Roth 401(k) vs. the Traditional 401(k): One Reader’s Thoughts

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:

Roth IRAs: Good for you or not?

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.

16 thoughts on “Roth 401(k) vs. the Traditional 401(k): One Reader’s Thoughts”

  1. “The only issue I have with Don’s thoughts is his computation…” Don’t limit yourself to thinking of IRAs and IRA limits and this complaint has less relevance. If at work you can contribute to a Roth 401(k) or a regular 401(k) the limits are substantially higher, more than I can afford to save in a year anyway.

    I tend to save to the pain point, in which case having the tax break today means I can save more. For a person who saves as much as they can afford, the calculation above is correct. If you have more money than you can find investments for within the contribution limits, then your are correct. You can “squeeze more” savings in the Roth vehicles.

  2. Oops. I didn’t read far enough. You did consider the 401(k). What you overlook is that substantially many people are less wealthy than you.

  3. re: taxing Roth withdrawals. The only way – legally speaking – the feds should be able to do this is to institute a tax scheme and grandfather previous contributions. For example, let us pretend I have $10,000 in a Roth IRA and the government decides they want to institute a tax on withdrawals. Any contributions (and growth on those contributions) done after the law goes into effect would be subject to that law. However, contributions (and growth on those contributions) done BEFORE the law went into effect should not be subject to the law, at least without a Constitutional amendment (and/or Supreme Court ignoring said Constitution).

    Here’s why: In Article I of the Constitution there is a limitation on the legislative branch which reads
    “No bill of attainder or ex post facto Law shall be passed.”

    In this case, it’s the ex post facto limitation that is important. Basically, the Constitution states that you cannot change the law and then use that new law to punish actions that occurred BEFORE THE LAW WAS ENACTED. Theoretically, then, Roth contributions made now would be shielded from any changes of this nature in the future.

    Now, this does assume the legislature actually pays attention to the Constitution, or – failing that – that some individual brings suit and the Supreme Court throws it out as unconstitutional. Obviously, it is possible that the SC could ignore the Constitution – it has been done before. Similarly, the executive branch could ignore the SC – that also has been done. However, I suspect that is an UNLIKELY scenario. *shrug*

    The upshot here is that, Constitutionally speaking, Roth contributions should be largely shielded.

  4. JLP,
    I understand your paranoia about the Feds changing the tax code when the Medicare/Social Security deficit train wreck starts piling up. I’m not sure whether Congress is crazy enough to mess with people’s Roth IRAs, though. After all, Congress seems to be unable to withstand any push back from the electorate – which is why the Medicare/Social Security deficit train wreck is moving on down the tracks.

    I think it makes more sense that they would do several “nibble around the edges” changes such as decreasing benefits slightly, increasing tax withholding slightly, a little increase in means testing, and so forth, hoping most people won’t notice or won’t object.

  5. I don’t think either type of plan is better than the other, they just serve two different purposes. And when it comes to taxes, you should diversify just like you do with your investments. The future is unknown, so the more options you have available, the more flexibility you’ll have in controlling how you are taxed.

    I think you would be able to crunch the numbers in a number of different scenarios to show that one is clearly the winner over the other, but that is like using past performance of a mutual fund to say that if you had invested in that fund vs. another fund it would have yielded better results.

  6. I don’t think the feds will ever try to tax your original contribution to ROTH when you take it out, since you already paid tax on that part. But I’m not so sure about the earnings. Those earnings (the increase in value plus dividends) weren’t taxed at the beginning, and currently they’re not taxed at the end either. That’s the money I could see them deciding to tax later, not the whole thing. Though if you leave money in there for 30 years it might be close to the whole thing.

    For example, right now if you earn money you pay income tax on it. If you then put the already-taxed money into a savings account, you must pay tax on the interest you get every year. The original amount you put in isn’t taxed again, but the increase is taxed. And as far as I can see in the ROTH right now, that’s not happening. So there’s money out there that the government didn’t get a share of, and I can see that changing down the road. Though I see sam’s point about pushback from the electorate (all those retired baby boomers!) so maybe it won’t happen.

