Regular 401k & IRA: The Undeniable Math To Avoid The Roth
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Updated on November 12th, 2021
Retirement planning does not come easy for most people and there are a plethora of choices to make in the process. If you have ever asked, “Should I do a Roth or traditional 401k,” this article is for you.
This article is not about discussing whether you should pick an Individual Retirement Account (IRA) versus a 401(k). Instead, it’s about whether you should pick the Roth or traditional style of either account type.
The obvious question is “Which account style leads to more money?” And the answer we will prove herein is that it’s the traditional 401k or standard IRA, and not the Roth account style, contrary to popular opinion and finance gurus.
What Is The Difference Between a 401(k) or IRA
For a quick recap on the difference between the two, your options are to either choose a Roth 401k (Roth IRA), where contributions are after-tax, or choose a traditional 401k (traditional IRA), where contributions are pre-tax. In retirement, the Roth accounts pay no taxes on distributions, while the standard accounts pay ordinary income taxes.
The 401k is handled through your employer and for 2020 & 2021 has a contribution limit of $19,500. With an IRA, you open an account at a retail brokerage such as Vanguard or Schwab and can contribute up to $6,000 for 2020 & 2021. Sadly the limit was not increased for 2021.
The options inside an employer 401k are usually pretty limited to a handful of funds, but with an IRA you can buy almost anything exchange traded.
Use this free tool to analyze your 401k and IRA for the proper fund allocation to properly balance risk and reward.
The Roth variation has only existed since 1997.
Which is Better Roth or Traditional?
Almost all the personal finance gurus out there favor the Roth account type and tout the benefits of having tax-free income in retirement after decades of compounding. But there is nothing magical about paying taxes upfront that somehow leads to more money in the future. In fact, quite the opposite.
I go against the herd and explain why most people should skip the Roth option and pick the traditional type because, for most people, it will lead to more money. This is explained through the concept of tax arbitrage.
Tax Arbitrage: 401k Math
The fundamental idea is whether you pay taxes now or pay taxes later.
Mathematically, if the tax rate is the same in the contribution period and the withdrawal period, the after-tax value of both account styles will be exactly the same from the commutative property of multiplication:
When is the Traditional 401k Better Than the Roth?
When your retirement tax rate is lower than your contribution rate.
This is the concept of tax arbitrage: You contribute during your peak earning years, taking a higher income tax rate deduction (saving more tax dollars now) and take distributions during retirement paying a lower income tax rate.
How Tax Arbitrage Works
If you wonder why your tax rate will be lower during retirement, it’s because when you contribute to a traditional retirement account during your working years, the deduction is applied against a single bracket, your highest marginal tax bracket, but when you take a distribution during retirement, your money is spread out over several lower tax brackets, each bucket being filled with a higher tax rate along the way, creating a lower average (effective) tax rate.
Of course, by retirement, the assumption is that you are actually retired. If you continue working while taking distributions from your retirement accounts, your regular working income will push up your marginal tax rate reducing the tax arbitrage benefit being described now.
The valuation formulas become:
Since Retire_Avg_Rate <= Marginal_Rate, mathematically the value of the traditional account will be greater than or equal to the Roth account type. The worst case scenario is that the accounts have the same after-tax value if you are in the lowest tax bracket in both the working and retirement periods.
The only way the Roth could have more after-tax value is if your average retirement tax rate is higher than your marginal tax rate during your working years, such as if future tax rates increase substantially. This is a commonly cited reason for choosing the Roth: risk aversion on future tax rates. I address this possibility in a section below, but first an example illustrating with numbers.
Example With Median Earning Family
Let’s say you are a median working family in America earning $55,000 annually and taking the standard deduction (and ignoring credits for children, etc., which will drop your adjusted income further).
Most financial advisors will advise that you aim to have enough funds in retirement to withdraw 80% of your working year salary. But to make it a fair comparison, let’s say you did well with your saving and investing and have enough to withdraw exactly 100% of your working salary every year, the whole $55,000 enchilada.
Tax brackets are adjusted by inflation so you can ignore the effects of inflation here. Alternatively, you could think about it in a simple two year period: your last working year and your first year of retirement.
At $55,000, your marginal federal income tax bracket will be 12% today (after factoring in the standard deduction), which means every $10,000 yearly contribution to a traditional 401k will save you $1,200 in taxes (12%) today right off the top. Five and a half years of contributions is $6,600 in taxes you didn’t have to pay right now, but would have to pay immediately with a Roth.
When you retire and you are not working, you will start living off your regular 401k and those distributions will be classified as ordinary income. A portion of that money will be tax free due to the standard deduction, then a portion will be subject to the lowest tax bracket, and the next portion will apply to the next highest tax bracket and so on. The key point to recognize is that the taxes you will pay in the future will have an average rate lower than the marginal rate you saved it at.
The table below shows that you first subtract the standard deduction of $24,000 per family (halve everything for singles). That leaves $31,000 of taxable income. Then with 2020 tax rates, the first $19,750 will be taxed at 10% and then next $11,250 will be taxed at 12%, creating an average tax rate of 6.05%. The required tax of $3,325 is about half the amount one is required to pay immediately if they choose a Roth account type.
In this median case you can save nearly 50% in taxes by choosing a traditional, standard retirement account!
When will there be no advantage of a traditional 401k over a Roth?
If you are a low income earner and only make income in the lowest tax bracket then neither account has an advantage over the other. If your family earns $43,750 or less ($21,875 for singles), the economic value of a Roth and a traditional account is the same, since all the money is taxed in the lowest tax bracket in both periods and no tax arbitrage is possible.
If your income will increase in the future, pushing your income above the lowest marginal rate, or you are worried about higher tax rates in the future, this would be the time to choose the Roth retirement account.
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What if Taxes Increase?
The most commonly cited reason for choosing a Roth 401k is the risk that tax rates will increase in the future because of the national debt. They may or they may not. Remember, taxes have been decreasing in the United States for decades now, so if someone chose a Roth account back when they were introduced in 1997, they left a lot of money on the table.
With interest rates near zero for the foreseeable future, the national debt servicing costs is the lowest it has been in the country’s entire history. If taxes are to be raised, it will be for other reasons, but I guarantee that paying down the national debt will take last priority.
