Disclaimer: I do not have CFA and my knowledge comes from google search and hearsay. Thus the information here (especially my view) may not be 100% correct.

First of all, as I mentioned in the other blog post, there are two major retirement plans in the US: 401(k) plan and individual retirement account (IRA). Contributions to these two plans are independent, and this post is only about 401(k).

I think the incentive for any retirement plans is tax treaty. The government is willing to collect less tax from us if we manage our own retirement. As a result, one should max out the tax treaty unless a more lucrative investment strategy exists.

basics: Roth and traditional 401(k) ($18.5k limit)

Money in the 401(k) plan is invested, thus conceptually there are two chunks of money in the 401(k) account:

  • contribution: money put in either by you or your employer
  • gain: extra money generated from investment

The 401(k) investment options vary depending on employer. Usually the average annual return is decent (say 8%, but in short term it could be negative too). (For the stock related options I have, the past 1 year return varies from 9% to 27%. That of the bond related options are mostly less than 1%.) For the past 20 years, the average annual stock market return is close to 10%. If we count from 1932 (after the depression), the average annual stock market return is over 10%.

Depending on how your want these two chunks to be taxed, there are two choices of 401(k) plans:

  • traditional 401(k): avoid tax now for the contribution (tax-deferred) and pay tax in retirement for both the contribution and gain
  • Roth 401(k): pay tax now for the contribution and withdraw tax-free after retirement for both the contribution and gain

The rationale of 401(k) tax treaty is to tax only once. Normally our money is taxed multiple times: first we pay income tax, if we buy things (with after-tax money) then there is sales tax. If our after-tax money generates more money, then the gain is taxed again. And the game of 401(k) is timing: by controlling our taxable income at different times, we pay tax at different rates.

There are two time points of interest: now for contribution and after retirement for withdraw. Note also if you withdraw money from 401(k) plan before retirement (age 59.5), there is a 10% penalty, unless the money is used for some special purposes (first-time home purchase, education expenses, medical emergency, etc). And I won’t consider early withdrawal in here.

Contributions to traditional 401(k) is not taxed until you withdraw money from it. It effectively reduces your annual taxable income, thus saves tax at your highest tax bracket (say 25%). Later if you only withdraw a small amount of money annually as income after retirement, your tax bracket will be much lower (say 10%).

Contributions to Roth 401(k) is taxed immediately and when you withdraw it after retirement, both the contribution and its investment gain is tax free. Note that for traditional 401(k), the investment gain is still taxable. Another benefit of Roth 401(k) is that there is no penalty if you withdraw money for medical emergency.

As of 2018, a person’s annual contribution to 401(k) (both traditional and Roth) is capped at $18.5k, and $6k more for someone over 50. In my opinion, all $18.5k contribution should go to traditional 401(k), unless

  • your current income is low, which puts you in a low tax bracket (say 10%-15%);
  • you expect to withdraw large amount of money annually after retirement;
  • you expect yourself to be so rich at the time of retirement that you will leave behind too much taxable money in the 401(k) account at the time of death.

To be concrete, we can run a simple calculation. Suppose you decide to put $10,000 in retirement plan this year, either all in traditional 401(k), or all in Roth 401(k). (In reality, you can put some of that $10k in one and rest in the other.) The money in the 401(k) plan changes as follows

\ year 0 year 10 year 20 year 30
traditional 10,000 21,589 46,610 100,627
Roth 8,000 17,271 37,288 80,501

Here I assume that your highest tax bracket is 20% at year 0 (i.e., now) and the average annual return of the 401(k) investment is 8%.

Suppose you retire at year 30, and somehow you want to withdraw $100k annually and that puts your highest tax bracket at 20% (your average tax rate will be lower than 20%). It then still makes sense to put all $10k in the traditional 401(k) plan now, because the $100k in traditional 401(k) after tax will still be more than the tax-free $80k in Roth 401(k).

On the other hand, normally one wouldn’t need to withdraw $100k annually after retirement. By that time, hopefully one only needs small amount of money for food and housing, which puts one’s highest tax bracket in a very low range. Thus I think traditional 401(k) makes more sense overall.

One can argue that the investment return from Roth 401(k) can be higher than traditional 401(k). Since there are other means to put money into Roth type accounts (for example, $5.5k annual allowance, and the after tax contribution in the next section), I still think all $18.5k should go into traditional 401(k).

use after-tax contribution to 401(k) if you are rich ($55k limit)

As of 2018, there is a $55k limit for annual 401(k) contribution, including sources from both the tax payer and the employer. For example, suppose your annual income is $100k and you put $18.5k in traditional 401(k), and your company matches 2%, which is an additional $2k in your traditional 401(k) account. There is still a pretty big gap to the $55k cap. If you are willing to put more money in 401(k), there is a so-called After-Tax 401(k). This is useful for people with high income to get further tax treaty. However, depending on your employer’s 401(k) policy, you may not have the freedom to put enough (or even anything at all) After-Tax contribution to max out that $55k limit.

As the name indicates, After-Tax 401(k) contribution comes from your after-tax income. By default, it goes into the traditional 401(k) account, which doesn’t really make sense. However, you can contact your 401(k) provider by phone (at every payroll point) to convert it to Roth 401(k) or Roth IRA without extra cost. I think Roth IRA is better since it has more investment options, for example, individual stocks.

To sum up, the $55k 401(k) limit applies to the total sum of the following contributions

  • 401(k)
  • 403(b)
  • employer match
  • After Tax (AT) contribution

Here 403(b) is the retirement plan for university or non-profit organization employees. It’s very similar to 401(k) plan in terms of benefits.


  • After switching jobs, the 401(k) plan from the previous employer can be rolled over to IRA.

  • When income is low, one can convert traditional 401(k) to Roth 401(k) or Roth IRA. The amount to be converted is considered as income.