I saw this topic today over at Nerdwallet, and wanted to share some insight on the matter. Note the standard disclaimer that everyone is unique, and to pay a professional if you want to do anything involving your money.
In order to understand this decision, you need to first understand the basic difference between a Roth and Traditional retirement account.
Pre vs Post
- Roth accounts are contributed to with zero tax savings at the time of contribution. They are funded ‘post tax’.
- Traditional accounts are contributed create a tax deduction in the tax year of contribution. They are funded ‘pre tax’.
A tax free bubble
Both accounts create a wrapper or bubble for the investments, and there is no taxable event realized during the accumulation years. If you sell an appreciated asset inside either, it is protected, a dividend or capital distribution has no taxable meaning to you during the years that it is growing.
Taxed differently on the way out
- Roth accounts are tax free after you meet the age requirements.
- Traditional accounts become ‘income’ and taxed at ordinary income tax rates.
Assumption 1
The first assumption people (even professionals) make based upon the above fact pattern is that you should choose a Roth or Traditional account based upon what you perceive your future tax rate to be. It is logical, but they get distracted by historical data. They go on tangents about national debt, and how rates should rise, and they bring in ‘noise’ that distracts from the truth.
The truth is that barring a huge change in rules and legislation, everyone will have a lower rate of income tax in the future, if they want one…. That isn’t due to macroeconomics, it is due to the income timeline you can see below:
There’s a gap. This gap in income is called ‘retirement’. When you turn off the valve of income from your employer, you get the opportunity to turn on the valve again immediately (if old enough) via Social Security, or to delay it. The current maximum deferment age for Social Security is 70. This means that you could easily see a gap of up to 20 years where you drop your base income to zero, and pull down from 401(k) accounts at a lower tax bracket than when you contributed.
Early Retirement Income Gap
If you consider early retirement, at age 55, while still delaying social security until age 70, the gap widens to a 15 year period.
Assumption 2
401(K)s and IRA’s are retirement accounts, therefore you should pick the best one. With proper planning, they’re actually wealth transfer accounts. When people talk about the value of pulling out ‘tax free’ money in retirement from their Roth.. the reality is that nobody should be touching a Roth until they are forced to do so via law.
Traditional accounts are subject to Required Minimum Distributions for the owner and their beneficiary, whereas Roth IRA accounts (Roth 401(k)s become Roth IRAs very easily) are only subject to this for beneficiary (and still tax free). As such, the Roth account has the benefit of the tax free wrapper/bubble until the day of death for the owner, and a limited version of this wrapper for the next generation. It is the account of last resort to drawdown on in retirement, and only in desperate times.
Instead of thinking of them as retirement accounts, think of a Traditional account as a way to get a tax deduction, and a Roth account as a way to pass your wealth down to the next generation. While you might need some of these accounts during your own lifetime, the end goal is to have your assets aligned in a way that is most tax efficient for you during your life, and beyond.
Assumption 3
Roth dollars are worth more than Traditional dollars because Roth dollars are free in the future… check out this quote from Nerdwallet and think about it (bolding mine):
Even if you expect your tax rate to go down in retirement, a dollar in a Roth 401(k) is worth more than a dollar in a traditional 401(k), says Tim Maurer, a certified financial planner and author of “Simple Money: A No-Nonsense Guide to Personal Finance.”
“Virtually all the time, for people who are considering making a contribution, the Roth dollar is more valuable, because the traditional is going to require tax payment,” he says. When you pull a dollar out of a Roth, you put that dollar in your pocket. When you pull a dollar out of a traditional 401(k), you put that dollar minus taxes in your pocket. That could leave you with 75 cents — maybe a little less, maybe a little more.
The only way a traditional meets the value of a Roth is if you expect your future tax rate to be lower — and you immediately invest the value of the tax deduction you receive now from contributing to a traditional 401(k). If you put $4,000 into a traditional account this year and you do the math to determine that the tax deduction on that contribution is worth $1,000, you need to invest that $1,000 as well.
