The 401(k) Series #5: Roth or Traditional Deferral?

By | August 16th, 2017|General|

The 401(k) is the preferred financial vehicle for saving for retirement, and will likely be your largest asset when you do retire. If you’re starting a new job, participating in your company’s 401(k) plan not only allows you to capture tax advantages, but often includes an employer match of your contributions. As we discussed in #1 of this series, signing up is almost always a great idea.

Recently, many companies have added a Roth option to their 401(k) plans. Should you put your money into a traditional 401(k) or opt for a Roth 401k)? Let’s analyze the differences between the two by first taking a quick quiz:

1. Will I be in a higher tax bracket today, or when I retire?

  • Today (generally, high earners and older workers): Traditional 401(k)
  • When I retire (generally, low earners and younger people): Roth 401(k)
The most important distinguishing factor between Roth and traditional 401(k)’s is when the money is taxed. If you are a high earner now, you may need the tax deduction in the current year and thus, opt for a traditional 401(k). If you’re in a tax bracket that you believe is lower than your tax bracket will be in retirement due to tax hikes, you may be better off contributing to a Roth, and saving those tax breaks for later. In technical terms, Traditional contributions are pre-tax, Roth contributions are after tax. However, on the other end, Roth withdrawals are tax-free and traditional withdrawals are taxed as income. Generally speaking, a Roth 401(k) is best for low-income and young people, who are likely in the lowest tax bracket of their careers.

2. Is there a chance I’ll need to withdraw before age 59 ½?

  • Yes: Roth 401(k)
  • No: Traditional 401(k)
The government discourages premature withdrawals from your 401(k), and therefore levies tax penalties on anyone who withdraws prior to age 59 ½, an unqualified withdrawal, aside from a few exceptions.

It’s possible to make an unqualified withdrawal, that is, a withdrawal before age 59 ½ that’s not on the list of exceptions. No matter whether you have a traditional or Roth 401(k), you have to pay income tax on the withdrawal, plus a 10% early distribution penalty. However, traditional withdrawals are taxed on the full amount, whereas Roth withdrawals only tax the earnings.

Hopefully, you will never have to make an early, unqualified withdrawal from your 401(k) and you can let the money grow in your account until you retire. However, life happens and if you want the flexibility of being able to withdraw without as steep a tax penalty, a Roth 401(k) may be a better fit for you. Keep in mind, any employer contributions will be taxed as regular income upon withdrawal, no matter they type of 401(k) you choose.

3. Is there a time (before retirement) when I’ll be making less than I am now?

  • Yes: Traditional 401(k)
  • No: Roth 401(k)
After separating from your employer there are options both ways for rolling over the funds. However, with traditional 401(k)’s you’ll have a second chance to decide when you want to be taxed, by rolling it to a traditional vehicle or a Roth vehicle. If you roll over a traditional 401(k) to a Roth 401(k) or Roth IRA, you’ll pay income taxes on the amount you transfer, though you won’t pay taxes on withdrawals once you retire. Essentially, with a traditional 401(k), you have the flexibility to decide when you’ll pay taxes on the money. A Roth 401(k) can only be rolled into a Roth IRA, so even if your situation changes, you don’t have an opportunity to change your mind on when you pay taxes. There are many scenarios that fit into the category where converting traditional funds to a Roth makes sense…going back to school, becoming a homemaker, etc. If you time the conversion right, you could avoid significant tax liabilities.

In sum, Roth and traditional 401(k) accounts have similarities and differences. Depending on your current and future tax bracket, need for early distributions, and desire to roll over accounts, one type of retirement account may be more beneficial than the other. One option would be to contribute to both to add to your tax savings flexibility (tax diversification).

The best place to start is with a financial advisor that can dig deeper into your current and potential situation. Our retirement calculators allow us to calculate the benefits of many different scenarios, for clients in all situations. Please feel free to contact us for a free analysis of your financial options and to help connect your choices to your personal situation.



By | August 1st, 2017|General|

COSTS MATTER. Whether you’re buying a car or selecting an investment strategy, the costs you expect to pay are likely to be an important factor in making any major financial decision.

People rely on a lot of different information about costs to help inform these decisions. When you buy a car, for example, the sticker price tells you approximately how much you can expect to pay for the car itself. But the sticker price is only one part of the overall cost of owning a car. Other things like sales tax, the cost of insurance, expected routine maintenance costs, and the potential cost of unexpected repairs are also important to understand. Some of these costs are easily observed, and others are more difficult to assess. Similarly, when investing in mutual funds, different variables need to be considered to evaluate how cost‑effective a strategy may be for a particular investor.

Expense ratios

Many types of costs lower the net return available to investors. One important cost is the expense ratio. Similar to the sticker price of a car, the expense ratio tells you a lot about what you can expect to pay for an investment strategy. Exhibit 1 helps illustrate why expense ratios are important and shows how hefty expense ratios can impact performance.

This data shows that funds with higher average expense ratios had lower rates of outperformance. For the 15-year period through 2016, only 9% of the highest-cost equity funds outperformed their benchmarks. This data indicates that a high expense ratio is often a challenging hurdle for funds to overcome, especially over longer horizons. From the investor’s point of view, an expense ratio of 0.25% vs. 0.75% means savings of $5,000 per year on a $1 million account. As Exhibit 2 helps to illustrate, those dollars can really add up over longer periods.

Exhibit 1.       High Costs Can Reduce Performance, Equity Fund Winners and Losers Based on Expense Ratios (%)

fees 2


Exhibit 2.       Hypothetical Growth of $1 Million at 6%, Less Expenses


For illustrative purposes only and not representative of an actual investment.

While the expense ratio is an important piece of information for an investor to evaluate, what matters most when gauging the true cost‑effectiveness of an investment strategy is the “total cost of ownership.” Similar to the car example, total cost of ownership is more holistic than any one figure. It looks at things that are readily observable, like expense ratios, but also at things that are more difficult to assess, like trading costs and tax impact. It is important for investors to be aware of these and other costs and to realize that an expense ratio, while useful, is not an all‑inclusive metric for total cost of ownership.

Trading costs

For example, while an expense ratio includes the fund’s investment management fee and expenses for fund accounting and shareholder reporting (among other items), it doesn’t include the potentially substantial cost of trading securities within the fund. Overall trading costs are a function of the amount of trading, or turnover, and the cost of each trade. If a manager trades excessively, costs like commissions and the price impact from trading can eat away at returns. Viewed through the lens of our car analogy, this impact is similar to excessively jamming your brakes or accelerating quickly. By regularly demanding immediacy like this when it may not be necessary, the more wear and tear your car is likely to experience and the more fuel you will end up using. These actions can increase your total cost of ownership. Additionally, excessive trading can also lead to negative tax consequences for the fund, which can increase the cost of ownership for investors holding funds in taxable accounts. The best way to try to decrease the impact of trading costs is for funds to avoid trading excessively and pay close attention to effectively minimizing cost per trade. Employing a flexible investment approach that reduces the need for immediacy, thereby enabling opportunistic execution, is one way to potentially help accomplish this goal. Keeping turnover low, remaining flexible, and transacting only when the potential benefits of a trade outweigh the costs can help keep overall trading costs down and help reduce the total cost of ownership.


The total cost of ownership of a mutual fund can be difficult to assess and requires a thorough understanding of costs beyond what an expense ratio can tell investors on its own. A good advisor can help investors look beyond any one cost metric and instead evaluate the total cost of ownership of an investment program—and ultimately help clients decide if a given strategy is right for them.

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