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?
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.
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the individual does not receive a tax deduction at the time of contribution, but the principal and earnings could be withdrawn tax-free at retirement.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:
- The value of the tax deduction today (Traditional 401(k); or
- The value of tax-free distributions tomorrow (Roth 401(k).
Meet Our Families
|Annual Income||Marginal Tax Rate|
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 Balance||Tax Liability|
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?
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 Type||Beginning Balance||Ending Balance|
|Kavalan Family||Traditional 401(k)||$37,000||$692,969|
|(35% less in Roth)||Roth 401(k)||$24,070||$450,804|
|(24% less in Roth)||Roth 401(k)||$28,120||$526,656|
|Walker Family||Traditional 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.
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???
|Married Filing Jointly|
|rate||Over||But not over|
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|
|rate||Over||But not over|
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!
I think we can draw 3 main conclusions.
- 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.
- 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.
- 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:
- Determine your after-tax needs utilizing current spending habits.
- Compare your marginal tax bracket today with that number in the 1980 brackets above.
- 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.