Kevin Michels, CFP®, EA
Nearly 80% of full-time workers have access to a 401(k) or some other type of employer-sponsored retirement plan. Along with the growing popularity of 401(k) plans, we are seeing employers offer Roth 401(k)s to their employees as well.
I frequently get the question from clients, friends, or family members on whether or not they should elect to save in their Traditional 401(k) or Roth 401(k).
Obviously, the answer always begins with “it depends”, however in the majority of cases I find myself recommending not doing just the Traditional 401(k) or just the Roth 401(k), but a combination of the two.
If you’re simply looking at the math on which option will provide you with more after-tax money only one factor comes into play: Your tax rate at the time of contribution compared to your tax rate at the time of withdrawal.
Scenario #1 – Tax rate is the same at time of contribution and withdrawal
Let’s assume you earn $120,000 per year and have elected to contribute 15% of your income, $18,000, to your Roth 401(k). Before the deferrals are contributed to your account, they are taxed up front. Assuming you are in the 25% tax bracket, you’ll be taxed $4,500 on your contributions, leaving you with $13,500 to contribute to your Roth 401(k). Let’s assume you let this contribution grows at 8% for 40 years. At the end of the 40 year period your contribution will have grown to $293,281. Qualified distributions from a Roth 401(k) are completely tax-free, leaving you with an after-tax amount of the full $293,281.
Now, let's assume you decided to defer 15% of your income to your Traditional 401(k) instead of your Roth 401(k). In this case, you are able to make the full $18,000 contribution since contributions aren’t taxed up front. An $18,000 contribution that grows for 40 years at 8% will end up totaling $391,041. However, all withdrawals from the account will be taxed at your ordinary income rate. Assuming you are in the same tax bracket at the time of withdrawals, 25%, your tax liability will be $97,760, leaving you with an after-tax amount of $293,281. Look familiar? It’s the same after-tax amount you ended up with had you saved in a Roth 401(k).
Scenario #2 – Tax rate at the time of withdrawal is higher than at the time of contribution
If we change the scenario so the tax rate at the time of withdrawal is higher, let’s say 33%, the outcome will be different. The Roth 401(k) scenario will yield the same result, an after-tax amount of $293,281. However, the Traditional 401(k) scenario will yield a worse result; your tax liability will jump to $129,043, leaving you with an after-tax amount of $281,550.
Scenario #3 – Tax rate at the time of withdrawal is lower than at the time of contribution
If we lower the tax rate at the time of withdrawal to 15% the Roth 401(k) scenario will still yield the same result, however, the Traditional 401(k) scenario will yield a better result; your tax liability will decrease to $58,656, leaving you with an after-tax amount of $332,385.
If you’re looking simply at the math on what your after-tax withdrawals will be, the only factor that matters is your tax rate at the time of contribution versus your tax rate at the time of withdrawal. This is what leads to the rule-of-thumb:
If you think your tax rate at the time of withdrawal will be lower than at the time of contribution, save in your Traditional 401(k).
If you think your tax rate at the time of withdrawal will be higher than at the time of contribution, save in your Roth 401(k).
However, I really dislike rules of thumb because they hardly ever apply. Here is why I believe utilizing a combination of the two types of accounts is beneficial for most people:
1) In all reality, you have no idea what your tax rate will be when you begin taking withdrawals
Over the past 60 years the Federal income tax rates and brackets have changed 12 times. That means on average, regardless of the fluctuation in your income, your tax rate could change every 5 years. Over that same time period there has been a total of 76 different tax brackets. Some support raising taxes. In their opinion raising taxes will help reduce the national debt and improve the quality of life for low and middle class Americans. Others believe that reducing taxes will stimulate the economy, help companies grow and provide more jobs which will increase the overall base of which the government can tax. In any case, we have no idea what the future holds, who will be in the White House, and who will control Congress.
2) Avoiding Required Minimum Distributions
Required Minimum Distributions (RMD) are distributions from your Traditional 401(k) or IRA that are mandated by the government. It is a way to force your savings out of the tax-deferred accounts so that they are subject to taxes. Once you turn age 70 ½, you are required to begin taking distributions from your account. The percentage you must withdraw starts at about 3.6% and increases every year after that. However, money you have saved in a Roth 401(k) and subsequently rolled over to a Roth IRA is not subject to RMDs, which can make a huge difference in the longevity of your retirement capital. As an example:
Let’s say you and your spouse need $100,000 annually to support the type of lifestyle you want in retirement. $38,000 of your income comes from Social Security, $15,000 comes from a rental property, and another $12,000 comes from a pension. That leaves $35,000 per year you need to withdraw from retirement accounts to supplement the rest of your income. If you have $2,000,000 saved in an account subject to RMDs, you’ll be required to withdraw $72,993 the year you turn 70 ½. That is almost $38,000 more than you actually need to withdraw. Assuming you’re in the 25% tax bracket this requires you to pay $9,500 in unnecessary income tax, and shifts your savings from tax-deferred accounts to taxable accounts (assuming your reinvest the proceeds).
If instead, you had saved $1,000,000 in your Traditional 401(k) and $1,000,000 in your Roth 401(k) your RMD the year you turn 70 ½ would be $36,497, almost exactly the amount you need to withdraw to supplement your fixed income. No unnecessary tax would be paid, and your savings would continue to grow tax-deferred.
Just as diversifying your investments improves your risk/reward relationship, so does diversifying the type of accounts you save in. If your employer offers a Traditional 401(k) and a Roth 401(k) consider using a combination of the two accounts to fund your retirement.