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When investing in retirement accounts such as a 401(k), or perhaps for you it’s a 403(b), SEP or SIMPLE IRA, or another variety, you will likely be faced with a choice.
Do you invest in traditional, tax-deferred manner or make Roth contributions? Maybe both?
Whatever you choose, it’s important that you invest. If you’re employed, there’s a good chance you’ll have some matching dollars invested on your behalf. Even without a match, there are wonderful tax advantages to either option, so be sure to invest as much in these accounts as you possibly can.
Before we discuss the factors that should push you in one direction or another, let’s review the two options.
Traditional contributions to retirement accounts are tax-deferred. That means every dollar contributed defers a dollar’s worth of tax from now to a future date. You won’t pay tax on that dollar in the tax year in which you contribute, but you will eventually pay income tax when you withdraw the money from the account.
A high-income professional investing $20,500 in a traditional 401(k) can expect to save $7,000 to $10,000 on income taxes in 2022 (assuming a total federal, state, and local marginal tax rate of 34% to 49%).
Roth contributions to retirement accounts offer no such benefit on the front end. That same high-income professional making 100% Roth contributions to her 401(k) or 403(b) will pay $7,000 to $10,000 more in income taxes in 2022 compared to the person making traditional contributions.
The biggest benefit of the Roth contribution comes on the back end. No taxes will be due when the money is withdrawn. Another benefit, particularly for those with large estates, is that Required Minimum Distributions (RMDs) are not mandated for Roth IRA accounts, although the same is not true for a Roth 401(k) or 403(b), both of which could be rolled over to a Roth IRA once you’ve left your employer.
Both types of contributions will benefit from tax-free growth. Unlike money in a taxable brokerage account, no taxes are levied annually on dividends and capital gains within a retirement account like the ones we’re talking about today.
Pay Taxes Now or Pay Taxes Later
Or pay taxes never? More on that third option later.
Most likely you’ll be paying taxes on your earnings at some point. The biggest determinant of when you should pay that tax is whether you expect your marginal tax rate to be higher or lower in retirement than it is right now. There is some guesswork involved here, but there are a number of indicators that can help you make an educated guess.
If you expect to be in a lower tax bracket when you’re no longer earning an income and withdrawing from your retirement account, you should choose traditional contributions today.
If you expect to be in a higher tax bracket as a retiree than you are right now, Roth contributions are the obvious choice.
If you anticipate no change in your marginal tax bracket, you’ve got a choice to make. I’d lean toward Roth contributions, as you’re effectively investing more of your own money in a tax-protected account. When you invest in a tax-deferred manner, a portion of that $20,500 belongs to the government. This could also be a good place to hedge your bet and make both traditional and Roth contributions.
Factors Favoring Traditional Contributions
The more boxes you can check in the following list, the more traditional, tax-deferred contributions make sense for you.
Factors that favor traditional (tax-deferred) contributions:
- High Income
- High Tax Bracket
- Single (higher tax brackets for single filers)
- High Income Tax State
- You Also Invest in a Taxable Account
- Close to Retirement
- Likely to Retire Early
- Anticipating Lower Taxable Income in Retirement
- You’re in a “phase out” income range for a tax deduction or credit
- You’re a natural-born saver
Let’s dig deeper into these one at a time.
If you are earning a great income now, you can use all the help you can get given the progressive nature of our federal income tax. If you’re in your peak earning years, tax-deferral can save you money now.
Along those lines, having a high marginal tax bracket favors traditional contributions. While this is a borderline redundant bullet point, high income is subjective, whereas marginal tax brackets have no gray areas.
For example, you may be in academic family medicine earning under $200,000. That may be on the low end of the doctor pay scale, but without some tax deductions, as a single person filing an individual tax return, you’ll find yourself in the 32% marginal tax bracket.
If the state you currently live and work in has a high state income tax, particularly one with a progressive state income tax, the tax deferral becomes even sweeter. If there’s a chance you’ll someday move to a low or no state income tax state, that tips the scales even further in favor of traditional contributions.
If you’ve got a good amount of money in a taxable brokerage account, you’ve got some tax diversification in your portfolio already. Those post-tax dollars have already been subject to the bulk of the taxes they’re going to see. That money gives you some flexibility in tax planning as a retiree. Taxable dollars are the next best thing to Roth dollars.
If you’re close to retirement, you’re better able to model what your future taxable income and tax situation will be. I consider this a reason to make tax-deferred contributions.