You can do that out of cash flow or from your tax refund. But many people don’t get a tax refund, and about half of those who did expect one last year planned to spend it, according to a National Retail Federation survey. That means the second part of this decision comes down to behavioral finance: Can you trust yourself to invest, rather than pocket, those tax savings each year? If not, go Roth.
The line of thinking is incorrect, and backed up by a strawman argument about how you likely won’t get a refund…
Matt’s note: if you put the same amount into a Traditional 401(k) compared to a Roth 401(k), you’d get a lower tax bill, which is a refund between the two choices. Guaranteed. 100%.
They raise a fair point about behavioural finance, and spending your refund money frivolously, but if you’re that guy, you’re probably have issues about how you spend down your Roth in retirement anyway…
But to the point of the $1 being more valuable in a Roth. This is incorrect for the vast majority of people who have a 401(k).
Anatomy of a Dollar
The Nerdwallet argument states that your distribution will be reduced to 75 cents from a Traditional account in retirement, due to income tax. Leaving aside the debate on that level of tax, let’s look at the more important topic.. the subject of risk free rate of return.
In your accumulation years you are much more likely to have access to a risk free rate of return that is more attractive than the market. This is because the rate of debt (Student Loans/Credit Cards/Mortgages) is likely to be higher than the rate from a Saving account.
When you think of your $1 in Traditional, it holds the inverse characteristics of the Roth described above. Arbitrarily, if a Traditional loses 25 cents on the way out, let’s say that a Roth loses 25 cents on the way in.
That 25 cents goes out of the family ecosystem during accumulation years, meaning it is not possible to apply it to accumulation – you’re essentially allowing the government to use it for their own investments (or debt) as a free gift. If you carry student loans, or mortgages, that means that 25 cents on every dollar is not being used for debt service. The rate of the debt could easily be between 3-6% after tax benefits.
Here’s an example of a married couple. They buy a $300,000 home, with a $250,000 mortgage at age 30 at a conservative 3% risk free rate of return. If they were to both max out Traditional 401(k) accounts at $18,000, that would be a $36,000 deduction. Let’s give them 20 cents (to be conservative) back on that, for a tax deduction of $7,200 per year, and add that annually to the mortgage payment, which is $1054 per month.
The prepayments of $7,200 accelerate the mortgage from a 30 year term to just 16 years, and from that point, the annual payments and tax savings would be $19,848, which would could invest again, at say, 2% APR.
Think of a Traditional 401(k) as the opportunity to borrow money (for free) from the government and apply it to your debts, or investments, depending on the rate you can get. Then, in your retirement years, you pay it back. This is a real value in itself, and it is compounded by the fact that you get to pick the tax rate you pay it back during the ‘income gap’ years.
When to start the income gap
If you use the Traditional over the Roth (and don’t waste the savings) you’re more likely to pay off student loans/credit card and mortgages before term, as you’ll have thousands in extra cash each year. When you’ve eradicated the living costs, and create a baseline of expenses that is low, you’re likely near the point where you can look at the cash flow impact of retirement. So by electing the Traditional 401(k) over the Roth 401(k) and (importantly!) not wasting the tax savings, you will be able to create an earlier start to the income gap.
As the chart above suggests, investing that difference at just a 2% rate of return would result in over $250,000 in additional taxable savings for your retirement gap years. Muni bonds here would be a good way to cover your (now lowered) expenses and allow you to run a series of partial roth conversions to fill up your wealth transfer account.
Exceptions
- If you work overseas you are able to claim the FEIE, you’d be unable to contribute to an IRA, but you may be able to contribute to a Roth 401(k). If your salary is below the annual FEIE level then there is no Traditional 401(k) deduction, so the Roth is smarter.
- If you are past the income gap age, and are about to hit RMDs, it can be a time to consider direct to Roth.
