Secure Act Analysis and Roth 401k vs. Traditional 401k (Updated for 2020)

February 17th, 2020

2020 brings us the SECURE Act, and with it, several changes to existing tax law.  Thus, it’s time to revisit whether you should be using the ROTH 401k or the Traditional 401k. But, before we do so, let’s briefly look at the other changes that the SECURE Act brings.

1.) Annuities will be easier to own within retirement plans. Since there is rarely a case when holding an annuity makes mathematical sense, this change is primarily a benefit for the insurance companies. However, more investment freedom, choices, and portability are always welcome from our point of view, even if we wouldn’t suggest utilizing the new options.

2.) Part-Time workers will have to be covered by employer retirement plans in many cases. While this may seem like a good thing on the face of it, we think historical data clearly shows, rather counter-intuitively,  that reducing employer freedom hurts part-time employers when it comes to wages and job availability.

3.) Increasing the Maximum contribution rate for participants in auto-enrollment 401k plans from 10% to 15%. This is a win for everyone, as it allows employers to have more freedom, and it raises the amount that employees can save for retirement.

4.) Having a child or adopting one will allow for a Qualified Distribution from a Retirement Account, penalty-free. This is a win, as it gives more freedom and choice to retirement account owners.

5.) Qualified distributions from 529 plans to pay student loans and graduate student stipends/fellowships/etc, are now considered income that can be contributed to retirement plans. These changes are wins for account owners. Small ones, but still wins none the less.

And now, the changes that affect the Traditional IRA/401k.

6.) Required Minimum Distributions, or RMDs, will now start at age 72, instead of 70.5. This is good news for those with a Traditional IRA or 401k.

7.)  There is no longer an age limit for contributing to a Traditional IRA. This is a win for the Traditional IRA, as you can continue to work and utilize a Traditional IRA at any age.

8.) Traditional IRAs and Roth IRAs inherited by non-spouses, in most cases, must be emptied within ten years. This is a  significant change to existing wealth transfer law and a HUGE negative for Traditional IRAs and Traditional 401ks because it will increase the taxes your heirs will pay on the distributions.

Now that you know the changes that the SECURE Act brings, it is time to learn what the best strategies are to deal with them. With regards to the Roth 401k vs. the Traditional 401k, if you are planning on primarily using your retirement accounts for yourself and not your heirs, our previous advice still holds, the Traditional 401k is better than the Roth for most people, as the SECURE Act does not change how that works. However, what if you plan to leave your heir(s) a large retirement account(s)?

Let us answer that question by revisiting an example from our previous articles with Joe and Jane. As before, they will save $10k per year for 30 years, retire, and then spend $40k per year in retirement until they die 30 years later. Starting at age 72, the Traditional IRA will have required minimum distributions, or RMDs taken out each year, with the distributions placed into a taxable investment account. For simplicity, we will keep the tax rates as the 2020 rates for the entire duration of the example.  Here are the results. (Note: There will be some rather detailed charts and math shown to provide evidence if you want to skip ahead to the conclusion, take-home point, and rule of thumb that you can use to select the best accounts for you, simply scroll down to the bottom.)

Choosing the Traditional 401k over the Roth made a significant difference in their net worth. Joe and Jane paid three times as much in taxes but had almost twice as much in net worth. This difference is due to the compounding benefit on larger net annual contributions (paying tax later vs. now) during their lifetime and the difference in marginal vs. effective tax rates.  These differences are why the Traditional 401k is better for most people than the Roth 401k, despite advice frequently being given to the contrary. But just how big is the advantage for the Traditional 401k? In order for the Roth the be the better choice, taxes would need to remain low during Joe and Jane’s entire 30 years working and contributing (rising tax rates during working years favor the Traditional 401k even more) and taxes would need to increase during retirement to levels never before seen in the 107-year history of taxation in the US on a 40k annual withdraw. So, the math would tell us that choosing the Traditional 401k is almost always going to be best for Joe and Jane, now we need to see how the Secure Act affects Joe and Jane’s wealth transfer to their heirs.

