To Roth or not to Roth, that is the question. Starting in 2008, like many other employers, my employer also started offering the Roth 401k option in our 401(k) plan. This question of whether one is better off with contributing to the Traditional 401k or contributing to the Roth 401k has been the subject of a lot of debate. Although there is no one-size-fits-all answer, I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I will state my case against Roth 401(k) in this post.
The basic premise of a Roth 401(k), and to some extent a Roth IRA, is that of prepayment. You are prepaying the tax now so you don't have to pay tax later. This prepayment concept is not uncommon. For example, buying a season ticket is prepaying for the individual events. Buying a timeshare is prepaying for vacation accommodation. Whenever we deal with a prepayment scheme, we have to assess whether prepaying is "worth it." The same paradigm also applies to Traditional versus Roth 401(k). There are several factors that make prepaying the taxes now not worth it.
1. Fill in lower tax brackets in retirement. I showed in a previous post Commutative Law of Multiplication that if the marginal tax rate at retirement is the same as it is now, the Traditional and Roth 401(k)'s are equivalent. If the marginal tax rate is higher now than in retirement, one is better off contributing to a Traditional 401k. If the current marginal tax rate is lower, one is better off contributing to a Roth 401k. But that applies only to the marginal dollar, which is the last dollar you can shift between Traditional and Roth 401(k). It is not necessarily the case for the entire contribution or the average dollar. The tax system in the United States is progressive and it will probably stay that way. That means that income is taxed at increasing rates as it goes higher. Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k).
This chart below illustrates what the tax brackets are in 2008 for a married couple earning $218,200 between the two of them if they file jointly using the standard deduction (click on the chart to see it in full size).
* Source: Tax Policy Center
The first $17,900 of income is not taxed because it's taken up by deductions and exemptions. The next $16,050 is taxed at 10%, the next $49,050 at 15%, the next $66,350 at 25%, so on and so forth. Because the way a Traditional 401(k) works, the dollars they contribute come off from the top, in the highest tax bracket for their income. After they retire, the dollars they receive from their Traditional 401(k) fill in from the bottom. Even if we assume their marginal tax bracket in retirement will be higher due to tax increases, a large portion of the 401(k) withdrawal may still be taxed at a lower rate than what it was when they contributed the money. This is the same argument raised by a reader on the AllFinancialMatters blog.
Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets, it doesn't make sense to contribute to a Roth 401(k). For people without a traditional defined benefit pension plan, it means the majority of the retirement savings should go to a Traditional 401(k), not Roth.
If you have a defined benefit pension plan and/or you expect to have a large balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing to Roth makes some sense.
2. Avoid high state income tax. Many people work in high tax states like California and New York today. They work there because there are a lot of good-paying jobs in those states. They won't necessarily retire there because the high taxes take away a significant portion of their retirement income. States popular with retirees like Florida and Texas have no state income tax. If you are working in a high tax state today but there is a chance you will retire in a no/low tax state, contributing to a Traditional 401(k) lets you avoid paying the high state income tax on the contributions. Prepaying the high state income tax now is a dead loss.
3. Leave the option open for Roth conversion in the future. When you leave your employer, you can rollover the Traditional 401(k) to a Traditional IRA, which then can be converted to a Roth IRA at a later time when it is advantageous to you. A Roth 401k or IRA on the other hand can never be converted back to Traditional. With a Traditional 401k, you hold the option, which has value. If you contribute to Roth, you give up that valuable option. You can decide to convert and pay the tax whenever you are in a lower tax bracket than where you are now. Good times for conversion include:
- going back to school for a career change;
- becoming unemployed due to layoffs or burn-out;
- starting a business (not as much income in the first few years);
- two-income couple having one parent stay at home or work part-time for a few years after they have kids;
- a high-income single person marrying a lower-income spouse;
- taking early retirement;
- moving from a high tax state to a no/low tax state;
Unless you are sure that your marginal tax bracket will never be lower throughout your career, you should leave the option open by putting money in a Traditional 401(k) and then convert to Roth when an opportunity comes.
4. Avoid triggering phase-outs and AMT. Because contributing to a Roth 401k does not reduce your gross income, you appear to be richer than you otherwise are if you contributed to a Traditional 401k. There are all kinds of income-based eligibility cutoffs and phase-outs in the tax code. When your exceed the income threshold, your tax benefits from those programs are either reduced or eliminated. Some of these tax breaks include:
- child tax credit;
- Hope credit;
- Lifetime Learning credit;
- itemized deductions;
- personal exemptions;
- eligibility to contribute to a Roth IRA;
- eligibility to contribute to a Coverdell ESA
Think for example the tax rebate from the 2008 economic stimulus package. If a single person earned $90,000 in 2007 but contributed $10,000 to a Roth 401k, he/she is not eligible for the $600 tax rebate. If he/she contributed $15,000 to a Traditional 401(k) instead, he/she is eligible. When your income appears to be "too high," not only you lose tax benefits, you may even trigger the AMT. Contributing to a Traditional 401(k) will help you qualify for tax benefits and escape or reduce the impact of AMT.