- You. This is a generic concept, your situation is not generic, do your homework!
Think very carefully about giving away your money. If you elect a Roth you are giving it up early, and lose the ability to invest, or pay down debt with it. And don’t forget that the income gap years highlighted above can occur throughout your lifetime, such as when you go back to college, launch a new business, or travel the world for a year or two. If you’ve already given away your taxes, you can’t benefit during these times. And if you don’t give away your taxes, you can pay off the mortgage sooner, and create these opportunities… it’s a win/win.
When it comes to people wanting your money.. let them wait.
I really enjoyed this read. It reinforces the idea I tend to preach, that a Traditional 401K is better than a Roth (in most cases). It would have been nice if you touched on the early retirement advantages of a Traditional 401K over a Roth but it would have probably detoured the main concepts expressed.
You mean the early distribution?
Early distributions or even the Roth IRA Conversion ladder. From what I understand, if you contribute to a Roth 401K account, you eliminate the option for early retirement (assuming you don’t have a substantial Roth IRA contributions). If you make Traditional 401K contributions and then quite your job or retire, you can then roll over those contributions into your IRA. Once they are in their respective accounts (Trad or Roth) you can then begin to start your conversion ladder. Sorry for reiterating if you already knew this.
MADFIentist has a great article covering the different early retirement options here: http://www.madfientist.com/how-to-access-retirement-funds-early/
I’m not a huge fan of the early withdrawal strategies. I do agree with partial conversions from Traditional to Roth for tax bracket arbitrage, but I don’t like to tap those too early in life.
I also think the 72t rules are overly restrictive.
My approach is to get to early retirement with enough taxable funds and income to not require leaning too heavily on the IRAs until further along, when they might be used for long term care and other events. They then reduce the need for LTC insurance and increase your chances of not dying a pauper.
Being as young as I am I don’t think I have fully decided on which method I want to pursue.
Although I am pushing for FI, I don’t think I could ever see myself not working. Something about working, especially when the work is something I am passionate about, is fulfilling. Whether it be consulting or sitting a board, the idea of working until retirement seems like the approach I want to go. So while I push for FI and want to fully contribute to tax deferred accounts, supplemental income from a taxable account also seems ideal.
So here I am reading reading article after article and thread after thread, I am slowly developing a sense of what I want my from financial future.
Thanks.
Don’t forget that working for yourself makes this a lot easier 🙂
Yup, which is why I am interested in consulting and/or starting my own business. Just gotta build my skill set and start marketing myself. Another year and I’ll be done with graduate school. At that point I’ll probably reevaluate my career goals as well as my financial goals.
72t is not the only way to tap 401k early as long as you leave company 55+
Correct. But the link he referenced talked about 72t and about ‘Roth Ladders’ which I also disagree with.
There’s a big difference though, in a strategy that takes from the IRA or 401(K) early VS the one I’m suggesting where you are still taking from it in retirement, perhaps even later than most.
Awesome article. When you say use munis to cover the now lower expenses (once the mortgage is paid off) are those purchased with cash using the money that was going towards the mortgage payment?
Yep. I used a very conservative rate of 2% here for that growth of that, but you might find it possible to get 3-4%, or in the future, even more.
Thanks for the reply. Where do taxable brokerage accounts belong in this discussion? Once you’ve maxed our roth and 401k contribution limits?
For me the pattern is this:
Tax Deferred
Debt
Brokerage
Do you pay any attention to the interest rate on the debt when going with that order?
I’ve been throwing more money into my brokerage account versus the mortgage payment at 4%. Short term, the mortgage is a lot safer and guaranteed, but I’m optimistic that the market will return more than 4% over the next few decades.
You see how I call it the risk free rate? That’s from capital asset pricing… when you compare a rate of return you need to factor that in.
Once factored, the debt substitutes for investment on a risk basis, and the higher rate for the debt is the arbitrage.
