The other day I got into a very frustrating argument with a popular anonymous Finance Twitter account about the epistemology of 401(k) savings vehicles. The frustration arose from a very specific phrase he used to describe one of the benefits of a Roth 401(k) over a traditional 401(k): “you’re able to contribute more with a Roth 401k.” This is such a strange claim I asked him to clarify his argument, but he was never really able to do so.
That being the case, I want to see if I can try to make the strong form of the argument that he wasn’t able to make.
It’s legal to save money in taxable accounts
While most financial planners will readily tell you that most people, under most circumstances, should maximize their workplace retirement savings contributions before investing in a taxable brokerage account, it’s important to remember that it’s perfectly legal to invest in taxable accounts at any time for any reason. Not only that, there are some advantages to doing so:
- Funds can be contributed in unlimited amounts, at any time, for any reason. For example, the S&P 500 hit its financial crisis low in March, 2009. If you were somehow aware of this fact at the time, making contributions through a workplace 401(k) would leave your hands somewhat tied: first of all, two months of payroll contributions had already been made for 2009, leaving you just 83% of your maximum $16,500 contribution left. Deferrals are limited to the amount of your paycheck, and sometimes to just a fraction of your paycheck, so it might take months to max out your contributions for the year, dramatically reducing the value of your clairvoyance.
- Dividends and capital gains are taxed at preferential rates, as low as 0%. Moreover, over time reinvesting dividends and capital gains allows you to establish a range of different cost bases for different lots, allowing you to right-size your capital gains depending on your tax rate year-to-year.
- Capital losses can be used to offset gains and ordinary income. A diversified taxable portfolio will experience gains and losses in different positions over time, giving taxable investors additional tools to manage their tax liability.
- Assets can be withdrawn at any time for any reason. There are no restrictions, no holding requirements, no caps, and no repayment requirements when withdrawing assets from a taxable account. It’s your money from the day you deposit it to the day you withdraw it.
Of course, there are disadvantages as well, first and foremost among them that taxable investments are made with after-tax money. Thus, the price you pay for all the advantages of taxable investments is the income taxes owed on the invested amount in the year it’s earned. To be consistent throughout, let’s use the 22% marginal tax rate on single filers making between $51,475 and $96,200 in earned income per year. In order to make $19,000 in taxable investments, this investor must first pay $5,359 in federal income tax on $24,359 in earned income.
Splitting it up in this way allows us to think about the $19,000 deposit as a “bundle” of two different assets: $19,000 in investible funds, plus the combination of rights and privileges the investor paid $5,359 for. This doesn’t mean preferential taxation and ease of access are worth $5,359, rather, it means they cost $5,359.
Knowing these facts allows us to perform all sorts of fancy calculations. For example, at a 0% discount rate (you value a dollar today exactly the same as a dollar in the future), it would take a little over 9 years for the benefits of maximal tax-loss harvesting ($3,000 in losses per year at a 22% income tax rate saves the taxpayer $660 per year) to recoup the amount paid for the right to tax-loss harvest. At a discount rate of 6%, it takes over 11 years to break even.
It also allows us to adjust the value of our asset in the face of changing circumstances. Raising the maximum amount of deductible losses from $3,000 to $3,500 raises the value of the asset by reducing the amount of time needed to break even. Lowering or eliminating deductible losses reduces the value of the asset by extending the breakeven period.
This sounds straightforward, because it is, but it’s also a useful tool to use when thinking about the difference between traditional and Roth 401(k) contributions.
Traditional 401(k)’s combine a discounted investment asset and a tax liability
Traditional 401(k) contributions are made from payroll and removed from your taxable earned income before it’s reported to the IRS. The same $24,359 in earned income as above can be split into a $19,000 traditional 401(k) deferral and, after paying federal income taxes at 22% on the remainder, a $4,180 taxable investment.
It’s essential to understand that your current-year cash flow situation is identical whether you make the traditional 401(k) deferral or whether you direct the income entirely into a taxable account: in both cases you earned $24,359 in income, in both cases you spent $0 on current-year consumption. The fact that in the first case you paid $1,179 in taxes while in the second you paid $5,359 in federal income taxes is entirely irrelevant to your current-year cash flow, which in each case is $24,359-in and $24,359-out.
