How Different 401(k) Plans Achieve Different Results

401k retirement plans yield different results

Here at BenefitMall, we partner with a well-known financial services company to provide innovative 401(k) plans to our clients. They can then offer those plans to their employees as part of a comprehensive benefits package. In light of that, it is in our best interests to keep up on the latest happenings in retirement benefits. The release of a brand-new study demonstrates why.

The study in question was conducted by researchers at the Harvard Business School. They looked at traditional 401(k) plans versus the relatively new Roth 401(k) to see which one would produce better results. What they found was somewhat surprising: when all things are equal, the Roth 401(k) is likely to produce better results than a more traditional 401(k) plan.

The biggest difference between traditional and Roth 401(k) plans is how contributions are treated for tax purposes. A traditional 401(k) allows workers to contribute pre-tax dollars taken directly from their paychecks. No taxes are due on that money until the worker starts withdrawing from the fund in retirement. A Roth 401(k) is just the opposite.

Contributions to Roth plans are made after taxes are deducted. That means if a worker contributes $100 from his or her paycheck, income and payroll taxes have already been applied to that money. On the other end, no tax is assessed on money withdrawn from the account in retirement.

Saving More in the Roth

Harvard researchers tracked both kinds of 401(k) plans and discovered that most retirement savers establish a certain amount they will contribute and then never change it. The researchers call this a 'rule of thumb'. So if the rule of thumb is to save $50 per week, employees contributing to their retirement plans would expect that same $50 deducted whether they were investing in a traditional or Roth 401(k).

That rule of thumb being equal across the board, workers contributing to a Roth plan are actually saving more because that $50 will not be taxed in retirement. The immediate difference in tax on such a small amount isn't much, but it really adds up over a lifetime of investing in a 401(k) plan.

No Tax on Earnings

The other benefit of the Roth 401(k) is that earnings are not taxed as income. This may seem like an optical illusion given the fact that retirees almost always fall into a lower tax bracket, but it's really not. Let's say you manage to save enough to create an account worth $500,000 over the course of your career. You did not contribute that much, but your contributions have combined with the earnings on your account to create a very nice nest egg. You pay absolutely no income tax on your 401(k) withdrawals.

On the other hand, let's say you save the exact same amount in a traditional 401(k) using pre-tax dollars. Because you are paying income tax on your withdrawals, you are being taxed both on the original amount and your returns. Ultimately, your total tax liability is likely to be higher with the traditional 401(k).

Obviously, every individual should be consulting with a financial advisor before deciding what to do with retirement savings. Some people will still fare better with a traditional 401(k) as opposed to a Roth. Others will find the Roth more to their liking. Individual circumstances do play a significant role here.

If you are looking to offer your employees a 401(k) plan as part of their benefits package, we urge you to contact us before making any decisions. In addition to comprehensive payroll solutions for small business, BenefitMall also offers innovative 401(k) plans, workers’ comp, and more.

Sources:

Wall Street Journal – https://www.wsj.com/articles/roth-vs-traditional-401-k-study-finds-a-clear-winner-1497233040