The Great Roth Controversy

I recently shared some thoughts on how to become Financially Independent in the shortest possible time by leveraging tax advantaged accounts such as the 401k, 403b, HSA, and Traditional IRA. Taking advantage of all possible tax deductions Today is a great way to Turbocharge Your Savings, accelerating Financial Independence by years

I even made some disparaging remarks about the Roth IRA. Some reader’s pushed back, which is always a good thing.

I will explain the reasons that I believe the Roth 401k and IRA are the least advantageous investment choices. Furthermore, I will provide an overall recommendation for where to save for Financial Independence

First a brief comparison

Dollars saved in a Traditional 401k / IRA are pre-tax. We pay no income tax on dollars going in, an immediate savings of up to 39.6%, the highest marginal rate. The invested funds are allowed to grow tax free, so all interest, dividends, and capital gains are untaxed until withdrawn from the account. Upon withdrawal, all funds are treated as ordinary income, similar to a paycheck.

Dollar saved in a Roth 401k / IRA are after-tax. We pay normal income tax on any money put into a Roth, but this is the only tax that will ever be paid on those funds. Any interest, dividends, and capital gains are tax free, forever

Ultimately the arguments for both types of accounts come down to one question: Will your tax rate after retirement be higher or lower than it is today?

Let’s explore a few scenarios

Median Income

Let’s look at the median income earner, a family making ~$54k/year. Because they are targeting early retirement, they are saving 50% of their after-tax income. (I outlined the median income earner family in the post on how to Turbocharge Your Savings.)

They heard general advise that young people and those with low income can benefit from a Roth 401k, and they thought, “That sounds like us!” Their highest marginal rate is “only 15%”, and some of the $17,500 savings would even be taxed at only 10%. “Surely our post-retirement tax rate will be higher!”

With a $17,500 contribution to the Roth 401k rather than the Traditional 401k, the family would pay an additional $2,502 in tax, an effective tax rate of 14.3%. I’ll be generous and consider the 401k match of 2.7% ($1,444) as part of the contribution, lowering the effective tax rate to 13.2%

Fast forward 16 years to the point where they have achieved financial independence, and decided to quit their job and travel the world. Maybe they’ll even do something crazy, like retire first then have kids. Sounds like a fine plan to me

Using constant 2014 dollars, how much would this family need to withdraw from the retirement account before paying the same tax rate of 13.2%?

$113,100! 5x their entire cost of living

Withdrawing their target spend of 50% of their after-tax working income, $22,700, they would pay an effective tax rate of 1%

But wait, it gets better. Remember that $2,502 that Mr and Mrs Median gave to Uncle Sam 16 years ago, instead of investing for their own use? Had they invested those funds in their brokerage account as I recommended, their total savings would be 13% larger

Using the Roth 401k cost them. They must either work longer, or be comfortable retiring with fewer assets

90% Percentile

What about somebody that earns a little more, perhaps at the 90th percentile of all US families? With an income of $118k, this family is firmly in the 25% marginal tax bracket.

Being generous once again, counting the Roth 401k employer match as part of contributions, our example family elects to hand over $4,375 to Uncle Sam instead of investing for long term personal freedom. They too targeted an early retirement budget of 50% of the working year income, a bit higher since they could afford a few luxurious due to their high earning power

How does this look come retirement time?

If they continue with their target spending of ~$48k, 50% of working years after-tax income, they will pay a tax rate of 6.9%. And let’s not forget, had they chosen the Traditional 401k, those tax dollars would have been invested as well

That’s a substantial haircut off the 25% they chose to pay years earlier

To pay the same effective tax rate, they would have to make a serious effort to see how the 1% lives, withdrawing $385k in one year. Kobe beef steaks and lobster tails on the yacht, anyone?

The Last Dollar Principle

In both examples, choosing a Roth 401k over a Traditional 401k resulted in less wealth and more tax. Why?

Think about it this way. When we invest $1 in a 401k, that dollar is the last dollar we earned. It is taxed at our highest marginal rate. But when we withdraw $1 from our 401k years from now, it is our First Dollar. As we saw in the pretty pictures earlier, the First Dollar is always taxed at 0%

Now as spending increases to large levels, above ~$94k into the 25% marginal tax rate things get interesting.

This is where some start to argue about mathematics. We could pull out our college algebra textbooks and prove beyond a shadow of the doubt that a Traditional 401k and a Roth 401k are EXACTLY THE SAME as long as the tax rate is the same. This is true. 25% tax paid today is mathematically the same as 25% tax paid in the future after our funds have grown tax deferred

But math textbooks make simplifying assumptions which are often impractical in the real world (Hello quadratic equation, I’m talking to you.)

The odds of our Mr and Mrs 90% earning $94k in income from other sources (the lower edge of the 25% marginal rate), and every penny withdrawn from their 401k is taxed at 25% in the future is infinitesimally small

What matters the most is the aggregate tax rate, and for both of our examples this is lower than the marginal rate.

Pensions and Social Security

But there are other income sources. I believe Social Security is here to stay, and we will certainly be able to access those funds in 30 or 40 years.

There are also a healthy number of people with pensions, although this is becoming less common

Above $44k in total income, 85% of Social Security is taxed as ordinary income. 100% of a pension is taxed at ordinary income

Both Social Security and Pensions are in proportion to working income. In other words, the more you earned while working the greater the amount received from SS and a Pension

A typical federal government pension (a very generous program) will pay 1% per year of service, so someone with 30 years of service could replace about 1/3 of their salary. A high earner that works until Age 65 could expect SS to replace about 26% of their salary.

