By JLP | February 26, 2008
Reader and frequent commenter, Don, sent me this email this morning. It’s his thoughts on the Roth 401(k) vs. Traditional 401(k). I’ve included my thoughts after Don’s email (edited slightly from the original). As always, your thoughts would be appreciated.
I was reading this Marketwatch article recently:
In it they noted that, “A regular 401(k) beats a Roth for a majority of our stylized households, but both offer a significant improvement over fully taxed savings.”
I wasn’t surprised that fully taxed savings were worse, but I would have expected the regular and Roth IRAs to be neck and neck. The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.
But the article suggests something different, and eventually my mathematical mind found a reason why their claim might be true. It depends on what percentage of your income you expect to be provided from your retirement assets and the fact that we have a progressive tax system. Here is a sort of maximal example.
Consider a couple that makes $80,000 and contributes 20% ($16,000) of their income into deductible 401(k) or IRA investments. That brings them just about down to one of the tax bracket boundaries, between the 15% and 25% bracket. Because it is their high-margin rate income that they put away, they saved 25% of $16,000 in tax, or $4,000 in federal tax.
Assume they retire next year (so we don’t have to think much about inflation or the tax code changing). The maximal case, would be having 100% of their income provided from accumulated retirement assets, although it would probably be less because of social security or pensions or the like. But if next year, we draw the same salary from their retirement assets ($80,000) it would in fact be taxed progressively: the first $15,650 at 10%; and then at 15% up to $63,700; and only the top $16,300 would be at the full 25% rate. Nearly 4/5 of their income would be taxed at a rate lower than the savings they got every year when they invested it even though they are in exactly the same bracket as before.
I believe this changes the naive Traditional/Roth comparison and it would tip in the favor of the Traditional (just as the article implies).
If you are the “typical” person, your Social Security income would account for 40% of your retirement income. In that case, starting from the scenario above, you’d be drawing $48,000 from your IRA. If we allocate the low-margin tax brackets to your Social Security, you’d still have $31,700 drawn from your retirement assets that would be taxed at the 15% and again only the top $16,300 would be taxed at the full 25% marginal rate. Nearly 2/3 of your income (provided by retirement assets) would be taxed at a lower rate than the rate you saved at when you made the contributions.
It seems that the practical advice to take from the analysis is this: if you are near a bracket boundary use Traditional IRA or 401(k) savings to reduce your savings just to the boundary. Further savings should be Roth savings. It makes sense to diversify in any event against tax changes that would adversely affect Traditional or Roth savings anyway since no one knows the future.
If you can’t save down to a boundary but could at least foresee where the boundary would land in retirement, you could split your Traditional/Roth savings to match that. In the example above where 40% of your retirement income is from Social Security, a reasonable person might make 2/3 of their savings Traditional and 1/3 of them Roth. You’re not really ahead or behind mathematically in this scenario, but you get “tax diversification” as well as the potential Roth advantages (no minimal distribution, etc.) on part of the money.
The only issue I have with Don’s thoughts is his computation:
The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.
Is that really how people would contribute to a Roth? I would think most people would contribute $4,000 no matter if they used a Roth or a traditional IRA or 401(k). If they used the traditional IRA of 401(k), they would get the tax advantage up front. If they contributed to the Roth, they would take it on the chin and pay the taxes up front but still contribute the full amount to the Roth. NOTE: I’m going to run some calculations on my own and report back to you what I find.
This is a pretty complex topic because not only are we talking about the here and now, we are also trying to get a grip on the future. Adding to the complexity is the fact that there are benefits to the Roth that aren’t easily computable like the ability to NOT HAVE TO TAKE required minimum distributions and the ability to pass the Roth on to relatives, which gives them the opportunity for tax-free withdrawals. One other advantage to the Roth is the fact that distributions from the Roth DO NOT count towards the income threshold for computing taxes on Social Security.
My concern with the Roth are that the politicians may decide to tax withdrawals at some point in the future. Could it happen? Yes. Is it likely to happen? I have no idea. All I can say is that if times get tough and our politicians are looking for money to pay for their programs, and they see a bunch of tax sheltered assets sitting in Roth accounts, I wouldn’t put it past them to tax them “for the greater good.”
Anyway, there’s more on this topic to come. I’m working on a spreadsheet as I write this post. If I find out anything interesting, I’ll be sure and let you know.
Thanks to Don for his thoughts.