Let’s start by looking at the most unfavorable situation for the Traditional 401k and Joe and Jane by assuming they only have one child, Jordan, and all of their money is going to pass to him. Under the Secure Act, in most cases, a non-spouse heir will have to withdraw all of their inheritance within ten years, regardless of whether the account is a Traditional IRA or Roth. The strategic approach for inheriting a Traditional IRA would be to spread the withdraws out over the entire ten year period, significantly reducing the tax burden on Jordan. However, we will elect to have Jordan take all of the money out upon inheriting it, which is the worst-case scenario for the Traditional 401k tax-wise.  Here is what happens.

To make this study as unfavorable as possible for the Traditional 401k, let’s assume they have only one child, Jordan, and all of their money is going to pass to him. Under the Secure Act, in most cases, a non-spouse heir will have to withdraw all of their inheritance within ten years, regardless of whether the account is a Traditional IRA or Roth. The strategic approach for inheriting a Traditional IRA would be to spread the withdraws out over the entire ten year period, significantly reducing the tax burden on Jordan. However, we will elect to have Jordan take all of the money out upon inheriting it, which is the worst-case scenario for the Traditional 401k.  Here is what happens.

Even under this very unfavorable scenario, choosing the Traditional 401k over the Roth once again made a significant difference in their net worth.  As a family, they paid nearly 9 times more in taxes, but still had $300k more in net worth in the end. If you are Jordan, while it isn’t fun to pay $370k in taxes, you would certainly still prefer to pay the taxes and wind up with $300k more in total inheritance when it was all said and done. But taxes are very low right now, and if they increase, at what point would the Roth become the better choice?  

At a 63% effective tax rate, the Traditional 401k and the Roth essentially break even. So if taxes increase above that level, the Roth will indeed become the better choice. But just how likely is that? 1981 was the last time that the federal income effective tax rate on $1,172,000 (Jordan’s income plus inheritance) was higher than 63%. Over the past 107 years, only 24% of the time was the effective rate higher than 63%. (Before 1913, there was no federal income tax.) So far, even the worst-case examples are coming out rather rosy for the Traditional 401k. Let’s look at one more example, this time using the proper withdrawal strategy in a high tax environment by spreading out the withdrawals over the entire ten year period.  Instead of taking the $1,072,000 out during the 1st year, Jordan will take it over ten years. This strategy will reduce Jordan’s annual income each year vs. taking it all at once, which will reduce his effective tax rate significantly. Let’s see what happens.

Utilizing this strategy, with Jordan’s expected annual withdrawal rate of $135k, we would expect a 30% effective tax rate historically. At this rate, the Traditional 401k once again far outpaces the Roth 401k in total net worth created. But what if taxes go higher? The highest effective tax rate in US history for an expected annual withdrawal rate of $235k is 40.7%, never even coming close to the 63% needed just for the Roth to break even! As with all things government, there is certainly a chance that future tax policy changes significantly and goes against the grain of history, but there is such a large gap that the probability of that happening to a significant enough degree is extremely small.  Thus, the wise strategy is to make decisions based upon probability, and at this point, that heavily favors the Traditional 401k as being the best choice. This even remains true when looking at unfavorable circumstances for wealth transfer. (One heir, taking everything out at once.)

To conclude, choosing the Traditional 401k over the Roth 401k will almost certainly mean that you will pay more in taxes, but you will also have significantly more net worth, both during your lifetime, and for your heirs. To aide your decision with which account to choose, here is our simple rule of thumb, if you are single and have more than $40k of AGI or if you are married and have more than $80k of AGI, choose the Traditional 401k instead of the Roth 401k.  If your retirement accounts will be used for wealth transfer, be sure to get your estate plan in order, as there are several strategies that can optimize your transfer process.

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