It’s impossible to know what congress has in store for future generations, but the best assumption for people with 8-12 years to go until retirement is to assume that rates will be about the same as they are today, since presidential cycles are the primary cause for adjustments.
But we can play with this assumption: What if the income tax rates were to double during your retirement years?
There are two parts to the tax brackets: the rates and how wide the brackets are, but assume the width of the brackets don’t change. If the width of the brackets increases, it just means more money is taxed at lower rates and since we are trying to challenge the traditional account type, we won’t make the comparison any easier.
Would you be lamenting today’s Roth 401k choice in this scenario? As the table below shows, not really. The after-tax value is almost the same (an extra $50 a year in taxes paid with the Traditional), which is a pretty strong result.
Think about that. The rates of the tax brackets could double after you’ve already saved your money and the traditional account still holds it weight against the Roth.
Additional Factors that Favor the Traditional 401(k)
State tax is another consideration in the analysis. Some states, like Pennsylvania, tax your contributions regardless of account type, but don’t tax distributions during retirement. Most other states, like Massachusetts, treat contributions and withdrawals the same way the federal tax code does. If you live in a state that follows the federal method and plan on retiring to a state with lower or no state income taxes, this strongly favors the traditional retirement account since you’ll be saving both the marginal federal rate and the state rate on top of it, which is usually an extra 5%.
To illustrate the complete picture, say your family earns $55,000, makes 20 years of contributions of $5,000, invested in index funds and earns 7% a year. Your state tax is 5% but you will move to Florida in retirement. At the end of the 20 years, the after-tax value of the traditional account will have 13% more than the Roth or taxable account. The taxable account and Roth have the same after-tax value here because the capital gains tax for families who earn under $80,000 a year is 0% in 2020, a very nice perk.
For a higher income family where the 22% tax bracket applies, and a 15% federal capital gains tax rate applies with a $10,000 yearly contribution, the Roth is worth 12% more than the taxable account, after-tax, and the traditional account is worth 20% more than the Roth, after-tax. That’s a full $60,000 more! Again, the value of the traditional retirement account is hard to beat.
So far this has only been an analysis related to the after-tax value of the account types, which is the main difference between the Roth and traditional IRA & 401K.
Roth accounts do have some other advantages, such as a lack of required minimum distributions (RMDs) in retirement, being able to withdrawal contributions for specific purposes without penalty, and income that doesn’t count towards Medicare Plan B payments. However, when you stack these all up, you find they are largely minor benefits that don’t skew the analysis away from the biggest expense which is the tax you actually pay. See the comments for a lively discussion of RMDs, Medicare Plan B and Social Security analysis thrown in – my conclusion is the same.
Roth accounts also technically let you stuff more into the account since you pay the taxes from funds outside of the retirement account and part of your traditional contribution is earmarked for the federal government later on, but that still doesn’t change the fact that you are substituting a high tax today for a low tax tomorrow. And there is another way to look at it: if you contribute $19,500 to a Roth today and pay an extra $4,290 in taxes today is the contribution really only $15,210?
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A lot of people overlook this concept as if the tax you pay immediately doesn’t count. For the traditional 401k, you can look at it as the federal government loaning you tax money to invest for decades of tax deferred compounding.
Either 401(k) Type Is Better Than None At All
If you are saving for retirement and you make enough income to pay over 0% in capital gains, you should use a tax advantaged account because Uncle Sam takes a cut on both ends, first when you earn it, and second when you grow it it, if you don’t. The whole pre tax vs Roth discussion is moot if you decide not to use a retirement account at all.
But the conclusion is that you’ll have more money in retirement if you first maximize your traditional 401k’s and IRA’s before considering Roth 401k’s and IRA’s if you are making more than $21,875 as a single or $43,750 as a family as of 2020.
Only after you have maximized traditional accounts should you consider the Roth variants to capitalize on the income tax arbitrage that leads to a higher balance of assets. If you are a high income earner and are above the traditional IRA income limits, first maximize your traditional 401k and then maximize your Roth IRA account. And if you are above the income limit for the Roth IRA account, consider a backdoor Roth conversion by first contributing after-tax money to a traditional IRA and then immediately converting it to a Roth. You are paying the tax dollars anyway in this situation, so at least you can save on the back end with the backdoor IRA Roth option.
Final Thoughts
This article puts some analysis to the Roth vs traditional 401k decision instead of just making assumptions that not paying taxes in the future is the preferable route.
Taxes are complex and there is a whole menu of credits and deductions that change from year to year.
Also, if your employer 401k is loaded with fees, or doesn’t offer a contribution match, it can wipe out the tax savings, and so you may want to go the IRA route. Similarly, if you load up your 401k or IRA with the wrong type of investments, your account could under-perform enough to wipe out any tax arbitrage advantage.
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Continue on into the comments where we discuss high income earners mixed with Social Security, Medicare Plan B and Required Minimum Distributions in retirement. If you don’t want to read through all the details, know that the conclusion still stands: the Regular 401k is the winner!
An investment that defers taxes like a retirement account (and eliminates tax upon death), is the Master Limited Partnership (MLP).
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Just found your site and subscribed. Very interested in Preferred instead of bonds in my retirement income portfolio. I’m a 72 year old Pitt MBA and share your bent for analysis! However, I think your analysis of 401K vs ROTH leaves out two very salient factors for retirees.
1. Taxation of Social Security benefits, the Provisional Income formula. Say our SS income is $63,900. Take 1/2 of that figure and add other income, say $50,000 from ROTH or IRA. The ROTH is ignored and Provisional Income is less than $32,000 so no tax is owed on the SS or the ROTH income! In the case of the IRA, 85% of the SS is taxable and 100% of the IRA is taxable (less the standard deduction). Huge difference!
2. IRMMA determines how much you pay for your Medicare Part B. Consider a single person with income of $87,000 pays 144.60 per month. Adding $50,000 of ROTH has no effect. Adding $50,000 of IRA RMD add a surcharge of 231.40 per month or an additional charge of $2776.80 per year.