Example: you shouldn’t be 100% in stocks when ‘in the market’ you should be blended in to form the efficient frontier. This includes a low risk low return fixed income element.
Substitute that element for the debt.
For me, I do this on a household level (across all accounts) so debt would always be a surrogate asset allocation if I had debt….
I think I understand. If I wanted to be 80% stocks and 20% bonds in general, it would be better to replace the 20% bonds with paying down the mortgage to get the risk free rate (the arbitrage you’re referring to).
In practice, how would I actually do that? The first step would be to de-vest out of any bonds (assuming I can do so tax-free or close) and throw that towards the mortgage, but what about future investments? Simply take ~20% of all brokerage contributions I make and pay towards the mortgage?
It feels weird because after paying off the debt, I would be 100% stocks all of the sudden (sort of) if I don’t count my house as an investment. Would I then shift existing stocks to bonds to bring back the 80/20 desired allocation?
I feel like I’m rambling, hopefully that made sense.
Yeah, it’s a little more complicated.. but generally that.
The complication stems from the idea that if you were 100% stocks, and there was a downturn in the market you’d have no access to rebalance, as it would be tucked into Home Equity.
However… if you do think of your debt as an investment vehicle (not your house as an investment) then you can do well.
I know it seems weird, but if you can visualize that you are borrowing from the mortgage to not pay the house, but to pay the poor performing bond allocation, it becomes more obvious.
I’ve never really been in debt while investing, but if I were to tell someone how to approach this I would suggest that they consider the 401(k) as their stock allocation (and have bonds in there for dryer powder) and take a fixed rate of 4% over a variable rate of…?
Then when you’ve got no mortgage and are forced to have too much cash and put it somewhere, you risk it in the market (if you can’t think of something better to do with it)
As always, a good read! What about the thought of tax diversification such that you have a variety of taxable and non-taxable sources of income upon retirement to offset tax-rate risk? One thing to mention is that as people get older (especially nearing retirement age) they are more likely to inherit from family, thus raising the chances of higher-than-calculated income at retirement. Thoughts?
I believe in diversification by default.
First, load up deferred accounts as much as possible, because of the instant tax savings. After that, the left over income plus the tax savings become your next weapon of choice.. they should be put to work. I pick debt repayment first because it is a guaranteed return, and when gone, I pick taxable savings. By default, you’re going to end up with a mix of taxable and deferred using this.
The non-taxable comes when you have enough assets to bridge the zero income gap, and you push deferred into tax free. But it isn’t intended for you, rather for the next generation.
The inheritance is important, but note that taxable assets inherited will step up in basis, so if they are inefficient (spinning off income via dividends) then you can swap that to tax free via Muni’s (within bounds of diversification). If you inherit Roths (ideally, if your benefactor read this blog..) then it’s tax free income and doesn’t change things. If you inherit Traditionals, your get a lowered RMD so the impact isn’t going to be that noticeable.
Thanks for taking something that seems a simple choice, explaining the usual logic, and deconstructing it. I especially liked this:
“The line of thinking is incorrect, and backed up by a strawman argument about how you likely won’t get a refund…
Matt’s note: if you put the same amount into a Traditional 401(k) compared to a Roth 401(k), you’d get a lower tax bill, which is a refund between the two choices. Guaranteed. 100%.
They raise a fair point about behavioural finance, and spending your refund money frivolously, but if you’re that guy, you’re probably have issues about how you spend down your Roth in retirement anyway…
But to the point of the $1 being more valuable in a Roth. This is incorrect for the vast majority of people who have a 401(k).”
While I am nearing RMD, and now understand Roths as a way to accomplish wealth transfer, I remember being asked way back when: “Do you think you’ll have more income in retirement or less?” Now that’s a hard question for many people who are just starting out to answer. The logic as you lay it out does not require such speculation and explains why this is not necessarily a useful question. Great post.
Happy holidays!
