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.