One common question advisors get is: should I contribute to my Roth 401k or Traditional 401k? The same question goes towards IRAs. My rule of thumb is that it’s better to contribute to tax deferred accounts if you are in a high tax bracket and to contribute to Roth accounts if you are in a lower tax bracket. Trying to think of a topic for the week, I wanted to test my theory, which is widely held by others, by creating a test case on my financial planning software, E Money.
First some ground rules:
Contributions are at 15% of salary and E Money makes assumptions as to what future 401k contribution rates will be.
My test person is 21 years old and plans to work until age 65.
The study was run using 3 different salaries: $50k, $150k, and $300k per year. In each scenario living expenses were half of the annual salary.
Pre-retirement investment returns average 7.54% annually and Post-retirement average 5.53% annually.
Any excess savings each year gets invested in the following manner: 90% toward a taxable account earning 5.54% annually and 10% to a cash account earning 2.52% annually.
No other variables are used: spouse, kids, mortgage, standard vs. itemized, etc…
Everyone’s individual circumstances are different. Do not take my findings as a solicitation to do one or the other; run the numbers for yourself or have a planner do it.
Next, let’s do a quick review. Pre tax accounts reduce your taxable income by the amount contributed each year. Money stays tax deferred until you withdraw it. When you withdraw from a tax deferred account you pay income tax on the amount withdrawn. The idea is that you earn more during your working years and would presumably be in a higher tax bracket. As you retire your expenses go down: mortgage is paid, kids are out of the house, etc… If these things are true, you should only need about 60-70% income replacement. The withdrawals are less than what your income was, and they’re taxed at a lower rate. Pre tax accounts require Required Minimum Distributions. These kick in at age 72 if you turned that age before Jan 1. 2023 and age 73 for those attaining that age after that date. The amount is based off IRS tables.
Roth account contributions don’t give a you a break on taxes each year you contribute. But the money contributed grows tax free, and you withdraw it tax free. There are no RMD requirements on Roth accounts.
Knowing what we know so far, over the long-term Roth accounts are probably better, right? You can withdraw tax free so it seems like a no brainer. BUT, you don’t get that tax break for your contributions. If you owe 20% in federal taxes, for every $100 you contribute to a tax deferred account you save $20 in tax. For a Roth you are contribution the entire $100. So, if you contribute the full $23,000 each year to a traditional 401k, you save $4600 in taxes, 20% of $23k. In my assumption, that $4600 goes toward the 90% investment account and 10% cash giving you more investing power over the years. You’ll have post tax money available to invest with the Roth 401k nut not as much.
My initial rule of thumb is that for lower incomes, the Roth is better. Lower tax rates mean you don’t get as much of a benefit from deferring taxes. To my surprise, this isn’t true when looking at overall net worth at different ages. Each scenario had a breakeven age of roughly 79 or 80. Before that age your net worth is higher across the board by making pretax contributions. After that age you are better off making Roth contributions during your career. The reason for the change is mostly due to Required Minimum Distributions. You are forced to withdraw and pay tax. That amount of tax evaporates from your net worth.
$50k Salary | ||
Age | Roth | Traditional |
60 | $3,649,577.00 | $3,846,160.00 |
70 | $6,532,477.00 | $6,865,759.00 |
80 | $10,723,969.00 | $10,720,385.00 |
90 | $17,697,156.00 | $15,659,321.00 |
$150k Salary | ||
Roth | Traditional | |
60 | $8,478,103.00 | $9,300,393.00 |
70 | $14,913,031.00 | $16,203,616.00 |
80 | $23,563,321.00 | $23,823,737.00 |
90 | $38,045,782.00 | $31,957,867.00 |
$300k Salary | ||
60 | $11,683,387.00 | $12,642,424.00 |
70 | $18,557,113.00 | $20,041,264.00 |
80 | $25,786,591.00 | $26,252,643.00 |
90 | $37,214,321.00 | $31,598,694.00 |
* Contributions are at 15% of salary and E Money makes assumptions as to what future 401k contribution rates will be.
As you can see, up until age 80 your net worth is the same or higher by making pre tax contributions to a Traditional 401k. But there’s a catch: when you die your assets pass to your beneficiary. If it’s a spouse then they can comingle the funds with their own but it would need to remained titled the same, Roth to Roth or Traditional to Traditional. They can treat the funds as their own. If it’s a non-spouse who inherits your money things get tricky. For Roth accounts a non spouse will inherit the money tax free other than estate taxes which are currently levied on an individual estate over $13.61Million in 2024. Non spouse beneficiaries need to open an Inherited Roth IRA to receive the funds. They can withdraw tax free from that account, but they need to deplete the account within 10 years, 5 years if the decedent passed before 2021 (Investopedia). It’s all tax free though whether you take it all in year 1 or spread it out over 10 years.
