Today’s main event: Roth vs. Traditional 401(k)

Imagine that it’s day one of your new job.

HR has left you a pile of papers about your new company’s retirement plan.

Thankfully, they offer an employer match in the 401(k) starting with your first paycheck! You know that you NEED to sign up today so you don’t miss out.

You’ve already decided to invest in the low-cost total market fund so you should be able to knock this task out quickly. You log in.

You enter your name and employee ID, etc. The next question asked in the sign up workflow is “Select Roth or Traditional.”

You then start muttering under your breath…“Huh, what? How am I supposed to know that?”

Unfortunately, this decision that you sometimes have to make in a hurry is very important. Making the right call can save you thousands of dollars in taxes!

Below I’ve compiled the most important details of the two plans to help you figure it out.

[If you’re looking to understand the basics of a 401(k), you may want to read How Does a 401(k) work]

What’s the Difference Between Roth and Traditional Plans?

A 401(k) is an employer-sponsored retirement plan. The good news is both a traditional and Roth are designed to encourage you to save for retirement. Both are designed to incentivize you with potential tax savings in order to save. Allow me to break down the differences.

A Traditional 401(k) Tax Is deferred

With a traditional 401(k), contributions are made with pre-tax dollars. This means you get to defer paying taxes on them until you withdraw the money.

For example, say you earned $100K in gross income before paying taxes. During the year you contributed $10,000 to a traditional 401(k). At the end of the year, your W2 will report income of $90,000. This number would be input onto your 1040 at tax time to calculate your tax bill.

When you withdraw the funds from your traditional 401(k) in the future, (usually at retirement age, but possibly sooner) that’s when you report the income to the IRS. At that point, you would have to pay any applicable taxes that were previously deferred.

Taxes on any gains in the portfolio are also deferred until they are withdrawn.

Want to hear a secret? It’s possible to you will never have to pay tax on this money! More on this later.

Roth 401(k) Contributions Grow Tax-Free

A Roth account works differently. You contribute after-tax dollars. This means you are not getting a discount on your current year taxes by contributing to a Roth.

With no current year discount, what’s the benefit of a Roth?

The beauty of a Roth account is since you’ve already paid taxes on this money, it is allowed to grow tax-free. You won’t have to pay taxes on any gains your investments make.

For example, say you earned $100K in gross income before paying taxes. During the year you contributed $10,000 to a Roth 401(k). At the end of the year, your W2 will report income of $100,000. This number would be input onto your 1040 at tax time to calculate your tax bill.

When you withdraw the funds from your Roth 401(k) in the future, (usually at retirement age, but possibly sooner) you will not have to pay taxes on this money again.

Tax-free growth can be a beautiful thing!

Let’s Visualize a Traditional Account vs. a Roth

Let’s say that Joe Taxpayer wants to contribute $10,000 of after-tax dollars towards his retirement. He’s currently in the 22% marginal tax bracket meaning that his next earned dollar will be taxed at this rate.

If you’re curious, you can find a summary of the 2019 marginal tax brackets here.

For this example, I’m going to compare a $10,000 Roth contribution to a $12,821 traditional contribution so that Joe’s out of pocket after tax cost for each contribution is the same.

Year 0 Contributions Summary

Traditional 401(k) Roth 401(k) Pre-Tax Amount Invested $12,821 $0 Post Tax Amount Invested $0 $10,000 Tax Savings (Based on 22% Marginal Tax Rate) ($2,821) $0 Total After Tax Amount Invested $10,000 $10,000

Great, so now we know what our contribution options look like. Joe is indifferent between the two options on an after-tax basis today. But which is better?

As usual with all of the “most fun” personal finance questions, it depends. We still don’t know what this will look like when Joe withdraws the money. That’s the real key to finding a winner.

First, I need to explain one more key concept.

What’s the Difference Between Marginal and Effective Tax Rates?

Marginal Tax Rate

Your Marginal tax rate is the rate you will pay on the next dollar you earn. For example, if you are in the 22% tax bracket, you will pay 22% of federal tax on the next dollar you earn, which is the same as your marginal tax rate.

Effective Tax Rate

Your effective tax rate is the blended rate you pay. The US tax structure is tiered. The first dollars earned are taxed very low and as you cross certain income thresholds, the marginal tax rate paid on each dollar increases. The blended rate between the income taxed at a low rate and high rate is your effective tax rate. For example, a married couple may earn $120,000 in Gross Income and be in the 22% tax bracket (marginal rate), while their total tax bill ends up being $13,000 for an effective tax rate of 10.8%.

Why It’s Important to Differentiate Between Marginal and Effective Tax Rates

To evaluate the better choice between a traditional 401(k) and a Roth, we need to compare the marginal tax savings on traditional contributions to the actual or projected marginal taxes paid on the money when it’s withdrawn. If the withdrawals occur in a year with no other income, the actual tax paid on them may match the (lower) effective rate paid by the taxpayer.

The Future (Scenario A): Current Marginal Tax Rate = Future Tax Rate On Distributed Amount

So we’ve hopped into our time machine. It’s 10 years later and Joe is retired with a pension. Interestingly enough, after his pensions take up all the room in the lower tax brackets, Joe still has a marginal effective tax rate of 22% when he withdraws the money.

