Back in March I wrote The Case Against Roth 401(k) in which I said I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I gave these reasons:
- Fill in lower tax brackets in retirement
- Avoid high state income tax
- Leave the option open for Roth conversion in the future
- Avoid triggering phase-outs and AMT
I still believe these are valid reasons in favor of contributing to a Traditional 401k instead of a Roth 401k. A few comments to that post said Roth is better because a Roth 401k lets you effectively shelter more from taxes than a Traditional 401k. That is true. My response was that the higher effective maximum comes into play only if someone actually contributes the maximum allowed, currently at $15,500 per person per year. According to a study by Vanguard, only 10% of people contribute the maximum. It's not surprising because in order to contribute the maximum, you need either a high income, a high savings rate, or both. Consider a married couple. The combined 401k and IRA maximum contributions are $41,000 per year. At 25% savings rate, this couple needs $160,000 of income. At 15% savings rate, this couple has to earn $270,000.
What if you are one of the 10%? People who read finance blogs probably earn more and save more. What is the value of the higher effective contribution limit in a Roth 401k?
It turns out that for the marginal dollar, a Roth 401k is worth about 5-10 percentage points in marginal tax rate. That is if you contribute the marginal dollar to a Roth 401k and your marginal tax rate drops 5-10 percentage points between now and retirement, you are still better off than contributing that same marginal dollar to a Traditional 401k and put the tax savings in a taxable account. Say you are down to the last $100 which you can either contribute to a Roth 401k or a Traditional 401k. If you contribute to a Traditional 401k, you also get a tax deduction. But because you already hit the max, you cannot put the tax savings into the Traditional 401k. Your only choice is a taxable account. The Roth is compared to Traditional + Taxable because the assumption is that you maxed out the contribution limit. If you are not maxing out, you can always gross up the contribution to the Traditional account.
How much exactly is a higher effective contribution limit in a Roth 401k worth depends on a number of assumptions. I made this spreadsheet on Zoho. You can plug in your own assumptions and see the result for yourself. Plug in some different assumptions and see how the results change. That's what a spreadsheet is for. Zoho is nice because it's all online. You don't need Excel or any other spreadsheet program. You don't have to register for Zoho either if you just want to use the spreadsheet.
For example, here's one set of assumptions I used.
For tax rates, I'm assuming the Bush tax cuts will expire after 2011. Dividends will be taxed as ordinary income and long term capital gains will be taxed at 20%. I also put in a factor for the cost advantage in a taxable account because 401k plans often have higher cost funds and higher admin costs. And here are the results.
Roth 401k and "Traditional 401k + Taxable" break even if the marginal tax rate at retirement is about 28%, versus the current marginal tax rate of 35%. That means the higher effective contribution limit is worth about 7 percentage points.
Here's the link to the spreadsheet again if you want to play with your own assumptions.
Finally, please note we are still talking about the marginal dollar here. The reasons for favoring the Traditional 401k are still valid for the majority of one's retirement dollars. If you max out all your tax favored contributions, you still have to decide how much should go to traditional. Those dollars in traditional will fill in the lower brackets after you retire. They will also be converted to Roth along the way if you have a window of opportunity.
8 comments:
Excellent post. I wrote on this topic on my web site at http://www.joetaxpayer.com/toomuch.html
and made similar observations, that one should save enough to fill in those lower brackets at retirement.
Joe
If you max out all your tax favored contributions then the amounts over the max which go into your taxable accounts will fill in the lower brackets when you retire. You don't need to increase traditional contributions in lieu of Roth to get this advantage unless you are planning to depend 100% on your tax favored accounts in retirement.
TFB,
thank you for this very interesting post. I am having hard time trying to reconcile it with the previous post on the subject though.
Are you, basically, saying that most of the people who don't contribute to the max would be better off contributing to traditional 401K--but those who contribute to the max are better off going Roth way as long as they don't expect their tax bracket to be more than ~7% lower in retirement?
Is it a good rule of thumb or it is overly simplistic? Is there better one you think?
Thanks!
serbeer - Unfortunately they don't make it easy for everybody. You have to take both posts into consideration. Any rule of thumb will be overly simplistic but if I have to make one, I'd say,
1) If you are not contributing to the max (that's 90% of people out there), you are likely better off with the Traditional 401k, unless you fall into one of the exceptions (have good pension, expect substantially higher income, etc.)
2) If you are contributing to the max, first make sure you create enough taxable income to fill in all the lower brackets. Just Social Security and dividends and capital gains from your taxable accounts are probably not going to be enough. Exactly how much you will need in the Traditional accounts is going to be a guess but make your best guess. After that, the contributions can go to Roth.
I'm going to expose my ignorance here, but how does the max get to 41k? I understand that my traditional 401k limit is $15.5k, so my wife and I can contribute up to $31k. I didn't think that I can contribute to an IRA or anything else if I maxed my 401k. I have an IRA, but it is all pre-tax contributions, and I don't want to mix pre-tax and taxed income in that account... am I missing something?
thanks in advance...
Jim - $41k is made up of $31k to two 401k's plus $5k each to two IRAs. If you are over 50, there's another $5k each in catch-up contributions to 401k's. Some people are eligible for Roth IRA. Some only eligible for non-deductible traditional IRA. You may not want to do non-deductible Traditional IRA but I still do it because additional tax-deferred space is still useful.
Good post. This topic is often lamented but I think you captured the issues rather well. One element you didn't mention is matches, which many 401k's have. Matching contributions are another way of saying "free money" and you are usually foolish to pass it up. So if you aren't maxing out -- that means you are likely missing a match $. Since its cheaper to put a dollar into traditional, but you still get the match, you should always contribute the full match amount at a minimum -- in the traditional. If you can afford the full match amount in Roth, then the conversation reverts to what you've put forward in your posts. For my my employer matches a % of the entire contribution amount, which means I have to hit 15500 in contributions to get the full match. So its traditional first and then fill with roth if you want to "save more" (as you suggest).
Silicon Shadow - That's a good point. Thank you for adding to the discussion. If someone is struggling to contribute enough for the full match, going Traditional is certainly a lot easier on the budget than going for Roth.
Post a Comment