With Traditional pre-tax accounts if a spouse inherits, they can roll it into their own IRA. There are other nuances, but we don’t need to muddy the waters with those for our purposes. If a non-spouse inherits the pre-tax assets they will have to withdraw the entire amount within 10 years, and this is taxed as income. The assumption in my study is that everything is withdrawn all at once. Without even looking at the numbers, you can see how big of a difference this will make on the amount of assets transferred. If millions of dollars are transferring to someone who needs to withdraw and pay tax, that’s a serious dent! Look at the effects after taxes. The following chart shows the net amount a beneficiary will receive after taxes have been levied on the withdrawal (Assumes a 35% tax and the amount withdrawn all at once, not spread over 10 years). After factoring in taxes to a non-spousal beneficiary, the Roth always wins:
$50k Salary |
| ||
Age | Roth Net Estate Transfer | Traditional Net Estate Transfer |
|
60 | $3,649,577.00 | $3,029,962.00 |
|
70 | $6,532,477.00 | $5,312,506.00 |
|
80 | $10,723,969.00 | $8,669,581.00 |
|
90 | $17,697,156.00 | $13,803,316.00 |
|
$150k Salary |
| ||
| |||
60 | $8,478,103.00 | $6,851,822.00 |
|
70 | $14,913,031.00 | $11,543,899.00 |
|
80 | $25,563,321.00 | $17,671,382.00 |
|
90 | $37,991,469.00 | $26,389,903.00 |
|
$300k Salary |
| ||
60 | $11,683,387.00 | $10,133,877.00 |
|
70 | $18,437,316.00 | $15,266,664.00 |
|
80 | $24,342,311.00 | $19,948,605.00 |
|
90 | $37,214,321.00 | $25,893,455.00 |
|
In my opinion this is where the Roth really shines. Money in Roth accounts should be earmarked for estate transfer. So the question is, are you looking to maximize your net worth and minimize taxes during your lifetime only? If so, pre tax is generally the better way to save unless you plan on living past 80. But, if you’re worried about passing assets on and maximizing net worth over multiple generations, the Roth is by far the better way to go.
Of course, all of this is hypothetical. The sad truth is that few people have accumulated anywhere close to these amounts over their careers. Some of it is due to contribution rates being lower for so long. Some of it is due to 401ks not being prevalent until the 80s. Roth IRAs weren’t even available until 1998. Here’s the average retirement savings by age in the US as of 2022:
Mean Retirement Savings Balances by Age Group (2022) | |
Age Group | Account Balances |
Under 35 | $49,130 |
35 to 44 | $141,520 |
45 to 54 | $313,220 |
55 to 64 | $537,560 |
65 to 74 | $609,230 |
75 and over | $462,410 |
Spread out over a 10 year period the tax hit isn’t going to be terrible, but the Roth still will likely come out ahead, slightly.
You also have the opportunity to convert pretax savings to Roth accounts. This creates a taxable event in your lifetime, but it helps with the net estate transfer. Plus, if you convert during years where the market has sold off, you can roll them to a Roth and watch it grow tax free for the rest of your lives. For example: you have $100k in a pre-tax account that you know you don’t need. The market sells off 20% and your account is now valued at $80k. You convert and pay 20% federal tax from the amount converted.
Year | Pre Tax | Pretax net to heirs, 30% tax | Roth minus 20% Tax upfront |
1 | $80,000.00 | $56,000.00 | $64,000.00 |
2 | $86,000.00 | $60,200.00 | $68,800.00 |
3 | $92,450.00 | $64,715.00 | $73,960.00 |
4 | $99,383.75 | $69,568.63 | $79,507.00 |
5 | $106,837.53 | $74,786.27 | $85,470.03 |
6 | $114,850.35 | $80,395.24 | $91,880.28 |
7 | $123,464.12 | $86,424.89 | $98,771.30 |
8 | $132,723.93 | $92,906.75 | $106,179.14 |
9 | $142,678.23 | $99,874.76 | $114,142.58 |
10 | $153,379.09 | $107,365.37 | $122,703.27 |
*Assumes investments grow at 7.5% annually.
As you can see, just looking at your net worth after 10 years, it’s better to keep the money pre-tax. We aren’t considering the impact of RMDs on these amounts, only the amount of estate transfer. Also, if you are in a higher tax bracket than your heirs would be, or if your heirs spread that distribution over 10 years and manage to stay in a lower tax bracket than you were when you converted, this doesn’t work. However, usually if a non-spouse inherits money, it’s from a parent. That child is presumably in their highest earning years whereas the deceased parent wasn’t.
In conclusion, Roths tend to be better when looking at the whole picture. Income taxes on pre-tax transfers can be killers. Conversions seem to be a good way to go too if you aren't going to need the money, and if you are in a low tax bracket. Again, everyone’s circumstances are a little different. Run these numbers for yourself. Other things to consider are the income limits needed to get tax credits for the Affordable Care Cct, child care credits, and the effect on Medicare premiums, the 5 year holding requirement on Roth conversions, etc... You can see that there are a lot of variables that can be applied. It’s like Ben Franklin said “…in this world nothing can be said to be certain, except death and taxes.” Fortunately, we have the technology to prolong our lives and delay taxes as well as laws to help mitigate tax when we do die.
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