Our Thinking

Roth 401k/IRA vs Traditional 401k/IRA

July 13th, 2012

Roth 401k or Traditional 401k? It’s a simple question that when answered correctly, has the potential to add hundreds of thousands of dollars to your net worth during your lifetime. Unfortunately, many people arrive at the wrong conclusion, but it’s not for lack of research or advice. Conventional wisdom from financial pundits and the internet often tout the Roth 401k as the better choice, suggesting that you will end up with more after tax dollars during retirement. However, in almost every case, the opposite is true, making the regular 401k the right choice for just about everyone. Let’s take a look at the main reason why.

Federal Taxes

“The hardest thing to understand in the world is the income tax.”
Albert Einstein

While there are several factors to be considered when comparing a Roth 401k to a regular 401k, none are more compelling than taxation. Understanding how the United States’ progressive tax structure applies to 401ks is the cornerstone of any retirement analysis. Let’s begin with discussing the important difference between marginal and effective tax.

 

Joe and Jane, Married Filing Jointly

100k Taxable Income During Working and Retirement Years

Working Year Contribution

(Marginal Rate)

Retirement Distribution

(Effective Rate)

Actual Tax Paid

Regular 401k

25% tax avoided

17.06% tax paid

17.06%

Roth 401k

25% tax paid

17.06% tax avoided

25%

Regular 401k Tax Savings vs Roth 401k

7.94%

 

Joe and Jane are married, filing jointly, and make 100k per year in taxable income.  Every dollar they make above $70,700 (2012 tax year) is taxed at their marginal rate of 25%. However, their effective tax rate on the entire $100,000 is just 17.06%. This difference in taxation is revealing, as it tells us that the last dollar made is taxed the most. The table below illustrates the power of this concept as it shows the differences between the regular 401k and the Roth 401k.

Assuming that Joe and Jane take $100k a year from their portfolio in retirement, they will be better off using the regular 401k by 7.94%. That gap is so large, that unless Joe and Jane take almost $300,000 in annual retirement income, their effective tax rate will still be below 25%.  Since most people don’t even need to replace 100% of their income in retirement ($100k in our example), increasing retirement income from 100k to 300k is extremely unlikely.

What does all this mean? Whenever the marginal tax rate applied to contributions while working will be higher than the effective tax rate on withdrawals during retirement, a regular 401k will outperform a Roth 401k. For just about everyone, this will be the case, making the regular 401k the best choice. However, there are a few exceptions where the Roth 401k is best.

Candidates for a Roth 401k

Very High Earners

If you are routinely making over $470k per year and expect to live off of a similar income in retirement, a Roth 401k begins to make sense. This is because marginal and effective tax rates begin to converge as your progress deeper into the top tax bracket, meaning that even a slight increase in the top marginal tax rate during retirement has a profoundly negative effect on you. It can be better to lock in your current marginal rate, which is historically low, rather than risk an increase.

Very Low Earners

Generally, teenagers and college graduates fit this category, but if your marginal tax rate is 10% or lower, a Roth 401k is the ideal choice.

A Quick Word about Future Tax Policy

While an entire article could be written about what could happen to future tax policy, this one will just touch on the most important takeaway. Almost all possible changes in tax structure would favor the regular 401k, and not the Roth, making the regular 401k a choice that has much less downside tax risk.

Conclusion

The Roth 401k has many advantages for the small segment of very wealthy taxpayers to which it mostly applies. Roth 401k structures also have many advantages not considered in this article, when used for purposes other than providing retirement income—such as estate planning or obtaining early access to funds.  Aside from those considerations, a regular 401k is most certainly the best choice and will provide a significant boost to net worth and after tax retirement income when compared to the Roth. Further, if you are subject to a state income tax, the regular 401k becomes even that much more attractive. So remember, when faced with the decision of Roth 401k or regular 401k, it’s almost always  best to choose the regular 401k.