As you have shown, one advantage of a Roth 401k (or IRA) over a traditional 401k is that more funds are put to tax-advantaged use if the maximum contribution limit is reached. This advantage is not insignificant, although it is likely less than the advantage the traditional plan has over the Roth for people who expect to be in significantly lower tax brackets when they retire. These effects can be quantified by looking at tax-adjusted yields for different scenarios and investment accounts. The tax-adjusted yield considers all taxes over the period of the investment (e.g., original income tax, income tax on withdrawals, annual dividends, realized capital gains).
For example, consider two people, A and B, with solid incomes living in a high tax state. Their federal plus state marginal tax rate is 35%. Person A has a significant taxable pension and plans to live in the high tax state after he retires. His effective tax rate on traditional 401k/IRA withdrawals when he retires will be 30%. Person B does not have a pension and plans to move to a low tax state when she retires. Her effective tax rate on traditional 401k/IRA withdrawals will be 15%. Both A and B plan to invest for 30 years and expect a nominal return of 10% (lets be optimistic), with 2% of the return coming from qualified dividends that are taxed each year for funds in taxable accounts. Assume the tax rate on qualified dividends is 15% and the tax rate on realized capital gains is 15%.
How should each person invest? What are the tax adjusted yields for different investment accounts?
Person A (35% tax rate while working, 30% when retired)
8.43% Roth 401k (or IRA)
8.38% Traditional 401k (maxing out contributions)
8.70% Traditional 401k (not maxing out contributions)
7.24% After-tax contributions to retirement account
7.69% Taxable investment account
Person B (35% tax rate while working, 15% when retired)
8.43% Roth 401k (or IRA)
8.89% Traditional 401k (maxing out contributions)
9.41% Traditional 401k (not maxing out contributions)
7.88% After-tax contributions to retirement account
7.69% Taxable investment account
Of course, there are near-infinite possible permutations of these examples including the fact that future tax rates are not known. But what can we learn from these results?
- For those with taxable pensions (401k/IRA withdraws will be highly taxed in retirement due to significant base income), the Roth may be slightly better than the traditional plan for people maximizing their contributions. But what ever you do, don't make after-tax contributions to a 401k or nondeductible contributions to an IRA unless you plan to immediately roll these contributions into a Roth (e.g., backdoor Roth). Instead, put the funds in a regular taxable account that is tax efficient (e.g., Vanguard index funds).
- For those without pensions (low tax rates on 401k/IRA withdrawals in retirement), the traditional 401k or IRA is almost definitely the better choice. Also, after-tax contributions to a 401k or nondeductible contributions to an IRA might be appropriate.
- For those not maxing out 401k or IRA contributions, the traditional plan is the way to go.
- For those with poor 401k plans such as those with high fees or those that offer only funds with high expense ratios (greater than 100-150 basis points), it may be better to forgo the 401k contributions and simply invest in a low cost taxable account if you plan to remain with your employer for several years (after any employer match).