Thankfully, all investment amounts from the year 0 contributions have doubled! Aren’t investment returns wonderful? Let’s take a look at how the traditional and Roth options have fared on an after-tax basis.

Year 10 – Scenario A Withdrawals Summary

Traditional 401(k) Roth 401(k) Pre-Tax Amount Withdrawn $25,642 $0 Post Tax Amount Withdrawn $0 $20,000 Total Amount Withdrawn Before Taxes $25,642 $20,000 Tax on Pre Tax Amount (22% Marginal Tax Rate) ($5,641) $0 Total Amount Withdrawn After Tax $20,000 $20,000

Yup. That’s right! It’s a tie. Yea I know I set you up for this one.

Notice what stayed the same between year 0 and Year 10 scenario A. Yup, the marginal tax rates stayed the same.

Aren’t hypothetical examples fun? If we knew for a fact that Joe’s marginal tax bracket would be the same in retirement and in the contribution year, he would be indifferent from an after-tax dollar perspective between a traditional 401(k) and a Roth 401(k).

Unfortunately, since we are trying to predict the future, there’s more than one possible outcome. Let’s check out another.

The Future (Scenario B): Higher Tax Rate Paid On Distributed Amount

We’re back into the time machine and end up at the same point in time but an alternate universe. Scenario B is my favorite for the Taxpayer family.

Sometime after making his year 0 contributions, Joe shot up the corporate ladder. He became CEO of his company and started raking in the real money. More than he’d ever really know what to do with. He even retired with a pension of $1M a year for life. WOW!

All the investment amounts from the year 0 contributions have doubled! In reality, Joe does not care because he has more than enough to live on. Since he’s now firmly in the highest tax bracket for life, Joe decides to pull his traditional IRA money out of the account in year 10. We’re going to calculate the cost of the withdrawals on the highest current marginal tax rate of 37%.

Year 10 – Scenario B Withdrawals Summary

Traditional 401(k) Roth 401(k) Pre-Tax Amount Withdrawn $25,642 $0 Post Tax Amount Withdrawn $0 $20,000 Total Amount Withdrawn Before Taxes $25,642 $20,000 Tax on Pre Tax Amount (37% Marginal Tax Rate) ($9,488) $0 Total Amount Withdrawn After Tax $16,154 $20,000

Imagine me saying the following in my best boxing announcers voice.

Ding ding ding. The winner by way of $3,846 after-tax dollars is the Roth 401(k).

It turns out when the tax rate that you pay on your traditional retirement plan withdrawals is more than the marginal rate when you made your contributions you would have been better off with a Roth.

The beauty of this scenario is that even if the Taxpayer family incorrectly chose the traditional in year 0, they’re still rich. If you made a mistake causing you to pay a few thousand in extra taxes, I’d imagine that it’s much more palatable with a million dollar annual pension.

Back into the time machine, we go.

The Future (Scenario C): Lower Tax Rate Paid On Distributed Amount

Back into the time machine one last time to yet another alternate universe. Scenario C is also 10 years after the contribution. Joe’s family has managed to save a million bucks and retire early.

He’s married and filed a joint return with his wife. Together they live a comfortable lifestyle and spend $50K a year.

Since we don’t know what the tax brackets are going to look like in 10 years let’s assume they stay the same as they are today.

By plugging $50,000 of taxable income into this calculator, it shows a total tax bill of $2,739 which represents a 5.5% effective tax rate. We’re using the effective tax rate in this case because we need to blend the tax cost of all 401(k) withdrawals in that year.

Just as before, all investment amounts from the year 0 contributions have doubled! Let’s take a look at how the traditional and Roth options have fared on an after-tax basis.

Year 10 – Scenario C Withdrawals Summary

Traditional 401(k) Roth 401(k) Pre-Tax Amount Withdrawn $25,642 $0 Post Tax Amount Withdrawn $0 $20,000 Total Amount Withdrawn Before Taxes $25,642 $20,000 Tax on Pre Tax Amount (5.5% Effective Tax Rate) ($1,410) $0 Total Amount Withdrawn After Tax $24,232 $20,000

Note that the chart above only shows the year 0 portion of the withdrawal. Joe pulled out $50K, the rest of which was funded in a different year.

Back to my best boxing announcers voice.

Ding ding ding. The winner by way of $4,232 after-tax dollars is the traditional 401(k).

It turns out when the effective tax rate that you pay on your traditional retirement plan withdrawals is less than the marginal rate when you made your contributions the plan favors the traditional.

Pay No Tax

Let’s pretend that in addition to the 401(k), Joe had some money in a taxable account that can be used for living expenses.

With the current $24,000 standard deduction available to a married couple filing jointly and no other taxable income, Mr. and Mrs. Taxpayer can pull $24,000 from their traditional 401(k) account each year tax free. If they are able to plan in advance for that scenario, they can avoid paying taxes on contributions into their 401(k) and withdrawals from it as well!

It turns out that unlike life and death, taxes are not guaranteed!

