The 401(k) Dilemma: Roth or Traditional
By John Owens, CFP®, EA
It may be the most contentious issue in financial planning - to save to a Roth or Traditional (pre-tax) 401(k) account. Ask 5 financial planners, get 6 different answers - OK, well maybe not that contentious but it ranks among some of the top questions we get asked by clients. And it’s not as simple as flipping a coin. This decision can impact your tax situation for decades to come. Let’s talk through some of the factors to consider.
Your Income Today
Is your income uncharacteristically high or low this year?
Did something unique happen that is ‘out of the ordinary’?
Your Future Income
Do you anticipate big raises or your company to go public?
Are you about to quit your job and take a big pay-cut to start your own business
Your Current Tax Rate
Are you currently in the top tax bracket?
Do you have high state and local taxes - like NY or CA?
Your Future Tax Rate
Are you moving from a high tax state like NY to Florida or Texas, a state without an income tax? Or vice versa?
Do you anticipate Federal income tax rates will be increasing?
These are all key considerations when choosing how to save for retirement. For example, if you have a bunch of RSUs that will vest this year, pushing you into the 37% tax bracket federally, and you live in NYC, your tax rate could easily be approaching 50%. Putting $19,500 in a 401(k) on a pre-tax basis can save you almost $10,000 in taxes!
That said, if you’re early on in your career - and see a lot of upward income potential, then you may be well served by saving to Roth when you’re in the 24% tax bracket or living in a lower tax state.
An Example
We have our fair share of folks who like to see the math, so let’s walk through an example. Sally has $5,000 to save to a retirement account. She’s in the 25% tax bracket and anticipates she’ll be there for a long time.
Roth 401(k) Math
Since Sally is saving to a Roth, she’ll pay tax on 25% of the $5,000 she has to save, and will be able to contribute $3,750 to her Roth 401(k). The market doubles in the time she’s invested and when she retires she withdrawals $7,500 tax-free.
Traditional 401(k) Math
Since she’s saving on a pre-tax basis, she’ll put the full $5,000 in the 401(k). Luckily, she doubles her money in her remaining working years and has $10,000 in the account when she retires. She’s still in the 25% tax bracket so when she empties it out there’s $7,500 left after-tax.
In both examples, Sally ends up with the same amount of funds after taxes. But what if Sally was in a different spot.
Let’s say everything else is the same except Sally is currently in the 37% tax bracket because of some equity compensation she had this year. And she lives in the city which pushes her tax bracket up to 45% overall. Sally dreams of retirement in sunny, tax-free Florida, and anticipates much of her income in retirement will be from dividends keeping her in the 24% tax bracket federally.
Roth 401(k) Math
If Sally has $5,000 to save to her Roth 401(k) this year, she’ll only have $2,750 to put in after her 45% tax bill. Assuming that doubles by the time she retires, she’ll have $5,500 tax-free when she pulls that money out - not bad, right?
Traditional 401(k) Math
If Sally went a different route and saved the $5,000 on a pre-tax basis to her 401(k), and saw it double by the time she retired, she’d have $10,000 pre-tax. If she took all that out in one year and paid tax at 24%, her new, lower tax bracket, she’d end up with $7,600 after-tax - $2,100 more than if she saved to the Roth 401(k)!
One more example, for fun!
This time let’s assume Sally is a young professional. She lives in the city but is just getting started. Her city, state and federal tax rate are a combined 30%. She sees herself climbing the corporate ladder and will never leave the city - there’s no better place to live. Her future earnings point to a 45% bracket in retirement.
Roth 401(k) Math
She has $5,000 to save - so after paying 30% in tax, she’ll put $3,500 in her Roth 401(k). It doubles by retirement and she has $7,000 tax free.
Traditional 401(k) Math
She puts the full $5,000 in the Traditional 401(k) and sees it double by the time she retires. Being the high earner that she is, she pays tax at 45% when she withdrawals the money and has $5,500 after-tax - $1,500 less than if she had saved to Roth.
Other Factors:
Required Minimum Distributions - Roth IRA accounts do not have required minimum distributions, while Traditional IRAs do.
Multigenerational Planning - if you end up leaving money in retirement accounts to heirs or charity, it can impact your choice of contribution.
Estate Taxes - $1M of Roth savings or $1M of Traditional savings has the same impact on estate taxes, even though they have very different impacts on income taxes. Albeit, very few folks end up paying estate taxes under current law.
As you can see, there’s no one-size-fits-all answer to this question, and Crockpot method of ‘set it and forget it’ for this choice can be problematic. Your tax situation varies year-to-year, so re-evaluating how you save should be an annual consideration. While we typically recommend our high-earning clients in the city to save on a pre-tax basis, tax diversification is key to the success of a long-term financial plan.