If you’re retiring within the next few years, you’ll likely be subject to the current tax rates which recently became more favorable. At least in the early years after you retire, tax brackets should not be drastically different than they are today, although the winds of political change can make a difference in a hurry.
If you plan to retire long before you turn 72 and required minimum distributions are mandatary, you’ll have plenty of time to convert traditional dollars to Roth, quite possibly in a lower tax bracket than you are today.
Related to future modeling, if you’re close to retirement, you’ll have a good idea of what your income streams are going to be and how that money will be taxed. If you’ve got a sizable taxable brokerage account and / or Roth account(s), you can probably expect to have a lower taxable income to meet your spending needs in retirement as many of your dollars are already post-tax.
If you have a household taxable income that subjects you to a phase-out or elimination of a tax deduction or credit, the tax deferral can be particularly advantageous.
This might come into play for a physician working on a 1099 basis (independent contractor) who is gradually phased out of the 20% pass-thru deduction with a household taxable income from $326,600 to $426,600 if married filing jointly (half those numbers for single filers) in 2020.
Also, the child tax credit of $2,000 per child phases out by $50 per thousand dollars of income (over a range of $40,000 per child) at a modified adjusted gross income above $400,000 with married filing jointly status ($200,000 for individual filers).
Finally, traditional contributions are better for natural born savers. Why? With tax-deferred contributions, you’re going to pay less tax, which means you’ll have more of your “disposable income” at your disposal. If you are likely to save and invest the tax savings, traditional contributions give you more money to invest.
Factors Favoring Roth Contributions
If you’ve read all I’ve written thus far, take the exact opposite of the preceding paragraphs and you’ll come up with reasons that Roth contributions are wiser. I’ll list them for you and give a brief overview of the rationale, but it should be fairly intuitive.
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Factors that favor Roth contributions:
- Lower Tax Brackets
- Married Filing Jointly (related again to tax brackets)
- Low or No Income Tax State
- Few investments that are not tax-deferred
- Far from Retirement
- Planning on a traditional retirement age
- Anticipating Equal or Higher Taxable Income in Retirement
- You’re a natural born spender
If you’re not in your peak earning years, not in that 32% or higher federal income tax bracket, and don’t have much if any state income tax burden, Roth contributions may be just the thing for you.
If you don’t pay state income tax (or much of one), the tax deferral from traditional contributions won’t benefit you as much. This is especially true if you’re planning on retiring in a place with higher state and / or city income taxes.
There is some benefit in tax diversification among your investment accounts. If all you’ve got to date is tax-deferred dollars saved up for retirement, you have very little flexibility in how you access your money. You’re essentially at the mercy of your annual spending.
Having some Roth contributions will allow you to spend down your retirement assets in a more flexible and potentially tax-efficient manner.
If retirement is a long ways off, retirement is more like a box of chocolates; you never know what you’re going to get. It might be marginal tax rates exceeding 50%. It might not be, but the future is unknowable. You may be more comfortable paying taxes at today’s known rates than crossing your fingers in hopes of taxes not going up in the next twenty or thirty years.
Retiring at 65 or 67 doesn’t leave much time for Roth conversions before Required Minimum Distributions (RMDs) kick in on tax-deferred dollars. You may be better off putting money into Roth now.
While I don’t expect many of us wage earners to be in higher tax brackets in retirement, it is possible for the ultra-high net worth types and those who end up with 8-figure tax-deferred retirement accounts. If that’s you or is going to be you, consider making some Roth contributions now. You’re going to have more money than you need either way.
Last, but not least, if you’re a natural born spender, by all means lock that money up in Roth contributions. It’s a form of forced savings. You won’t have that extra $7,000 to $9,500 to blow on an 85-inch outdoor 4k television.
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Paying Tax Never
While it’s less likely that a high income professional will find themselves in this position, it’s worth mentioning that tax-deferred contributions can become tax-free on withdrawal with a low enough taxable income. Roth conversions can also be done in the tax-free zone.
The standard deduction is now $25,900 per couple in 2022. That means you can have $25,900 in taxable income without paying a penny in tax.
Let’s say you’re living on a modest budget of $50,000 a year as empty nesters with a paid-off home. $39,000 comes from a half-million dollar taxable account invested in growth funds and no-dividend stocks like Berkshire Hathaway. Selling the most recently purchased shares, you only take $8,000 in long-term capital gains and the $500,000 account spits off another $5,000 in dividends.
