The Asterisk in the Roth v Traditional 401(k) Decision

Buckle your seatbelts boys and girls and hold on tight, this is going to be a bumpy ride. Today, we’re looking to tackle what’s better, Roth 401(k) or Traditional 401(k) retirement accounts. The sheer volume of variables impacting the decision can make your head spin. But fear not, if you can get through this post you should be able to draw some reasonable conclusions that can be applied to your specific retirement plan.

Roth 401(k) or Traditional 401(k)?

Physician on Fire covered the Roth v Traditional debate in a very comprehensive post – Should You Invest in a Roth or Traditional 401(k)?

His conclusion: if you are in the peak earning years of your career and your income is likely to go down during retirement, then that lower income means a lower tax bracket and a lower bracket means you’re better off with a Traditional 401(k). This thought process is both logical and correct; but, it hinges on the assumption that our tax rates will stay the same.

I will take a slightly contrarian view to that assumption.  My fear is not that I will earn more income during retirement; my fear is that I will pay higher taxes on less income due to changes in the tax code.  How would such a change impact this decision?  And how likely is that to happen?

This post will answer the first question, and other than Marty McFly no one can really answer the second; however, we can use historical rates to compare different tax environments. For this exercise, I will compare 2018 tax rates with 1980 rates.

I chose 1980 because the Tax Reform Act of 1986 ushered in a significant shift in tax policy, therefore using 1980 and 2018 allows for a more apt comparison of different tax policies (for a more thorough explanation of historical tax rates, check out my post on the TCJA Tax Diversity).  The question I want to answer is, what would a deduction today look like if rates shift again?

Spoiler Alert

Should tax rates remain relatively close to 2018 levels the better option is the Traditional 401(k) account. Should rates move higher and closer to 1980s levels, then the Roth 401(k) is the better bet.  Keep reading to see how drastic the differences are, which will allow you to determine how much you should hedge against rising income tax rates.

The Basics

Roth 401(k) is a retirement plan where the individual does not receive a tax deduction at the time of contribution, but the principal and earnings could be withdrawn tax-free at retirement.

Traditional 401(k) is a retirement plan where the individual receives an immediate tax deduction at the time of contribution but pays tax when withdrawn at retirement.

There are many arguments for and against Roth plans but what it boils down is what’s better:

  1. The value of the tax deduction today (Traditional 401(k); or
  2. The value of tax-free distributions tomorrow (Roth 401(k).

Meet Our Families

Annual IncomeMarginal Tax Rate
Kavalans$500,00035%
Yamazakis$250,00024%
Walkers$100,00022%

All three families are:

  • In their mid-30s, would like to work until age 65
  • Recently been offered a Roth option for their 401(k)s.
  • Able to contribute up to $37,000 pre-tax.

For the Traditional 401(k) option, the tax deduction means they can contribute the full $37,000 to the plan while for the Roth 401(k) the contribution will be reduced based on their tax bracket.  This reduction is the “cost” of the Roth and the basis for our discussion.

Is the reduction worth the tax-free distributions?

MB = Marginal Bracket

Beginning BalanceTax Liability
KavalanTraditional $37,000$0
35% MBRoth$24,070$12,930
YamazakiTraditional $37,000$0
24% MBRoth$28,120$8,880
Walker Traditional $37,000$0
22% MBRoth$30,300$6,700

The question we’re trying to answer is at what point is the growth resulting from the higher contribution amount in the Traditional 401(k) not worth the additional tax liability?

Future Values

Now let’s invest the money in an S&P 500 index fund.   Over the prior 30 years, assuming dividend reinvestment, this fund grew an amazing 1,872.89%. Obviously, it’s impossible to forecast future growth, so for purposes of this exercise let’s hop into our time machines and pretend we made this investment 30 years ago in 1988. (To see different historical returns on the S&P check out the calculator on DQYDJ.com.)

