever amount you invest will grow to 10x the original amount at which point you will start withdrawing it.
• Your marginal tax rate will still be 25% at retirement/withdraw.

Scenario 1:

• You deposit the 10K in a traditional 401K, paying no tax on the money.
• The balance eventually grows to 100K, then stops growing.
• You withdraw 10K per year, your marginal tax rate is still 25% so after paying $2,500 you are left with $7,500 post tax dollars.

Scenario 2:

• You have $10k, pay $2,500 in taxes, then deposit the remaining $7.5k in a Roth.
• The balance eventually grows to 75K, then stops growing.
• You withdraw 7.5K per year paying no additional tax.

Conclusion: Both a traditional and a Roth 401K/IRA end up performing the same from a tax perspective if your tax rate stays the same from when you invest the money to when you withdraw it.

If your marginal tax rate increases in retirement, the roth account ends up being the better deal. If the marginal rate decreases, the traditional account ends up being the better deal.

Yes, but that probably does not mean what you think it means. Remember that if you put money into a Roth, it is post-tax money, meaning that you would need to have started with more money in the first place. When you do your comparison, ensure you are starting with the same amount of pre-tax money in both cases before you make a contribution.

• 401k: Earn, contribute, grow, withdraw, tax
• Roth: Earn, tax, contribute, grow, withdraw

If your tax rate were to stay the same, you would end up with the exact same amount of post-tax money either way. If your tax rate is LOWER in the future when you take the money out (as is likely), then you will end up with more post-tax money after withdrawing from a 401k and paying taxes on it. If your tax rate is higher in the future, the reverse is true.