There may be other effects like NIIT taxes and Medicare .009 surcharges, but I am not sure.
I have found that there are many aspects of retirement that are very obscure until you become old enough to pay attention, at which point it is costly to change.
Looking forward to learning from you as I intend to convert a significant amount of my IRA mutual funds into Preferreds in my ROTH. I will leave enough in the IRA to do our tithing and charitable giving via QCDs.
I hope this sparks an ongoing conversation!
I always thought that Pitt was coolest campus with the Cathedral of Learning. Very unique.
Two things on Social Security:
1) The income figures I was using in my examples has the implicit assumption that it consists of all income sources. The average $55,000 earner probably won’t actually have a large enough 401(k) balance by retirement to pull out $55,000 every year in retirement when the average account balance in one’s 60s is less than a few hundred thousand (source).
But say the retiree has $1,000,000 by retirement and employs the oft cited 4% rule; $40,000 a year will come from the taxable retirement accounts. With the average benefit of social security being $16,272 a year (source), and assuming someone making an average $55,000 a year would get approximately that, that would put someone right back to the $56k range. Then we are right back to the tax arbitrage comparison point of earning the same amount in both periods.
Two things that it are hard to forecast:
1. What one’s Social Security benefit will be when one has 30 years of work remaining.
2. How much one’s 401(k) balance will be at retirement.
2) You are safe at your age with the social security benefits you are currently receiving, but for us youngins, social security might not make up a significant portion of our retirement income. The trust is scheduled to run out of funds by 2035 (source), at which point payouts will only be 75% of what they are supposed to be. Congress will probably increase taxes and lower benefits to prevent this from happening, but both of these events are not great for people of my age. If I could opt out of social security and never have to pay the 7% again, I certainly would.
As for medicare Part B, I did look at this but when I looked at the table (source), a single person making $87,000 or less ($ 174,000 married) will pay $144.60 a month anyway. It’s only when your income is above that do the surcharges start kicking in. At the next level up to $109,000 for a single and $218,000 for a married couple, it’s an extra $689 a year. Or like you said it you are earning an extra $50,000 a year on top of the minimum threshold ($137,000/$272,000) it’s an extra $2,776 a year, or about 2% of the income. High income readers should consider if that surcharge will cost them more than they are saving.
And I agree that there are other variables like the the ACA surcharge for net investment income over $200,000. The moral of the story is that high income earners have more to worry about with the potential gotchas and should fine tune any analysis to their own personal situation. Luckily most readers won’t have to worry about these issues.
And you are exactly right that most people should think about these obscure issues now instead of making an arbitrary decision that might cost them in the future. I hope this page and comments will do exactly that.
To your final comment, if you have stocks or highly appreciated mutual funds outside of retirement accounts, you should look into donating those shares without first selling them. You’ll be able to avoid paying taxes on them and the donation will amount to more. Probably can’t do that same tactic from IRA funds, but a tax advisor might have some special tricks up their sleeve.
Thanks for the thoughtful reply.
A third point regarding Social Security is that you can begin taking 401k/Trad IRA distributions at a younger age than you can begin receiving Social Security, even more so if you hold out for maximum Social Security benefits (and Social Security full retirement age could very likely go up as we reach the shortfall). If you put everything in a Roth, you could find yourself having missed out on the opportunity to pay much lower taxes during this span regardless of what happens with Social Security beyond then.
Perfect explanation, thank you
Liked the math analysis – could tell you have a solid math background. However, I think Roth works out better for higher earners. If one is 30 years old & maxing out their 401K till they retire (let’s say another 30 years), they would end up with ~5 mil (assuming an 8% yoy increase). The RMD for such a portfolio would be almost 200K a year on retirement (& increases with age). Wouldn’t Roth be flat out a better case for such high earners?
^Assuming you roll over your ROth 401K to a Roth IRA to prevent RMD, i.e
Are their RMDs on a Roth 401k?
Hi Ayush,
Thanks for the comment. I love putting some numbers to the story line. So, with your assumptions, the account balance 30 years later will be about $2.5 million. There are these cool little calculators I am using in this comment for illustration (source).
Ultimately the answer really depends on what tax bracket (+state tax) the high income earner is in now versus later. Even if the RMD is $200,000 a year, the effective federal tax rate is only 15% (if married) today. The marginal tax rate for the same income is 24%, so there is still about 6% of arbitrage if the state tax in both periods is the same (source).
That 24% rate for a married couple goes all the way up to $321,450 of income. So if you are a super high income earner above that, you may have a problem.
Some more thoughts on RMDs:
1) RMDs don’t kick in until 70.5 years of age
2) RMDs for this example start at around $100,000 a year and then scale up, but you wouldn’t start taking out $200,000 until age 85, assuming you didn’t withdraw anything before 70.5. There’s a cool calculator for this too (source)
3) If you actually retire at 60, per our example assumptions, you still have a solid 10.5 years of throttled withdrawals that will reduce the account balance even more.
4) You could optimize how much you take out before 70.5, keeping your withdraws under a particular tax bracket and then contribute that amount to a Roth IRA.
5) Bonus: There is a rule of 55 that allows you to start taking your money out of your 401(k) if you leave your job after 55. I’m suspecting that people with multi-million dollar 401(k)s would consider retiring early. That further provides the opportunity to start optimally extracting money out of the 401(k).
6) RMDs of $200,000 a year are ultimately a good problem that few people will have. If I have this “problem” at 85 years old and if Congress jacks tax rates up significantly, the thought that I might not have optimized my tax savings over the prior decades won’t be high up on my priority list. 🙂
Thanks for that analysis! I forgot to mention this, but such a high earner would probably have high social security benefits as well (assuming we still go on with social security, which I know you mentioned in another comment may not be the case). If you have both RMD’s and security benefits kicking into the same year, wouldn’t the arbitrage benefit be offset by the additional taxes you pay on the social security? Let’s use the same example for consistency. Your first RMD kicks in age 70.5. To make it harder for my cases, I’ll assume you reduced funds to 1 mill by taking out funds after 60 like you mentioned. The RMD is 40K at year 70 and let’s assume the social security benefit is 80K (conservative estimate using https://smartasset.com/retirement/social-security-calculator). The taxes you’d be paying on the benefits at age 70 would be ~7K more than if you were taking out the same 40K from a Roth account. Even assuming a generous tax arbitrage of 10%, the 7K loss outweighs the 4K gain on a 40K withdrawal. Let me know if there are any holes in my analysis!
