In this newsletter, I want to help you make a decision whether to put your money in a Traditional 401k or Roth 401k.
What is the difference?
In a traditional retirement account, such as 401k, your contributions (money you put into the account through your employer) are tax deductible. You would pay no taxes on the growth. When you withdraw from this account during retirement (after age 59 ½), you will pay ordinary tax rates.
In a Roth retirement account, such as Roth 401k, your contributions are not tax deductible. You would pay no taxes on the growth and withdrawals during retirement (after age 59 ½).
What is the best option?
The best option is the one that would leave you with the highest income after taxes during retirement. It generally comes down to the difference between your current marginal tax rate vs your future marginal tax rate.
If your current marginal tax rate is higher than your expected marginal tax rate during retirement, then the traditional 401k is better. If your marginal tax rate during retirement is expected to be higher, then the Roth 401k is better. So how do we decide?
Estimating your current marginal tax rate
The best way to calculate your current marginal tax rate is by simulating your income, credits, and deductions in a tax software. Then, add proposed traditional 401(k) contributions and calculate the percentage change (change in tax divided by the change in taxable income). If this percentage matches one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that would be your marginal tax rate.
Obviously you might not have access to the tax software that would allow you to run these projections. Another way would be to look for free tax return excel templates, like Excel1040.
Another quick method for simple scenarios (i.e. wages with no credits/phase outs) would be to take your wages, subtract the standard deduction, and find your tax bracket.
For example, if you earn $100,000 on a W-2, subtract the standard deduction for a single filer, which is $14,600. This leaves you with $85,400 taxable income, or a 22% tax rate bracket.
So, with every dollar you contribute to a Traditional 401k, you can expect to save 22% on your taxes. If a 22% tax rate is higher than your projected future marginal tax rate, then choosing a Traditional 401k would be better than Roth 401k.
Estimating your future marginal tax rate
Estimating your future marginal tax rate is much harder. It consists of 2 parts:
- Estimating your taxable income during retirement
Your future income income will come from a few different sources:
→ Pre-tax accounts (Traditional 401k/Traditional IRA)
Annual income = Current pre-tax balance * (1 + r)^t * wr
r = Real rate of return on investments (6% is an average rate)
t = years until retirement starts
wr = Safe withdrawal rate (2% to 6%, with 4% being used as the average)
→ Taxable brokerage account
Annual Income = FV(r – Dt, t, d, Pv) * dividend yield/withdrawal rate.
r = real rate of return
Dt = dividend yield times dividend tax rate (usually 15%)
t = years until retirement
d = any additional yearly contributions
Pv = current value of the account
Note that capital gains/qualified dividends are taxed at preferential tax rates.
→ Social Security benefits
Project your social security income. Use the SSA quick calculator to estimate monthly income.
→ Other
Include any other types of income, such as pension, part-time work, rental properties, etc.
→ Standard deduction
The standard deduction is $14,600 (single) or $29,200 (married filing jointly) for taxpayers under 65, and $16,550 (single) or $32,300 (married the standard deduction is $16,550 (single) or $32,300 (MFJ) for taxpayers age 65 and older.
- Predicting the tax rates
Predicting the tax rates is the difficult part. No one knows what will happen. Currently, we have one of the lowest tax rates they’ve ever been. For example, the highest tax bracket in 1986 was 50%, as opposed to 37% now.
Generally, using this year’s tax rate is a good starting point, but if you have a strong opinion about the future rates, make sure to add that in your projection.
Example
Let’s consider a single individual who earns $225,000 per year from a W-2 job and has a current marginal tax rate of 32%. He currently has $250,000 in a traditional 401(k) and expects it to grow at an 8% return. He plans to retire in 25 years at the age of 65. Inflation is expected to be 2.5% per year. According to the calculator, he expects to receive $3,000 per month in Social Security benefits. He does not anticipate any additional income in retirement. Should he contribute to a Roth or Traditional 401k?
Here are calculations of his income:
He would fall into the 22-24% marginal tax bracket during withdrawal. If you believe the tax brackets would increase by 5%, that would result in a 27-29% tax rate. Since the current marginal tax rate (32%) is higher than his projected marginal tax rate during retirement, contributing to the Traditional 401k is better than a Roth 401k.
Other considerations:
• State tax
It’s also important to consider state marginal tax rates.
For example, if you get a traditional 401k deduction in a state with income taxes, but retire in a state which has no tax, then the traditional contributions will have an advantage over Roth.
• Roth conversions
It’s possible to contribute to a Traditional 401k, get a 22-32% tax deduction, and convert it to Roth during future years when the tax rate is low. I discussed Roth conversions in my other newsletter issue.
Closing thoughts
There is a rule of thumb that suggests if your tax bracket is 12% or below, you should contribute to a Roth 401k; if your tax bracket is 22% or above, contribute to a Traditional 401k. I generally agree with this rule of thumb, but it’s important to analyze your own scenario and projections for a more accurate analysis.
If you have any questions or suggestions on how to improve The Crunch, please reply back to this email. I read all the emails.
MC, CPA