The difference is that in the second case you have created, alongside $23,180 in total investible assets, a new bundle of liabilities. Just as a taxable account represents “investments plus rights,” a traditional 401(k) represents “investments plus duties.”
But this is a very peculiar liability. Most importantly, it is:
- the duty to pay taxes at your ordinary income tax rate, plus a 10% penalty, on withdrawals made before age 59 1/2.
- the duty to pay taxes at your ordinary income tax rate on withdrawals made between ages 59 1/2 and 70 1/2.
- the duty to make withdrawals (and pay ordinary income tax) starting at age 70 1/2.
Moreover, we know precisely what the federal government is willing to pay our investor for this liability: $4,180, the taxes foregone on his income when he made the traditional 401(k) deferral. The terms of this deal have some obvious advantages to the investor:
- playing with the house’s money. Traditional 401(k) deferrals offer a kind of heads-I-win-tails-you-lose dynamic, since only 78 cents of each dollar in the account was contributed by the investor. This might allow the investor to take on more risk: if they hit a home run, there will be plenty left over to pay back their liability with, while if the account goes to zero, they get to walk away from their liability with no consequences.
- control over timing. While the $4,180 liability was created at a 22% marginal tax rate, it’s paid back at the investor’s marginal tax rate at the time of retirement. Planning on an early retirement and taking advantage of the Social Security magic trick might allow the investor to repay their liability at a 12% tax rate or below.
- pre-retirement rollovers and conversions. During a break in service it may be possible to move assets from traditional 401(k)’s into Roth IRA’s, exchanging a liability for an asset at a deep discount, depending on your marginal tax rate.
Just as we can adjust the value of our taxable rights up and down as the tax code changes, we can adjust the value of our traditional 401(k) liability up and down. With the end of the “marriage penalty” and cuts in personal tax rates at least through 2028, tax brackets are historically wide and marginal tax rates are historically low. If those brackets narrow, or are tied to a slower measure of inflation, then the value of the traditional 401(k) liability might even grow faster than the value of the assets in the account. If you work longer or earn more money than expected, the value of the liability will likewise grow.
Meanwhile, if you retire earlier than expected, your income is lower than expected or tax-exempt for whatever reason, tax rates are cut further, inflation adjustments are made even larger, or the required minimum distribution age is increased to 72 or higher, then the value of the liability on your books will fall.
Roth 401(k)’s are just another bundle of investments and rights
All of this brings me back to Jake’s bizarre claim that Roth 401(k)’s allow you to “save more money.” As should be clear at this point, nothing could be further from the truth. With $24,359 in earned income, you can:
- invest $19,000 in a taxable account;
- invest $19,000 in a traditional 401(k) account and $4,180 in a taxable account;
- or invest $19,000 in a Roth 401(k) account.
In each case you have “saved” the same $24,359, in the concrete material sense that you earned the money but did not spend it. In the first case you pay $5,359 in federal income taxes for the right to preferential dividend and capital gains taxation and the ability to offset ordinary income with capital losses. In the second case you receive $4,180 in investible assets in exchange for a liability to pay your marginal ordinary income tax rate, plus penalties under certain circumstances, on any amount withdrawn from the account. And in the third case, you receive $19,000 in investible assets that can be withdrawn tax- and penalty-free in retirement.
All of these assets and liabilities can be analyzed, assigned a value, and recorded on your personal ledger based on a sober analysis of present and future conditions. Moreover, the value can be adjusted over time as the future becomes clearer. It can be worth incurring liabilities to invest more money (traditional IRA’s) if the investment will yield a higher return than the liability, and it can be worth paying for an asset up front (taxable and Roth investments) if you believe the value of the asset will appreciate at a faster rate than the consideration paid.
And, of course, you can diversify your investments, assets, and liabilities across all three, and change that allocation over time, as public policy and your life circumstances change.
That’s the argument I hoped Jake was making in his initial tweet, but since he wasn’t able to make it, I figured I would instead.