P.S – I think you mentioned this in the comment earlier that social security and how much you have in your 401K on retirement is hard to predict. But I think a safe bet for high earners would be to put in money in both, with an emphasis on Roth. Would you agree?
I’m actually glad you brought the social security argument back into the fold.
The maximum benefit allowed by law if social security is deferred to 70.5 would be $82,000. To get that amount it would require the earner to have earned more than the maximum tax cap of $137,700 for 30 years adjusted for inflation. (If it is not deferred and instead taken at 65 it would be a starting benefit of about $55k) (Social Security Tables)
So, if the family earned between $137,000-171,000 for the 30 years, they would have paid (Roth) or saved (traditional) the marginal tax rate of 22%.
When they take it out, with a deferred $80,000 yearly social security pension, it would push them right back into the same 22% tax rate. They could have a maximum of $91,000 in taxable income from all sources and remain in the same tax bracket. Consequently, there would be no benefit from either account type from a Federal tax standpoint.
+If you factor in the Medicare plan B discussion in the comment above, it tips the scales slightly into the Roth account by 1-2%.
+But if you move from a state paying 5% tax to a tax free state in retirement like a lot of retirees do, it tips the scales back into the regular 401(k) camp even with the medicare plan B.
+If your family earns more than $171,000 now, you are in the next tax bracket (24%) and the traditional account is the winner again.
The nice thing about the traditional 401(k) is you have more flexibility for strategy in your later years. With the Roth, you pre-pay the tax upfront at the highest rate and there is nothing else to be done. When you retire and defer taking social security, you will have a number of years (as many as 15 if retiring at 55) to take the maximum amount that would keep you under the prior high tax rate, about $104,000 (80,000+24,000), and transfer some or all of it to a traditional IRA and then do an immediate conversion to a Roth. This way you will end up with Roth assets during your RMD years anyway.
And remember, the RMD is only the minimum. If you have a $1,500,000 account at 70, you are only required to take out about $55,000. You could take out an extra $35,000 and that would keep your RMDs under the $91,000 threshold for a lot longer than if you only took out the minimum and let the balance continue to grow.
So, if you are confident that you will earn the maximum social security benefit, your account balance will be more than $2,500,000 at age 70.4 when RMDs kick in, and IF you won’t move to a tax free state, then having a portion of that account in a Roth 401(k) could benefit you. It would require some great modeling with a lot of assumptions to determine what that optimal percentage is, of course.
But again, the state tax is SO critical to the analysis. Simply moving to a tax free state and saving 5%, you could have RMDs up to $222,601 a year (which would occur at year 14 with a $3 million starting account balance at age 70.5) and still do better with the traditional (32% bracket at 24k+80k+222k=326k).
So to answer your last question, I strongly believe that the odds are so stacked against the Roth account that I contribute nothing to a Roth 401(k) and max my traditional account, and that is the conclusion I think applies to most people.
Thanks again for taking the time to reply! I carefully read through you’re analysis and have to agree – odds are it’s better to go with a traditional. Unless you have 2.5 mil by 70 haha. I’m in a state without income tax right now though. So I guess the best strategy is to keep most of it in a traditional401K. But probably need to revisit it every year and adjust so that you’re going to hit the right numbers closer to age 70, updating it according to the latest laws.
On a side note, tax strategy would have been so much simpler if everything was a flat tax :D. The piecewise break up makes it a horribly non linear problem lol.
Glad to help! It’s been an interesting analysis problem to work through.
And you are absolutely right – taxes would be so much simpler with just a flat tax and say, a single standard deduction. Unfortunately we’ll never have that in this country though.
And like you also said, tax laws change every couple of years, so keeping up on the latest rules will help guide along the planning.
Feel free to comment on any other articles of interest 🙂
FYI, the RMD age has been changed to 72 from 70 1/2. This was after you posted your comment, but people reading this now need to know this.
I am very intrigued by this article. While the tax savings math you used with the distribution amount example makes a lot of sense, it’s looking at the bigger picture that confuses me. Since I am 23 years old now, in theory I would have about 40 years to retirement. Using average stock market return rate of 7% shows me that the end result of contributing only 3k a year leaves me with an account balance of almost 600k, with total amount contributed at 120k. I can’t wrap my mind around any tax rate where it would be better to pay taxes on 600k vs paying for 120k. So I took to Google and ended up on Bankrate with a traditional vs roth calculator and found there that according to their calculations, roth comes out on top. The only caveat is that when selecting the option on the calculations to “invest immediate tax saving from traditional contributions” the traditional comes out on top by maybe a couple percent. However, this strategy seems a little to savvy for the average person as most people don’t just dump their tax return into an IRA or taxable. Curious on your thoughts.
Hi Jared,
That’s exactly the crux of the issue. Usually the comparison between the two account types only looks at the taxes not paid at the end of 30-40 years but ignores the reinvested tax savings over 30 years. Let’s say you make a commitment to contribute $10,000 a year into your 401(k). With the traditional, that $10,000 comes right out of your annual income. With the Roth, if you contribute that, then you need an extra say $2,000 to fund the tax bill. So if you only want $10,000 to come out of your paychecks you’d actually only contribute $8,000 to your Roth. So effectively with the traditional account, the government is giving you a $2,000 a year tax deferred loan to invest on their behalf, which a portion will have taxes taken out in the end. The real irony here is that you can end up paying a lot more in taxes than the taxes paid on the 120k contributed, but still have more after-tax money for yourself too. Conversely, you might not pay any taxes on the money at all in retirement if the account is appropriately throttled to stay under the lowest tax bracket. Good job on researching these issues early in your career!
OK Ryan:
My wife and I are 58. We have $1,300,000 in traditional 401 and IRA and another $250,000 in emergency savings. Own our home outright, $400K and have no debt. My wife is to retire at 62 and I will at 65, at least thats the plan. Should we continue the traditional route or go Roth? Should we consider a converstion? many tout the Roth. I am of the mind that the current tax savings, allowed to reinvest for years, is a big plus. Your thoughts?