With so many disadvantages, whom is Roth 401(k) good for then? Roth 401(k) is good for people in low paying jobs now but expect to have high paying jobs later. Medical doctors in residence programs fit that description very well. They are paid very low while they are in residency but their income is expected to rise substantially higher when they finish the program. Their income will stay high in their career and they will receive a high income after they retire. Prepaying tax now makes sense because they are prepaying at a low rate now and they will avoid paying a higher rate later. College students working part-time jobs or recent graduates working in entry-level jobs are also good examples for taking advantage of a Roth 401(k) while their income (and their tax rate) is low. Roth 401(k) is also good for people who are already in the top tax bracket and expect to be there forever. If they don't see any chance of being in a lower tax bracket, prepaying tax now will lock in the tax rate so they won't have to worry about future tax increases.
What about the idea of tax diversification? Some advocate doing both Roth 401k and Traditional 401k because the tax rates in the future is uncertain. Diversification is good in general but it doesn't mean automatic 50:50. Just like investing in emerging markets provides diversification, but it doesn't mean you should invest 50% of your money in emerging markets. You still have to decide how much you should allocate your retirement savings between Traditional and Roth just like you allocate a portfolio between developed markets and emerging markets. Tax diversification also doesn't mean you have to do it right now if you are in your peak earning years. There might be better times coming up in the future.
For myself, I'm 100% in Traditional 401(k). Prepaying tax now is just not worth it.
See also: Roth vs Traditional 401K on Bogleheads Forum.
19 comments:
Interesting. I love the Roths, but I seem I am one of your exceptions. I have a very good pension plan, I'm in the 15% tax bracket, I now live in a state with no state income tax, and I expect my tax rate to go nowhere but up in the future, mostly because I think tax rates will climb, but I also kind of hope to get big raises one day! (See what the tax rates were in the 1970s, and you'll see what I'm afraid of.)
Nice analysis.
My company began offering the Roth 401(k) in addition to the traditional 401(k) this year. I stuck with traditional even though I'm just starting out in my career and hope that my income will only go up from here. The deciding factor for me was that the company would not be matching anything in the Roth plan, but would continue it's current match structure on the Traditional.
No sense in giving away free money!
This is one of the best posts I've read in a long time. I *totally* agree.
I'm paying federal + state marginal rates of about 43%. I fully expect to have less taxable income in retirement, and to live in a lower-tax state. I can see no benefit to putting money into a Roth 401k in this situation.
It amazes me that alleged financial experts refuse to recognize that for those of us whose retirement income will come entirely from 401k accounts, using a tax-deferred account can result in a tremendous tax savings.
@Debbie - I agree that Roth is perfect for you.
@onthehomefront - Usually employers don't penalize you for using Roth. If you contribute to Roth 401k, they will still do the match. It's just the match is placed in a Traditional 401k account. You will have your money on the Roth side and their match on the Traditional side. If you are just starting your career and you expect higher income (and higher tax rate) down the road, Roth is still good for you.
@anonymous - Thank you for the compliments. I'm glad you agree with me.
I don't agree with this. Kaye Thomas lays out an extensive comparison between Roth vs Traditional accounts. The bottom line is this:
http://www.fairmark.com/rothira/roth401k/wealth.htm
The Roth 401(k) is _bigger_ than the traditional 401k. While the nominal contribution limit is the same for both ($15,500), the Roth limit applies to after-tax dollars. This "quirk" of the rules means that while the nominal limits are the same, the Roth is effectively bigger.
With all due respect to Kaye Thomas, the first part of her analysis is not valid because it does not take into account the impact on take-home pay. "Saving in a Roth account can make you as much as 53% wealthier in retirement!" Yeah, right, but you also pay 53% more when you contribute. Until the heading "So the traditional account always loses?" it then starts to make sense.
Yes Roth lets you effectively save beyond the $15,500 cap on Traditional 401k but people who can afford to do so are also in the high tax brackets. So it comes at a higher cost. Can a single person earning $50,000 gross afford to save $15,500 after tax money in a Roth? Not likely. You need perhaps $100k gross income before you hit the cap. When you are at $100k though, your marginal tax bracket is already pretty high. Read what the 3rd comment said. Is it worth it to pay 43% tax in order to save in a Roth 401k?
Roth 401K's were not available when I was working, so all my deferred dollars are in TIRA/401K's. My pension puts me just inside the 25% bracket. I ran a projection on what my RMD's would be starting in 10 years or so and was alarmed at what I'd have to take out by the time I reached 80.
Over the next 10 years, I am going to convert TIRA $$ to Roth up to the top of the 25% bracket. That will help reduce the RMD problem, but it will still be there.
I encourage folks to watch this aspect. A mix of TIRA/Roth seems best; unfortunately, I don't have time to reach the mix I want without forcing myself into the 28% bracket now.
Paul
Your commutative math law is wrong becuase it doesn't account for the growth which is taxed on the traditional but not on the Roth. Assume a 40% marginal tax and $100 contribution and 10% growth for 1 year. In the Roth you have $110. In the Traditional you have $110 + 44 (you invested the extra take home pay) = $154. Tax is $44 on the 401(k) and $1.60 on the $4 which leaves you with a net $108.40. Roth wins.