For a federal pension and social security to pay $90k in taxable income a year, working year income would need to be greater than $185k.

As this is firmly in the 28% marginal tax rate, this family would also benefit by using a Traditional 401k

Required Minimum Distributions

Starting at Age 70.5, Uncle Sam will require that you withdraw funds from your IRA and 401k. The amount is based on life expectancy, so the older you get the larger the minimum distribution. See Jim Collins’ excellent post on this topic for more detail

How much $ would we need in a 401k for the RMD to have a punishing impact? As we saw above in the case of Mr and Mrs 90%, a withdrawal of $385k has an effective tax rate of 25%

At Age 70.5, this equates to a 401k value of over $10.5 million

An individual that made maximum 401k contributions, with employer match, for 30 years could theoretically have this amount in their 401k. All it requires is an annual return of about 16% for 30 years. It’s not inconceivable, Warren Buffett did it

(If this is you, let’s blow this Popsicle stand and start a hedge fund)

When Is The Roth A Good Idea?

I’m glad you asked

The option to pay tax today and never again is of value, no doubt. If you have an effective tax rate today of 0%, not uncommon for students and others in temporary low income situations, a Roth 401k or IRA is a great idea

It is also not a bad idea if you’ve already maxed out your Traditional 401k and have additional funds to invest. When saving a high percentage of income, this SHOULD be the case. Instead of putting an extra $5,500 into a brokerage account, you could put them in a Roth

For many, however, a brokerage account is just as good. If during your retirement years you expect to earn less than ~$90k/year, staying below the 25% tax bracket, then all Long Term Capital Gains and Qualified Dividends are already taxed at 0%. At these income levels, a brokerage account effectively has a 0% tax rate for stocks, much like a Roth

The brokerage account also has the advantage of being able to harvest capital losses, and to spend dividends or gains anytime before Age 59.5

Conclusions

We have seen that for people with median income and above, taking advantage of the tax benefits of a Traditional 401k has long term tax advantages, allowing one to become Financially Independent in the shortest possible time

We also saw that the impact of Social Security, Pensions, and RMDs also favor the Traditional solutions over the Roth

In conclusion, the preferred investment vehicle is the 401k. The HSA is also great. Only when all other options have been exhausted does the Roth start to look interesting, except for families with poverty level incomes (ideally temporary)

For a rule of thumb, I would save funds into accounts in this order during the working years:

401k up to company match HSA 401k up to maximum Traditional IRA if tax deductible (subject to MAGI thresholds) Brokerage account Maybe $5k in a Roth (subject to MAGI thresholds) Maybe after-tax contributions to a 401k for Backdoor Roth (pros/cons)

Addendum:

Why a Roth last? As can be seen in the comments, this is a contentious topic

What if you have already maxed out a 401k, an HSA, are not eligible for a deduction on a Traditional IRA, and have quite a bit of money remaining to be invested. Isn’t putting $5,500 into a Roth better than putting those funds into a Brokerage account?

No

Because we aspire for a long retirement, our portfolio is stock heavy. As explained in our classic post, Never Pay Taxes Again, taxes on Long Term Capital Gains and Qualified Dividends is 0% for incomes below ~$94k.

This is the same tax profile as a Roth, but with one distinct difference

We can spend those capital gains and dividends whenever we want, whereas the earnings in a Roth cannot be touched until Age 59.5 without facing a penalty and taxation (you can only access the Contributions)

Let’s look at that in numbers for Mr and Mrs 90%

Over a 13 year working career (faster due to using tax breaks of 401k), putting $5,500/year into a Roth IRA results in about $72k in contributions. Using the FV function in Excel and a 7% annual return, when we retire early the account is worth about $110k.

If we had invested those funds in a Brokerage account instead, we would also have $110k. Since Mr and Mrs 90% didn’t sell any of their stock they generated no capital gains. And since they invested in their 401k reducing their marginal tax rate to 15%, they paid no tax on any of the dividends.

Of course with that stock being in a brokerage account, they have full use of the annual dividends. At a 2% dividend rate on the S&P500, that is $2200 per year in cash flow for our use with zero tax

Fast forward 10 years, assuming the same annual growth rate, the account is now worth about $218k and continues to pay dividends (isn’t it great when the market only goes up?) Speaking of the market going up, you can’t harvest capital loss in a Roth

Assume at this point we need access to $150k in future dollars to buy a large sailboat to fulfill our dream of sailing around the world.

If we had invested in a Roth and we try to access our Roth contributions at that point, we only have access to our original $72k investment. We need more money

While full access to contributions is often cited as an advantage of a Roth, those contributions lose to inflation with each year. While we can access our $72k in contributions, those funds are only worth about $53k in Jan 2015 dollars. The earnings are much more valuable

Because we didn’t have access to the dividends in the Roth during our decade of joyful living, we’ve been spending down the Brokerage account a little faster. Maybe we don’t have enough funds there to cover the difference

Now we need to either tap the Traditional 401k/IRA or the earnings in the Roth. Both result in a 10% early withdrawal penalty and full tax on the withdrawal. Such is the price of fulfilling our dreams

But what if instead we didn’t use the Roth years earlier? We have $218k sitting there in our brokerage account, ready to use at our leisure without restriction.

And that is why the Roth is last, and why there is a big Maybe for all Roth contributions

(Post Early Retirement, creating a Roth IRA Conversion Ladder as part of our overall tax strategy, is a great practice to minimize long term taxes. This is how we pay $0 in tax on our contributions and $0 on the withdrawals)