A client recently ask whether and how much to contribute to her Roth 401k rather than her traditional 401k. Roth 401ks are relatively new on the retirement savings scene. If your employer offers one they allow you to contribute post-tax dollars. Amounts you withdraw after age 59.5 are not taxed.
Roth 401ks are unlike traditional 401k plans (or 403b or 457 plans) in which you make your contributions before taxes (pre-tax contributions). But withdrawals from a traditional 401k are taxed as ordinary income in the year of the distribution.
In addition, you are required to take minimum distributions from a traditional 401k starting in the year you turn age 70.5. There are no required minimum distributions from Roth 401ks. Thus they can grow and grow. They also can be a useful way to leave tax-free money to your heirs.
1. Marginal Tax Rate Avoided on Contributions versus Average Tax Rate Applied to Distributions
My client was skeptical of the traditional 401k because any gains would be subject to higher ordinary income taxes. Whereas gains in a taxable brokerage account are subject to lower capital gains tax rates.
Her limitation was that her net paycheck had to stay the same regardless of whether she made a pre-tax traditional 401k contribution or a post-tax Roth 401k contribution. Her marginal tax bracket was 28%. Meaning that each dollar she contributed to a traditional 401k avoided the 28% federal tax. So what was better? $12,960/year in post-tax Roth 401k contributions or $18,000/year in traditional pre-tax IRA contributions?
The answer lies in the fact that we have a progressive federal income taxation system. A progressive tax system means that income tax rate increases as the taxable amount increases. The term “progressive” refers to the way the tax rate progresses from low to high, with the result that a taxpayer’s average tax rate is less than the person’s marginal tax rate. For single filers, for example, the first $9,275 in taxable income is taxed at 10%, taxable income from $9,276 to 37,650 is taxed at 15%, taxable income from $37,651 to $91,150 is taxed at 25% and so on.
So let’s look at how the contributions would grow over 20 years. At 7.0% annual growth, she would have $1,700,294 in 20 years of $18,000 contributions compared to $1,224,212 of 20 years of $12,960 contributions. The pre-tax contributions yielded $476,082 more than the Roth 401k contributions.
But here is the key. The larger amount will be taxed on withdrawal at her average tax rate of 20%, not the marginal tax rate of 28% on her contributions. Remember, we have a progressive tax system. So as long as her average tax rate in retirement is lower than her marginal tax rate now, the traditional IRA pre-tax contribution would yield more over the long term.
This same logic holds for those in the 25% bracket. But for those in the 15% marginal tax bracket – see the next point.
2. Lower Wage Earns May Benefit by Roth 401k Contributions Now
Roth 401k contributions may be better if you are in a lower tax bracket now, say 15%, and you are likely to have salary growth. This situation is often the case for younger workers who are starting out their careers. A pretax benefit of 15% of the contribution is not that great compared to an average tax rate of 20% in retirement.
So make Roth 401k contribution if you have a low marginal tax rate and have room for salary growth. Later when you get that higher salary and are in the marginal tax bracket to the 25%, 28%, or 33% marginal bracket, switch to the pre-tax traditional 401k contribution.
In sum, my client kept her traditional 401k contribution at $18,000/year.