Congrats on the successful retirement planning, you are in good shape! I am of the same opinion for current tax savings, as indicated from my lengthy post.
If you are 58, you are likely in your prime earning years, so your tax rate is high and when you both retire, your tax rate will be lower, so the regular 401k is the way to go. If you do a conversion, all that you convert will be taxed at your highest tax rate, which is not good. The only time a conversion makes sense is if someone has lower income relative to other years where they can sneak the converted amount into lower tax brackets, such as if they had a bout of unemployment, or are in retirement.
I find there’s even more savings then listed with the traditional. My husband makes about 48,000 in taxable income and we have 2 kids. When it comes to the earned income credit for every $50 less we make (aka invest in traditional) the government gives us $10 more in the credit. The tax system is very complex and the EIC is mind blowing. I can’t believe the government has such a credit it’s redistribution of wealth at it’s finest but I’m playing the game. We wont always be at such a low income. So just looking at the tax brackets doesn’t give the best picture of tax savings overall.
You are precisely right! Another arrow in the quiver for the traditional. Thanks for commenting!
You might be interested in knowing the history of the EITC (earned income tax credit). See its entry in Wikipedia: https://en.wikipedia.org/wiki/Earned_income_tax_credit
Some cases where a Roth makes sense:
1) you have net operating losses to apply and your income is really low
2) you’ve maxed out your 401k. Now a back door Roth or a mega backdoor Roth may make sense.
3) you use the Roth as part of your emergency savings. After covering your emergencies, it no longer helps to contribute further though
But in general, I think you’re right that if you are in a >15% tax bracket now and have a limited amount to save that you won’t hit caps, traditional is better.
Thanks for the thoughtful article and formulas. With regards to high savers (high income or otherwise) your math breaks down. When people hit the “limits” (whether that be the $19,500 or even the 415c limit of $57,000) it’s better to go to Roth. For example, when applying “$19,500” to your first formula, at 20 years, 7% ROI and 32% Tax rate, both formulas yield “$51,312”. But the only reason they are equal is that the first step in the Roth formula is to back out the taxes from the Roth contribution. That’s not how high savers operate. They’d invest the full $19,500 in a Roth 401k. Looking at this another way (I think we’re 100% in agreement with this statement), a traditional saver MUST invest their tax savings to keep up with a Roth saver given equal tax rates. However, when hitting the IRS investment limits, the only option is a taxable brokerage. Then the math gets complicated with taxable dividends, how much your mutual funds turnover (tax) and, of course, capital gains at the end of all of that (minus the principle). Maybe that traditional saver utilizes a Roth IRA on the side to avoid all of that. But to the super-saver, who is maximizing all of their “tax advantaged limits”, Roth investing lets them effectively stuff more dollars under those limits to the tune of the amount of tax they’re paying on them at the time of investment.
Hi Tom. In the second to last paragraph of section 4, I briefly mention this. You can pay your taxes outside the Roth account and it allows you to stuff more after-tax dollars into the account. If high income saver invests the full $19,500 in a Roth 401k, they would then pay $6,240 in federal income taxes upfront (assuming 32%). So were it to be truly equal the traditional 401(k) it would need an account limit of $25,740 to match the contribution limit of the Roth 401(k).
That being said, if they make under the 124,000–$139,000 2020 phase out range (married 196,000–$206,000), they could maximize the traditional 401(k) and then immediately invest the tax savings into the Roth IRA to invest those tax savings for tax free growth. In that situation, the Roth would again have no account maximization advantage.
And like you said, if they make more than $139k, the tax saving would have to be invested in a taxable account and it gets a little more complicated. But if those savings are invested in the S&P500, there would be a nominal 15% tax on the 2% quarterly dividend and a 15% capital gains tax on the back end (unless the saver’s retirement income is below $80,000 a year to qualify for 0% capital gains taxes).
However, the high income saver is still paying the maximum amount of taxes with the Roth 401k. Another tax I didn’t mention here is the Net Investment Income tax (NII) that taxes investment income when total income is more than $200,000 a year. That 3.8% tax is worth another $741 on $19,500. And using the traditional 401(k) can drop your income under the limit. So potentially, the high income saver could be paying 32% (federal) + 3.8% (NII) + 5% (state tax) = 40.8%. That’s an additional 20-25% that one must earn on their investments over time to make up the initial shortfall.
Thanks Ryan – I love these discussions. A couple of points. For “super-savers”, who push the IRS limits, one can always turn to the backdoor Roth IRA for further tax savings. That’s precisely what I do. So, although a taxable brokerage is certainly an option, Roth IRA’s are really available to everybody. So, maximizing my Roth 401k plus maximizing both mine and my spouses Roth IRA’s is a start for me (company contribution is Traditional money of course). If I chose to invest in a Traditional 401k, I’d have to invest that extra $6240 you mention (actually higher for me in a 5% state income tax state) in a taxable brokerage subject to those taxes you mention to keep up with my Roth 401k savings of $19,500. But don’t forget, that $6,240 is all subject to tax, so in apples-apples scenario, $6,240 becomes $4243 invested, $1,997 tax at 32%. So, for “super savers” (really regardless of income) going “all Roth” allows you to stuff more tax advantaged dollars under the IRS limits. At worst, the net value is going to work out to be equal dollars (you should run some drawdown scenarios as well) even with higher taxes paid in the savings years. You mentioned Net Investment Income tax as well. Apply that to the drawdown years. I think it speaks to the benefit of Roth money keeping your retirement income below those levels that may push your AGI above those levels. Don’t get me wrong – people with AGI’s > 200k in retirement are certainly the exception, but those are exactly the people who can benefit from tax free income.