Account TypeBeginning BalanceEnding Balance
Kavalan FamilyTraditional 401(k)$37,000$692,969
(35% less in Roth)Roth 401(k)$24,070$450,804
Yamazaki FamilyTraditional$37,000$692,969
(24% less in Roth)Roth 401(k)$28,120$526,656
Walker FamilyTraditional 401(k)$30,300$692,969
(18% less in Roth)Roth 401(k)$28,120$567,486

Not surprisingly, the Traditional account’s balance has, percentage-wise, the same differential from the Roth it had at contribution (ie. the marginal tax bracket or tax savings at contribution). The only difference being the Walker family who reduced their marginal rate by contributing to a Traditional versus a Roth.

Now that we’ve quantified the long-term value of the tax deduction, we need to quantify the value of the tax liability upon distribution to properly compare it against its Roth counterpart.

Distribution Phase

Let’s fast forward to retirement.

The Kavalans, whose marginal rate was 35% when the contribution was made, earned 35% more in the Traditional 401(k) versus its Roth counterpart. Accordingly, during retirement they are better off utilizing a Traditional 401(k) account so long as their marginal tax rate is below 35%.  Anything beyond 35% and the additional growth within the Traditional account is overrun by taxes and they would have been better off with the tax-free Roth account.

Based on today’s rates, the Kavalan’s “win” so long as their taxable income is below $400,000 (32% < 35%). They “push” between $400,000 and $600,000 (35% = 35%). And they “lose” should they earn anything beyond $600,000 (37% > 35%).

The Yamazaki family made 24% more in the Traditional account versus its Roth counterpart, so they “win” so long as their taxable income is below $165,000 (22% < 24%). They “push” between $165,000 and $315,000 (24% = 24%). And they “lose” should they earn anything beyond $315,000 (32% > 24%).

And the Walkers, at 18.1%, “win” at anything below $77,400, and lose for every dollar earned thereafter.

So we’re done, right???

2018 Brackets
Married Filing Jointly
rateOverBut not over
10%$-$19,050
12%$19,050$77,400
22%$77,400$165,000
24%$165,000$315,000
32%$315,000$400,000
35%$400,000$600,000
37%$600,000

Pump the Brakes!

While the prior section certainly suggests that for the majority of taxpayers, the Traditional 401(k) is the better option. That calculation has a plot hole bigger than the Death Star’s thermal exhaust port.

That calculation relies on today’s rates and therein lies the rub.  We have no clue what tax rates will be in thirty years!  Moreover, most of us reading PF blogs weren’t old enough to earn much of anything prior to Reagan so we have little to no experience with rates prior to the 1986 Tax Reform Act.

Let’s use tax rates from the 1980s with incomes indexed using 2% inflation so they represent 2018 dollars.

1980 Brackets in 2018 Dollars
Married Filing Jointly
rateOverBut not over
0.00%$-$10,421
14.00%$10,421$16,857
16.00%$16,857$23,293
18.00%$23,293$36,472
21.00%$36,472$49,039
24.00%$49,039$61,912
28.00%$61,912$75,398
32.00%$75,398$91,642
37.00%$91,642$107,886
43.00%$107,886$140,375
49.00%$140,375$183,898
54.00%$183,898$262,361
59.00%$262,361$335,307
64.00%$335,307$497,751
68.00%$497,751$660,194
70.00%$660,194

No, your eyes aren’t deceiving you, there really were sixteen brackets!

Under these rates, the Kavalans are better off using the Roth option for every dollar after $91,642. Ouch!

And the Yamazakis only win with the Traditional option at distributions below $49,039. Double Ouch!

The Walkers, at 18.1% are suddenly living on $36,472.  Super Ouch!

Conclusion

I think we can draw 3 main conclusions.

