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.
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.
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.
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.
- 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.