Hi Ryan, I’ve found this article and the corresponding discussion on the comments really interesting. Would love your thoughts on my particular situation. My wife and I are both 38 years old and would like to retire by 65 if not a few years earlier. My annual income is ~$300K per year and likely to continue to increase before retirement. My wife is currently not working to stay home with our children. For the past several years, I’ve been maxing out my Roth 401K contribution ($19,500 in 2020), and then doing an “after-tax Mega Backdoor” Roth 401 conversion up to my company’s limit of $27,500. My company also puts in something like 8k in matching. I also put $6K in both my wife and my’s Traditional IRAs and immediately convert it to our Roth IRAs via the backdoor. Altogether, not counting the company match, we’re saying $59,000 per year in Roth accounts at the moment. My question is that would we be better off in retirement with taxes if I put the first $19,500 in my traditional 401K rather than putting it in the Roth 401k. Due to our high income there’s no other option for the other Roth contributions other than the backdoor approaches. Note, we have about $350K in our traditional 401Ks at the moment but had not planned to make many more contributions beyond the company matching funds. Thank you in advance for your thoughts!
It sounds like you are on your way to a comfortable retirement regardless of what you do, but that is the gist of what this article is about, saving tax money immediately and paying lower taxes later when you are retired. It looks like you are in the 24% tax bracket but pretty soon will be in the 32% tax bracket so if you are currently doing all Roth accounts, you are front loading your tax with the highest rates you would ever pay. You should think about maxing your Traditional 401(k) first and then doing the other backdoor Roth conversion strategies so that you max both types of accounts. Since you are highly paid, your employer might also offer another income deferral plan that differs from the 401k but also saves you tax dollars today.
Thanks, Ryan. I had a feeling you’d say that. I’ll adjust my withholdings for 2021 and beyond accordingly to max out the traditional option with the initial $19,500! Thank you again!
Here’s something no FA’s talk about and when I bring it up it stumps them. I am 54 and want to go part time when I am 57. Me and wife have 1.2 mil currently in 401k and 40% is Roth. Yes we had small paychecks because of it but were able to stuff more in doing Roth because for the last 12 years we maxed out our contributions. Here is the KICKER, If we decide to go part time at 57, or hang it up all together (I have a small pension as well) WE CAN WITHDRAW OUR ROTH money and stay below 45K in wages for the year and get he Obamacare at the cheapest rate there is. So if we withdraw 30K in roth and say we make 40K in part time wages guess what? Our income is 40K!!! CHEAP HEALTH INSURANCE from the ACA.
So discuss this, since no one else ever thinks about that angle even though health care costs are always the biggest worry
Hi Patrick. You are in a pretty good place! Congratulations!
I’m glad someone brought this up, since it’s another income adjusted price program. I guess for someone young thinking about this fork in the road, the comparison would have to focus on how much extra tax would be paid and investment return forgone from the Roth 401(k) portion, relative to the future higher ACA plan costs. This wouldn’t be too hard to model by taking the NPV of the extra ACA costs (Traditional) and comparing it to the NPV of the additional taxes paid (Roth).
Unfortunately, there are a lot of variables that go into this premium calculation so there doesn’t appear to be a generic calculation that could apply to the average individual situation. However, I went to the ACA site and picked some numbers for a couple living in California, 57 & 54, medium health care usage and tried $40,000 and then $60,000 for income. The options on the resulting plans a little different from screen to screen, but it looked like the average difference in premium was about $200 a month for that particular situation. Live to age 90, potentially a savings of (undiscounted) $79,200? Have you run some calculations for your specific circumstances? It would be interesting to see what you come up with.
This is for me and spouse. My pension is 21K per month if I took it at age 57, if I can work part time and make 20K I would have that 41K income. Then I can draw off my roth to put my real disposable income at whatever I wish depending on how much I want to take out, without affecting my taxable income. I could do this until SS kicks in. I have some past health conditions that lead me to think I will not be around past 72 years old. If I claim 40K in income a plan with a 4000.00 deductible and 13.300 max out of pocket is 377.00 per month. Now if I run the same plan at 80K income the same plan is 2036.00 per month!!!
A 4000.00 deductable and 13300.00 max out of pocket plan is:
40K income 377.00 a month.
80K income 2036.00 per month
That is an insane cost structure!
Hence the reason this is something to really include into weather ot not a Roth is better than a traditional depending on the situation. For nayone looking to retire before Medicare kicks in this is HUGE
Remember that Obamacare may not be around forever. It should be around for the next 4 years because Biden is in the White House, but after that, if we have a Republican president and GOP majorities in both houses of Congress, it could be eliminated. At age 58, without the ACA law, you might have problems getting health insurance. One thing that the ACA did was get rid of an insurer’s ability to turn you down for coverage due to “pre-existing conditions,” which you may have at 58…or 64. I’m not trying to be a “Debbie Downer,” but we have to be realistic. By the way, congrats on your excellent financial situation.
Also, when you are part-time or retired and younger than RMD age (72), you can do Roth conversions judiciously. I say “judiciously” because you will want to keep in mind several income thresholds:
1. When you are under 65 (after which you will have Medicare) but relying on Obamacare, keep your income at a level that optimizes (minimizes) what you pay for Obamacare.
2. Once you are 65 and on Medicare, you will want to keep your income below the threshold for having to pay more for your Part B.
3. You probably don’t want to push your income into the next tax bracket.
Why do you want to do these Roth conversions?
1. You will reduce what is in your pretax account, to minimize your RMD withdrawals. Too much in pretax accounts? That translates into too much income, which in turn translates into taxable SS, higher income taxes, and higher Medicare Part B payments.
2. You are spreading out your withdrawals over fewer years, so spreading out your taxable income. Suppose you have $600K, retire at 62, and live to be 92. There is a difference between taking out $30K a year for 20 years, and taking out $20K a year for 30 years.
3. If you do this before RMD age, you can choose to put the money in a Roth, with its taxless growth. After RMD age, you have to put this money into an account with taxable growth. If you need to spend the money, it makes no difference, but if you are saving it, it can make a difference.
4. You can take out the amount of money that you want, a little or a lot. Once you hit RMD age, Uncle Sam tells you how much to take out each year for the rest of your life.