  1. At retirement it’s most efficient to use a Traditional account for income equal to or less than the marginal tax rate of your working years.  Meaning, no matter what happens to tax rates there will be some headroom for withdrawals at rates below your current marginal bracket.
  2. For income above your current marginal rate, it’s most efficient to withdraw from a Roth account. More importantly, the further you are from retirement, the less you can rely on today’s rates being an indicator of what you can withdraw at favorable tax rates.  Since the Reagan tax cuts we saw tax brackets tick up to 39.6%, we experienced a 3.8% Medicare surtax and saw our itemized deductions dwindle under the Pease Limitation. These were all tax increasing measures.  What’s more, we still maintain an imbalanced budget and carry a record debt load.  These trends, this debt, and historical rates all point towards a future with higher rates.
  3. To take advantage of the additional growth benefit in the Traditional account while also hedging against the risk of paying punitive tax rates, a well balanced financial plan includes income in both tax-deferred and tax-free buckets.  How much you’ll need in each bucket depends on the individual.  

A quick exercise you can run using the charts in this post to help determine “your” number is the following:

  1. Determine your after-tax needs utilizing current spending habits.
  2. Compare your marginal tax bracket today with that number in the 1980 brackets above.
  3. The amount below your marginal bracket is safe to withdraw from the Traditional Account, the amount above is better served coming from a Roth account.

Obviously this exercise does not account for deductions, social security, pension or other income sources but it should give you an idea of your income tax exposure and serve as a starting point to help determine how much to contribute into a Roth account versus a Traditional.

Cheers,

Woodstock

7 comments

  1. Great post! I’ve wondered about contributing (at least partially) to my Roth 401k instead of my traditional plan, but I ran the numbers and had a similar conclusion to this post. Our top tax rate is only 25%, or 22% in 2018 terms. It’s always good to think about your options and make sure you’re making the right choice.

    Also, I visited the “Kavalan Family” at their distillery in Taiwan. Nice people, awesome place!

  2. Thanks Adam! Glad you liked it. And the Kavalans are easily my favorite family. Especially aunt Sherry.

  3. I like to do both — we max out our traditional 401k’s, which reduces our MAGI, making us eligible for full Roth IRA deposits. Then, we max both Roth IRAs. Feel like it’s the only logical thing to do, as we don’t qualify to deduct taxes on Traditional IRA contributions due to our income and availability of an employer-sponsored retirement plan.

  4. Appreciate the analysis, I was always if the mindset that if you keep expenses (withdrawals) low in retirement, similar to the median income household in the USA, that you wouldn’t get hot too hard with tax rate changes. This certainly suggests otherwise and I appreciate the varying viewpoints. I still think there would be time to adjust since tax rates wouldn’t be changed back to pre-1986 cakes overnight.
    You could cut rates that day but I don’t think you could raise them that quickly.

    1. Thanks for reading Cole. I agree, nothing with government happens quickly (or for that matter, logically).

  5. The solution, as always, is hedge your bets. Use Roth 401(k)s during residency/low earnings years. Do Backdoor Roth IRAs every year. Consider Roth conversions during early retirement. Super savers and those with substantial rental property or pensions should lean more toward Roth contributions and conversions than those without.

    Most of your retirement account contributions (employer portion of 401(k)/PSP and all of a Defined benefit/cash balance plan and all of a second 401(k)) HAVE to be tax-deferred. So no need to make a decision there.

    All that’s left to decide is the $18.5K of employee 401(k) contributions each year. Whether that goes Roth or traditional 401(k) isn’t going to have any real impact on my retirement (currently only 20% of my retirement account savings and 4% of my total retirement savings), and probably not on that of most people. So if you really feel strongly one way or the other, then do that. But otherwise, I think the default is still tax-deferred during peak earnings years. The tax rates selected for this analysis are totally cherry-picked. Run your numbers again using the LOWEST tax rates you can find. Even if we ended up with 1980s tax rates, what are the chances you have them for your ENTIRE retirement?

    1. My main take away from the article was to hedge your bets and have some Roth money in your portfolio. I wish everyone had a perfect retirement plan with the backdoor Roth and Roth conversion strategies in retirement but the reality is some people solely rely on the $18.5K employee contribution for their retirement. Also, as you mentioned, the rest of your retirement accounts will be tax deferred anyway.

      Anytime we have the Roth vs traditional debate we have to make some assumptions and most of the time you hear “based on current tax rates” which is cherry picking in its own. This was just to show the other end of the spectrum hence the title of the article.

      Anyway thanks for stopping by.

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