Trust me the math law isn't wrong. You assumed the tax savings must be invested outside the 401k. Actually you can gross up your 401k contributions to $166.67 and still get the same take home pay (166.67 * 60% = 100). So grow it by 10% you get $183.33. Tax is $183.33 * 40% = $73.33. After paying the tax, you get the same $110.
Interesting post, TFB.
My wife is a teacher and will have a decent pension. I was a federal employee and will have a small pension. The Roth seems to make sense for us, but we are also making contributions to traditional IRA/401ks so that we can take advantage of opportunistic Roth conversions. My wife wants to stay home with our kids for awhile, eventually wants to take a sabbatical. These income-depressing events will be perfect to make Roth conversions more cost-effective.
quote: Trust me the math law isn't wrong. You assumed the tax savings must be invested outside the 401k.
Well, I'm assuming you are maxing out your 401(k) in either case. I just used $100 to make the math easier.
One valuable benefit of the Roth 401(k) is the ability to convert it to a Roth IRA without any tax orcost (once you leave employment). At that point, you can take penalty free withdrawals up to your contributions for any reason at anytime.
@anonymous re: being able to rollover to Roth IRA and do penalty-free withdrawals. It's true, although not all will agree that being able to raid your retirement account so easily is a valuable benefit. If one really needs money, I think a 401k loan is a better option than taking penalty-free withdrawals because once the money is withdrawn, there is no way to put it back.
Are you locked into a one size fits all mentality? It isn't raiding your retirement account if you are retiring before the government says you are of retirement age.
I'm so glad someone else has come to this conclusion. I got a bit of flak over at AllFinancialMatters over a similar analysis.
I agree with you. There is a lot of jumping on the Roth bandwagon, and there might be good reason to consider the old-fashioned Traditional savings.
i track my tax situation very closely. i should hit the 25% rate in September. And that's when I'll push every penny to the traditional self-401k. In a future year where I don't hit the 25% rate, I might convert the traditional funds in to Roth. So traditional acts as a "buffer" to keep me out of the 25% rate, but also soaking up the 15% rate as long as it's attainable. and there's an exit strategy, too: i converted $11k a few years ago. after five years I can withdraw it without penalty, such as in a low rate scenario where i can pay down mortgage that's at a higher rate.
so traditional wins as an interim to roth when the tax rate is favorable.
Nice piece of work. I didn't do the math, but decided to stick to the traditional 401k until our tax bracket was lower. The tax deduction was just too significant to miss out on ;-).
Nice analysis, but I've spent some time thinking about this and want to call your attention to 2 issues.
1.) If your tax rate at retirement and now is exactly the same, and you max out your 401K, then Roth vs. Traditional are not equal... you are actually better off with a Roth.
I know WHY you think they are the same. You are saying that (Tax_rate)*(1+r)^years is the same as (1+r)^years*(Tax rate). On that point I agree, but the two are still not the same.
The main reason is that both Roth and traditional have the same NOMINAL cap in dollars... $15,500 for 2008. Now which one has the highest cap in POST-TAX dollars? That would be the Roth. You can put $15,500 pretax into a traditional 401K, or, if your tax rate is 50%, then you can put $31,000 of pretax into a Roth. Of course, in a traditional case, you'd still have $15,500 leftover to invest in taxable accounts, but do the math and you won't come out ahead if your tax is the same.
2.) On tax diversification, most people have employer matching, and the matching part is always in pretax dollars (so even if you put money in a Roth, your employer matching will look like it is going into a traditional). Therefore, Roth is actually a nice diversification.
I concede that the prepayment option is the most compelling case for Traditional. I personally could picture myself going unemployed one year in my 40s, moving to Vegas with no state income tax, and converting the whole thing in a fell swoop.
It might be good to consider though that right now, Bush has cut taxes to near lows in recent history, and you have to wonder whether we foresee income taxes actually being lower in the future. Also, you are a smart person financially, so I suspect you will be quite rich when you reach 59.5, flush with stocks, bonds, real estate, and lots of other sources of passive and portfolio income. You may very well be forced into the top bracket by your retirement, so if you aren't there now, go ahead and prepay :-)
Lee - Thank you for your detailed comments. On the first issue of Roth allowing you to shelter more, it's true, although it only matters if you are hitting the maximum. According to this study by Vanguard, only 10% of people max out their 401k. If you are one of the 10%, then yes, Roth 401k means you can contribute more. For the other 90%, instead of contributing to Roth 401k, they can also increase their Traditional 401k contributions. If you have enough income to contribute $15,500 after tax money to a Roth 401k, it also means your tax rate is high and therefore you are paying high cost for doing so.
On your second point of having the match in Traditional as tax diversification, I think the match alone is not going to fill in the lower brackets in the future. Like most people in my generation who don't have a pension, the majority of my retirement income will come from my 401k and IRAs. For a married couple, the combined 401k and IRA contribution limit is $41k a year. Unless their income is really high, how many people still have money for investing in taxable accounts after putting in $41k a year toward their retirement accounts? The marginal tax rate might be higher, but there will still be lower brackets that need to be filled.
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