I have a question about marital status. For every married couple, there will be one spouse who survives longer than the other. After a year or two, the survivor will have to start filing a single (rather than a married filing jointly) tax return. Assuming little change in income this could cause a jump to a higher marginal tax bracket. Sometimes that jump could be big — from 12% to 22% or from 24% to 32%. Isn’t protecting the surviving spouse from a higher tax bracket a reason to hold some of one’s retirement assets in a Roth account? Especially if most of the contributions are being made while married?
There is a documented Widowhood effect that shows that surviving spouses generally die within a short period of time after their spouse dies, but this is a valid point, especially if one of the spouses is more unhealthy than the other one. Of course, the allocation decision is usually made decades before health problems become evident, but it is something for readers to consider. But also, distributions would likely be halved since there less money required for living expenses. Thanks for the comment!
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3968855/
“Generally” doesn’t help you if your situation doesn’t fall into that situation. My mom lived 19 years after my dad died.
Under the current fiscal and monetary policies, we project that our tax deferred accounts using conservative returns to be just shy of 20 mil before our first RMD in a few years. Presently, our draw down at this point is less than 2% in order stay under the earlier stated $321K threshold before the jump to the next tax bracket. Our fear is the higher tax rates that will kick in on RMDs when taken. Looking solely at the tax consequences upon withdrawal using a traditional IRA, we figure that the tax savings and total contributions have already come out of our account in the first couple of years of retirement. Because of our anticipated tax consequences, we have steered our adult children to fund Roth accounts. The notion of lower taxes in retirement is dependent on returns over your total investment years. You can run all the what if scenarios in anticipation, but your final outcome is based on statements from your accounts. Great discussion, I only wanted to provide a different point of view based on actual experience.
Wow, $20 million in retirement accounts, congratulations on that one! I think the question we all have is how? Did you buy a bunch of Apple 20 years ago and just hold onto it? That is exceptionally above average.
You are partly correct. Individual stock exposure helped us along the way. The first million came by way of INTC and MSFT beginning around the time of 286 chip set. Moore’s Law provided growth for these companies. Intel, for the most part was tied at the hip with MSFT’s ever burgeoning demand for processor speed. Early days of Qualcomm, Taser and Mastercard helped propel the growth as well. With the credit debacle, we moved out of mutual funds and began to follow the growth of individual stocks in order to make up our losses. When I saw the first iPhone on display at the San Francisco MacWorld, Apple created a unique opportunity. My daughter stood in line all day to get her hands on one. Although I did not buy a phone until the iPhone 6 came along, I did commit a large portion of my retirement account to the cause at the time. Luckily, it paid off. Forays in FB, NFLX, SQ, PYPL, and TSLA of shorter durations provided some degree of diversification and pushed my returns. Major holdings today are AAPL, MA, AMZN, LMT, VTI and TQQQ and cash. Dead money in the account is in oil (BP and CVX) albeit small positions. There was a little bit of risk taking, but it paid off over the long haul. The major mile stone in our investing was breaking the $100,000 mark. Staying invested and compounding rate of return did the rest. Mistakes were made early on involving sales charges for services provided by sales people masquerading as financial planners who needed to eat. Our investing philosophy is similar to baseball. One only needs to get on base, forget aiming for the fence. Find an investing style that suits your intestinal fortitude and stick with it, if you can stomach the downturns. Looking long term, there has and continues to be an upward bias.
Hi Ryan.
As a retired HS physics teacher, who started an encore career as a financial planner, I love your mathematical analysis of a regular versus a Roth 401k. I think a lot of people will have problems understanding the tax arbitrage because they don’t fully grasp the concepts of marginal tax rates versus effective tax rates. A good visual using buckets showing which bucket the contributions are taken and where the distributions are received is helpful. I work in the DC metro region and a significant number of clients are retired teachers, government workers and high ranking military, all of whom have a significant floor from pensions. Most of the working couples will be in the 24% bracket in retirement, so I would think that earlier in their careers or whenever they have a drop in their income, such that they are in the 24% or less marginal bracket, they should contribute to the Roth accounts. Later in their careers they may end up in a higher bracket and thus make regular contributions. It’s great to have both accounts so that you can adjust the amount withdrawn, especially between 60 and 72 to minimize IRMAA issues and keeping below the 32% bracket. Social Security is usually a non-issue in this area whereas almost every ends up having 85% subject to taxes. We sometimes do Roth conversions to fill the 24% tax bucket between retirement and 70 if the regular account value is high. If a client will never need the majority of the principal and the accounts are generally a legacy play, we look at the tax brackets of the kids who are likely to inherit them. With the elimination of the stretch IRA for non-spouses, drawing down a few million over 10 years during prime working years can be brutal tax wise. We attempt to convert at 24 or even 32% if it looks like 10 year withdrawals will be in excess of 200k per year. Thanks again for your great treatment of this important issue.
Another point to consider: during many of your working years, most people have dependent children, so you get that extra tax break there. For most retirees, the kids have grown up, so you lose that. However, when you reach 65 there is a higher stand deduction.
Great article and all the extra discussion in the comments is really helpful. I’ve always contributed tax-defered for the reasons you raised; more money invested now has the advantage of compounding growth. One tricky thing: I read an article the other day about how when you leave a company and get your 401K rolled over, often they don’t keep the tax-deferred and tax-paid contributions separate. Once it’s mingled, you’re stuck and it will all be treated as tax-differed. So you’ll pay taxes twice on the tax-paid!
One favorable use of a Roth, in my opinion, is for a minor. We have a custodial Roth IRA for my son. So it’s ‘tax-paid’ but he doesn’t make enough to actually pay taxes. Started the account when he was 14 and it will transfer to him when he is 18. He has an annual contribution goal. He’s invested in very aggressive growth and he earned 43% in 2020. I’m thinking it will be a good path through college while he’s a low earner (little or no tax burden). Once he’s in his career, he’ll have a traditional account and be paying taxes and likely put his focus on tax-deferred investing. But, if he’s smart and doesn’t use the Roth money until he retires, he will have decades of compounding interest! If you have any advice/thoughts on this topic, I would love if you would share here!
RT – you mention that in an article, they often co-mingle contributions. My personal experience in rolling over Roth 401Ks and regular 401Ks is that it never gets co-mingled, and I’ve done it with 3 jobs. Since they have to report both pre and post tax accounts, they report each account separately.