  7. I have another variable to throw in. Your tax bracket while emplyed will likely not likely be lower than it is new because of inevitable pay raises. As such, you may want to get more in ROTH accounts now. Say you are at 15% bracket now and are at a 25% in 10 years. If you max out a ROTH now and then max out a traditional then, you will save the most. In addition, you could convert some ROTH ammounts to traditional in future years and deduct the ammount from our taxes.

    As a simple example, say your funds double every ten years, you contribute $10k one time at 25 and are in a 15% bracket till age 35 and 25% thearafter.

    If you go 50/50, you will have $10k in roth and $10k traditional at age 35.

    If you contribute 100% to ROTH, it will cost you an extra $750 in the first year because of taxes. At 10 years, you have $20k in a roth 401k. Now, say you convert half to a traditional 401k and deduct tht from your taxes. You end up with the same $10k roth/$10k traditional, but you save $2500 on your taxes. Doing this, you get a return of $2500 from $750 over 10 years. Thats a 12.8% return when the market returns 7.2% over the same period. Of course the numbers chagne with different market returns.

    Bottom line, It is good to get as much as you can in a roth when you your marginal rate is lower and to level out your balances when you can do it at tax savings.

    Note: I agree with the point that you are really getting mroe invested when you max out with roth vs traditional, but the math on that is harder:)

  8. They might tax Roth contributions. There’s no principal reason why they couldn’t. But I suspect it would be easier to raise tax rates on regular income, since they are so low right now. That would hurt the traditional 401k/IRA contributions much more.

    And the “ex post facto laws” provision of the Constitution has no effect on taxing Roth contributions, since the *withdrawal* takes place after the law. Similarly if there is a higher capital gains tax you can’t avoid paying it because when you invested the taxes were lower.

  9. The best approach is to have both types of accounts. Then you can withdraw from your traditional 401k/IRA until you hit some marginal tax bracket (e.g. withdraw up to the whole 15% bracket) and then withdraw from your Roth 401k/IRA for the rest of the money. That way you maximize your tax savings. Generally taxable investments should be taken last because if you die your heirs won’t have to pay any capital gains.

  10. I have to agree with Andy. Personally I divide up my 401k contributions as 66% to my traditional 401k, 34% to my Roth 401k, and max out my Roth IRA. I don’t have a crystal ball and it is way to complicated for me to try and predict the future as far as tax rates, tax breaks, future earnings etc etc etc (trust me I’ve tried to run all the numbers but there’s not real conclusive data to base a decision upon).

    Since no one can predict the future my thought is its best to diversify.

  11. In general, the more you make, the better the Traditional 401K works out, especially if you plan to arrange your life so that you pay lower tax in retirement (move to a no-income-tax state, overseas, etc). Another factor: for two years, my wife and I were able to fund Roth IRAs because our (maxed out) 401K contributions got our MAGI under the max for Roth IRA funding. If we’d been funding Roth 401Ks in those years, we couldn’t have funded Roth IRAs.

    Given the vast uncertainties regarding the tax code, a mix of Traditional instruments, Roth-type instruments, and after tax investments is best. Traditional ones will likely do best if we, for example, go to a consumption tax – which will nail Roths.

  12. It seems this debate will rage on. I guess the good thing is if you’re diligent towards putting money away for retirement (however you do it) you’re on the right path and can’t go too wrong in the end.

    A couple quick points:

    If they change the rules for Roth’s you will be grandfathered or fairly compensated in some other way (anecdotally speaking). It’s unfathomable to me that everything you would have done properly is taken away (this isn’t Checnya)… you will be grandfathered.

    With that said, regardless of future tax rates nothing beats a 0% rate. With that said, I think Jeremy has it right, you can spin it any way you want with a financial calculator… but from my experience, what can’t be quantified are the positive psychological benefits of controlling your future tax situation, knowing somewhere in your future you won’t have to pay taxes. That’s a big deal! that motivates investors to stay with their yearly and systematic contributions and be more proactive with their investments in general, which is a big part of it.