For many couples, living on $24,000 a year in the “pay no tax scenario” may not be practical. If you want to live on more and still avoid paying taxes, the withdrawals from a traditional plan can be supplemented with after-tax savings in taxable or Roth accounts. Also, note that the next bucket of income would only be taxed at 12% federally based on 2018 tax rates so paying a little tax may not be portfolio busting.

The Most Important Factor In Choosing Between a Traditional and Roth

I think you’ve probably figured it out based on the scenarios above but I’ll restate the obvious.

To maximize your after-tax dollars, also known as the money you have available to spend, you want to minimize your taxes.

A traditional account is a winner if you pay a higher tax rate on your last dollar earned now than you would pay in taxes when you withdraw your savings

A Roth account is the winner if you pay a lower tax rate on your last dollar earned now than you would pay in taxes to withdraw the money.

I’m Probably Going to Make More Money In The Future Than I Do Today. Does This Mean I Should Pick The Roth?

It’s true that in most cases, income increases throughout a career. Your marginal tax bracket could also increase with your income.

It’s important not to confuse a higher tax bracket during your future working years with the tax rate you will pay on your withdrawals in retirement.

In most cases, you’d wait until you retire to withdraw the money in a traditional retirement account. In retirement, your tax bracket would be based on your income at that time.

During retirement, you may have income from pensions, social security, withdrawals from traditional retirement accounts, investment income and other business income. Those are the items to consider when thinking about your future tax rate. During your peak career income, you would be very unlikely to be withdrawing funds from a traditional plan.

How Do I Know What My Tax Rate Will Be When I Need The Money?

That my friends is the money question. We can do our best to plan based on what we already know such as an expected pension, current savings and expected retirement spending.

Unfortunately, the tax code can change every year and all we can do is guess what it will look like years from now.

Even if we assume the tax code stays the same, we don’t know for sure what our future earnings, savings and spending needs will be.

All we can do is use the information we have available and make a decision based on our best guess of the tax rates we will pay in the future.

Other Differences Between a Roth and Traditional Account that Matter

Other Advantages of a Roth Account

Roth accounts have no Required Minimum Distributions (RMDs)

With all 401(k) accounts, you are required to start withdrawing money by the age of 70.5. This could force you to pull more money out than intended. If so, the extra can still be reinvested in a taxable account but it will be subject to capital gains tax.

A Roth 401(k) can be rolled over to a Roth IRA with no tax consequences. Roth IRA’s are not subject to RMD’s.

A RMD may cause you to pay taxes at a higher marginal rate than planned, disqualify you from qualifying for certain tax credits or even cause social security benefits to become taxable. Roth IRA accounts do not require you to take the money out of them until the death of the owner.

Shield More Money In Tax-Advantaged Accounts

If you are going to max out your choice of account, contributing on an after-tax basis into a Roth allows you to protect more money in tax-advantaged accounts than putting the same amount in a traditional account.

If you have more pre-tax money to invest after maxing out traditional accounts, the difference would be invested in a taxable account. The Roth also may force you to save if you don’t have the discipline to invest the tax savings had you gone the traditional route.

State Estate Taxes

For states that have estate taxes, the higher balance of a traditional account may trigger an estate tax bill. As Michael Kitces of a Nerds Eye View explains, “it’s bad news to pay estate taxes on a retirement account when part of it isn’t even yours in the first place – it’s earmarked for Uncle Sam!”

Other Advantage of a Traditional Account

A neat trick to keep tax bills low by paying the tax from a traditional plan in the year you choose to is to convert funds from your traditional 401(k) to a Roth IRA.

A Roth conversion lets you convert funds from a traditional IRA to a Roth account. The amount you roll over will be treated as income in the year of the conversion. This is a two-step process.

Rollover your traditional 401(k) to traditional IRA Convert funds from traditional IRA to Roth IRA

Roth Conversions can be an early retiree’s best friend. Here’s why. You can get the best aspect of a traditional and a Roth.

The idea is that you’ve already contributed to a traditional plan and enjoyed the tax savings. Upon retirement (or another period of lower income) you convert your traditional 401(k) to a Roth IRA following the steps above. By converting small enough amounts to stay in a low tax rate, you pay less in overall taxes.

Once converted into a Roth IRA, the retiree can withdraw the “contributions” after five years tax-free. Any investment growth after the conversion is also tax-free and not subject to RMD’s during the plan owners lifetime.

Yup, with these steps, you can theoretically put money into a traditional account pretax, convert it into a Roth paying no (or low) taxes. Then you can let it grow tax-free for the rest of your life. #Winning

Other Considerations – State Taxes

Most of the taxes mentioned above are of the federal variety.

State taxes matter too. One key consideration that may impact your choice is the taxes of the state you live in today compared to where you live in when you withdraw the money.

If you are planning to move from New York (that charges a state income tax) to Florida (with no income tax) at retirement, that would favor a traditional plan. If your planning to retire to a state that has a higher tax rate than your current state, it would favor a Roth.

What’s Your Strategy?

Whew. That was a lot of info. Thanks for sticking with me to the end. If you have any questions, please schedule a free consultation to learn how I can help you.