Ah, good! Hopefully, your experience supports that this is unlikely to happen. I tried to find the article again to share but couldn’t. They were basically saying to be careful to not let that happen. Just a watch-out.
I am 57 and have been maxing out my 401k and Roth IRA contributions for a number of years. I now have $800k in the 401k, $100k in the Roth IRAs, and $100k in traditional IRA. I am in California.
I haven’t done the math to figure out if a Roth 401k is better for me. However, I recently switched 50% of my 401k contribution to Roth 401k. Going forward, I plan to adjust my contributions towards Roth 401k at the rate of 10% more a year. So in 5 more years it will be 100% Roth 401k.
The only reason I am doing this is tax diversification. I want to be able to optimize my distribution strategy 10 years from now, and periodically thereafter.
I don’t know what I will be facing in 10, 20, 30 years. But I know that I don’t want to have all of my money in tax-deferred accounts.
What I am doing today may not be optimal. But to optimize requires knowledge the the rules and of my personal financial situation for decades in advance.
Here’s why I think everyone should utilize a Roth 401K instead of regular 401K (even though I have no problems with your analysis):
I switched all my work contributions to the Roth 401K back in 2006 (I was 40 yrs old). when it was first introduced. With a Roth 401K, the company match is ALWAYS pre-tax, so you’re getting the match as a regular 401K.
When I would switch jobs, I always rolled over the Roth 401K & regular 401K to a brokerage such as Vanguard and Fidelity – which gave me the ability to purchase stocks ,ETFs and mutual funds with these funds. I choose higher risk stocks such as Amazon, Apple in the Roth account so that oversized gains are all tax free. Many of these stocks purchased >5 years have returned 400-600% – now all tax free.
Luckily, I was able to retire at 50, and my wife and my Roth IRA accounts for about 33% of overall retirement savings. With the 33% in Roth, once we turn 59 1/2, we can artificially keep our AGI to the lowest tax rate until we reach 70 (when we have to take social security) – which also helps our marketplace medical coverage stay extremely low.
The bottom line is that a Roth will provide tax free income that can be used to keep your AGI at the lowest tax bracket for an extended time. The taxes paid up front can pale in comparison to the gains that can be earned over 10-20 years.
DK – I’m researching opening a brokeragelink account in my Fidelity 401K. All my 401K is not Roth. Would you suggest I start putting a percentage of my contributions toward Roth 401K and use that money to then fund the brokeragelink? (I ask this assuming I’d get my choice of which money to move.)
Also – how I got to this article on wantfi was from researching the Roth “5yr rule” and Roth conversion ladders. Any thoughts on that topic?
RT – Sorry, I just saw your post on 5/31. Personally I would contribute as much as possible into a Roth 401K and your company match (most likely by default) would go into the regular 401K. I would start with a percentage that you feel comfortable investing in more aggressive stocks/mutual funds within your brokerage – with the caveat that you know what limits your acceptable losses may be.
I’ve found the best articles on the Roth 5 yr rules came from investopedia (https://www.investopedia.com/ask/answers/05/waitingperiodroth.asp). The key takeaways are:
1) make sure you opened your 1st Roth at least 5 years before withdrawing any money (to keep it simple)
2) If you do a Roth Conversion, each conversion has it’s own 5 year period.
The company match always goes into a traditional account. There isn’t an option for Roth matches.
article said:
“And if you are above the income limit for the Roth IRA account, consider a backdoor Roth conversion by first contributing after-tax money to a traditional IRA and then immediately converting it to a Roth. You are paying the tax dollars anyway in this situation, so at least you can save on the back end with the backdoor IRA Roth option.”
Attempting a backdoor Roth conversion can be a trap for the unwary if you have any money in any existing IRA. Why? because you don’t want to pay taxes on the conversion, and if you have any money in an IRA (after the conversion), you will screw yourself with double taxation on the backdoor money. There are plenty of nice web pages outlining all the details on doing a backdoor conversion, and how to report it on your tax return. Don’t underestimate the possibility of screwing it up.
The pro-rata rule is NOT your friend:
“How the IRS accounts for after-tax and pre-tax funds in an IRA when the taxpayer is doing a partial Roth conversion is referred to as the pro-rata rule.
The formula for the pro-rata calculation is the total after-tax money in all IRAs divided by total value of all IRAs multiplied by the amount converted.”
Good point. This is why I have never attempted it because I have another IRA. A potential solution is to rollover your existing IRA into your 401k plan if your plan administrator allows it. They like more asset management fees so they should allow it.
Hello Ryan
Very interesting article and one that has generated a lot of interest in the financial community. Even this blog has comments that span almost a year. The focal point of your thesis is the mathematical equation comparing the value of Traditional vs Roth, where Traditional = Roth, for same tax rate in both periods. However, I wonder if the RMD factor complicates the assumptions of your equation. A Traditional IRA has an RMD, whose intent is to deplete the account over one’s (extended) lifetime. And Traditional IRA RMD currently starts at age 72. Conversely, a Roth does not have an RMD. So, at age 72, the Roth account can remain intact and continue to grow tax free. Hence, without a comparable voluntary withdrawal from the Roth, at 72 and beyond, the value of the “contribution” in your equation begins to diverge with a higher amount for the Roth.
My apologies if I have missed your previous reply to this topic. And if you have, can you please point to the reply date?
Thank you for this intriguing and sound article.
George
Hi George,
See the May 3, 2020 comment. You’d have to have a very sizable Traditional IRA/401k account (~2.5 million) for the RMDs to push you into a higher tax bracket than you deducted at if you wait until the RMDs force your hand.
“… when you contribute to a traditional retirement account during your working years, the deduction is applied against a single bracket, your highest marginal tax bracket, but when you take a distribution during retirement, your money is spread out over several lower tax brackets, each bucket being filled with a higher tax rate along the way, creating a lower average (effective) tax rate.”
THANK YOU for making this very important point!! I have understood this point for years, but I have NEVER BEFORE seen anyone make this point, in the many articles, blog posts, and books that I have read on retirement saving.
Me neither! Correcting this misunderstanding was one of the original goals of this blog.