    Also, as mentioned somewhere above, another major benefit of the Roth is no forced RMD’s and estate planning possibilities, these are huge. If we’re talking about the kind of person that can follow this thread… than chances are they will have done pretty well from the planning (for retirement) standpoint, and may want to have the option of using their retirement assets for purposes other than taking distributions.

    I have quite a few clients that are pissed off because they are forced to take RMD’s each year from traditional IRA’s, raising their taxable income.

    This is getting long so I’ll wrap… I think tax diversification is wise (just like investment diversification is numero uno) but when it comes to prioritizing your contributions I think its obvious where I stand, where I think the first contributions should be made and what should be the cornerstone of your future plans. (of course after taking advantage of any employee match in a traditional 401K, 403b etc 🙂

  13. Can someone clarify taxing of Roth IRA withdrawals after retirement age? I’ve always had the understanding that Roth IRA money has already been taxed and withdrawals, after retirement age, will not be taxed. To clarify my question, imagine my wife and I earn $80,000 a year today and our earned income is taxed at 35%. We retire tomorrow and our only retirement “income” is from Roth IRA withdrawals. Can we withdraw $80,000 a year from our Roth IRA savings and pay no “income” taxes? After all, we paid 35% on the money just prior to depositing it.

  14. Aardvark,

    Sorry for the confusion.

    Roth IRA withdrawals ARE NOT taxed (as long as you have had the account at least 5 years and are at least 59 1/2 when you start withdrawing).

  15. Finally, I read a comparison that gets this correct. I have emailed may “financial experts” clamering for the ROTH is better. has a quiz that says a Roth 401k is better. Sometimes it is some times it is not. The mistake is when you contribute to a 401K you save (or can invest an extra) is at you marginal tax rate. When you withdraw, you are taxed at your effective tax rate.
    The calculation can be done 2 ways 1 you do not max out your 401k and 2 you max it out.
    1. You can figure you make 50k and invest 10K a year in a 401k, or $8500 a year in a roth (assuming 25% tax rate). After 30 years with a 5% return over inflation the Roth will have 500K the traditional 660K in todays money. Lets say that is 36K to 48K. Subtact taxes out todays rate will lead to about 7K + 2k(added ss taxes). you are left with 39K traditional, and 36k Roth. This way the traditional usually has a slight advantage due to lower retirement income. (most experts figure taxes 48K *.25=12K, so you get 36K to 36K.) That is not how our tax system works. Even if taxes are raised 10%, it is still 38 to 36.
    2. You contribute 15k to each. Plus an additional 3750 to a taxed account for a traditional. The taxed amount will only earn 5*.85 or 4.25%. From this we have roth 72K a year, compaired to 87k. The income will be about 65K a year for a traditional to 72 for a roth. The Roth has a slight advantage. For this calculation.(Which all experts do).
    I tend to envoke a balance 60-80% traditional, 20-40% Roth. The reason to lean more on traditional is for two reasons. The first is currently you pay no taxes on the first 8.5K for each person a year. That means about a 120K balance in the traditional is not taxed for a single person, and 240K for a couple. The medium balance for a Boomer is 50K, and I believe 100K for those who invest. The second is the Roth helps the more you have for retirement. Until you can see you are going to be someone who is well off, that 3K in senerio 1. is more valuable than that 7K in senerio 2. Plus even in senerio 2, after 15 years and good growth is seen, they can contribute only to a roth, and come out with about the same 72k. Also for most Americans 27-50 a roth is slightly more atractive do to child tax breaks.

  16. I am still confused. I don’t make alot of money. Currently I put 10% (5900) away per year in 401K (plus half of that is matched). In the near future I want to start to save an additional 3K a year. It would be psychologically easier for me simply to up my percentage in my 401K (I am nowhere near my maximum), but I keep hearing about Roths. What would you do in my situation? Diversify (by putting it in a Roth), or is it really not worth it considering my financial situation?

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