Yes, I think reframing it a little helps with the guessing game 🙂
Reading this article made me think about an idea: I have a self directed 401K that allows me to buy individual securities, if it was possible to sell my mortgage note to my own 401K/IRA it would eliminate the % paid to the bank which makes up a large portion of the note over 30 years and would thus drastically lower my cost of living expenses, naturally I’d be sacrificing the nice interest tax deduction however I believe no interest period & owning my home outright trumps the interest tax rebate/refund. What do you think of this idea, is my logic flawed and would this option even be possible? Thanks
I don’t think it is possible, but no harm in asking your provider. From what I know of the self directed accounts that do hold Real Estate, it is for investment only, and they have very strict personal use rules. If you invalidate those then you cause a major headache.
The other conceptual consideration is who would own the home? If the 401(k) owned it, then it would lose the section 121 exclusion.
In addition to the Behavior Finance aspect, there is another important facet to the “a Roth dollar is worth more than a Traditional dollar” piece. If you are able to contribute the maximum whether Roth/Traditional, is it better to contribute Roth dollars since you are effectively saving more? For example, if you are in the 33% marginal tax bracket, $18k Roth is roughly equivalent to $26,800 traditional. So is it worth giving up Traditional flexibility on the $18k to get Roth treatment on almost $9k on otherwise plain taxable income?
I raise the question but in practice I have stuck with Traditional. I would love to hear any arguments on either side though.
I think that’s a pure behavioural finance aspect – it comes down to whether you’d spend all left over cash, or if you’d allocate it to paying the mortgage or investing.
I don’t believe it’s that simple. Consider an example in which, you have $18k annually of post-tax income and are contributing $0 to 401k but maxing out all other tax-advantaged paths. You could (1) contribute $18k to Traditional 401k, and if you’re in the 33% marginal tax bracket you’d have ~$6k leftover. Or you could (2) contribute $18k to Roth 401k and you’d have $0 leftover.
In both cases assume 100% growth until withdrawing monies. In option (1), you would have ($18k*2 + $6k) * (1-0.33) + $6k = $34.14k. In option (2) you would have $36k. The difference is simply that the $6k you had leftover had taxable gains, while all the Roth monies of course did not. Yes, this assumes that your marginal tax rate is still 33%, which is a large assumption. But the point is, normally in a Traditional vs Roth comparison, if the tax rate remains the same, the options are indifferent. You get a measurable benefit by putting the $18k in Roth rather than Traditional in that you get access to additional tax-advantaged space. Admittedly this is at the sacrifice of the flexibility that Traditional provides, but I think it’s an important aspect in this conversation.
Your line of thinking ignores the value gained from the debt repayment, which most people will have, and also ignores tax bracket changes. These are two influence points of arbitrage.
Also, the 33% bracket earner is going to have a tremendous amount of wealth saved if they truly are overpaying mortgages and removing debt from an early age. So they’re likely to have the ability to retire early, and create a wider income gap.
This income gap period cannot be at 33% unless they have some sort of other income stream, such as rental property, annuity, or a ton of dividends coming in from taxable. If you allocate Munis and ETFs in taxable, I can’t see you being near that 33% bracket unless you have many millions in taxable investment income, probably something like $6-7M if you are filing Single, and over $10M if you are MFJ.
What about people that are entitled to pensions? I’d assume the Roth is the better option, but I’m not sure of this. That’s why I read your article!
Possibly. Depends on the income gap, salary level and pension amount.
Looks to me like this only applies to people who can max out their 401k contribution during accumulation and have money left over.
If not, are they better off dumping everything they can into the Traditional 401k until they are close to retirement age? I haven’t done the math, but off the top of my head, long term rates of return minus taxes would add up to more than the risk-free returns from prepaying the mortgage.
The post is comparing Traditional to Roth. When you say wouldn’t they be better dumping their money into the Traditional you are agreeing with me 🙂