You’re now at $13,000 in “taxable income,” although dividends and capital gains are untaxed up to a taxable income of $83,350 in 2022. That gives you $12,900 to play with before any federal income tax would kick in. $11,800 could be withdrawn from an IRA to make up the rest of the annual budget.
If you’ve got children under 17 at home, you can take a much larger withdrawal (or make Roth conversions) without owing tax since you now get a $3,000 tax credit per child.
Far-fetched? Maybe. But certainly not unheard of. See The Taxman Leaveth for details on six-figure spending budgets with no federal income tax.
The Likelihood of Lower Taxes in Retirement
While few of us will find ourselves in the situation described, there is lots of room in the lower tax brackets to withdraw tax-deferred money, offering an opportunity to later take advantage of the tax arbitrage offered by deferring $18,500 a year at your current marginal tax bracket.
Some people balk at the idea of being in a lower tax bracket in retirement, as it suggests to them a lower standard of living. For the high-income professional, this is utter nonsense.
Let’s say you’re like Dr. C. Raising a family, paying the mortgage, and living well, you’re spending $160,000 in your working years. You earn $300,000 as a household and after taxes, you’re setting aside about $80,000 per year for retirement.
Once you’re retired, the mortgage is paid off, and you’ve put the kids through college, you’re able to live the same lifestyle on $120,000 a year. Let’s say $10,000 comes from qualified dividends in a taxable account, $50,000 comes from selling shares from that taxable account, generating $25,000 in long-term capital gains, and $60,000 comes from a traditional 401(k) (or traditional IRA, etc…).
Your taxable income is the $10,000 in dividends, the $25,000 in capital gains, and $60,000 from the tax-deferred account for a total of $95,000. You’re still married after all these years and take the $25,900 standard deduction, reducing your taxable income to $69,100.
That puts you in the 0% bracket for the dividends and capital gains, so you only owe tax on the $60,000 you withdrew from the 401(k) or IRA. You’re in the 12% marginal tax bracket and owe about $4,000 in federal income tax on a $120,000 annual budget.
What I Did With My 401(k) Contributions.
As you might have guessed, I take advantage of every penny of tax deferral I’m allowed. That means traditional, tax deferred contributions to my 401(k) and 457(b), and HSA (which is the only option here).
Why?
When working, I checked nearly all the boxes in the list of factors that make tax deferral a better choice.
I had a high income. We were living in Minnesota. We have a progressive state income tax with a top bracket (which we were in) of 9.85%.
More than half of our assets are currently in taxable investments. That includes our Vanguard brokerage account, passive real estate investments, our second home, and additional lakefront property.
We already have more Roth money than tax-deferred money. I made a “mega Roth conversion” of over $300,000 from a SEP IRA in 2010 and we make annual backdoor Roth contributions.
I may be close to retirement. I retired from medicine next year at age 43, but, as stated in my coming clean post, that wasn’t the end of earned income.
I will almost certainly be in a lower income tax bracket when I stop earning an income. Tax-deferred investments account for 17% of our retirement assets. It would not be at all difficult to have many zero-federal-income-tax years if I were to retire completely today.
Last, but not least, I’m a natural born saver. Money has burned no holes in my pockets.
What has been your approach to retirement contributions? Do you make mostly traditional or Roth contributions? Will that change for you in the future? Please let me know below!
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73 thoughts on “Should You Invest in a Roth or Traditional 401(k)?”
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Physician couple with combined salary in higher tax bracket living in a state with no income tax. Maximizing 401K and back door Roth IRA. I have traditional 401K and spouse has option of Roth 401K. No 401K match. Retirement is 20 years away. Should spouse contribute to Roth 401 K?
It’s your call and there’s no right or wrong answer. We’ll only know which was mathematically better in hindsight.
If you might move to a state with an income tax after retiring, that’s a checkmark in favor of Roth. If you will likely stay put and possibly retire sooner than 20 years from now, that would push me toward recommending tax-deferred.
But I can’t tell you which is best. She may have the option of doing some of both, too.
Cheers!
-PoF
Hi!
Thank you for article.
May I ask a question?
I don’t have 401k from work and my spouse have one. Our modified adjusted gross income (mine + my spouse) is $150k.
It looks like I can deduct trad IRA contribution because our MAGI is less that $196,000. But my spouse cannot deduct trad IRA contribution because our income more that $124,000. Is it correct?
Thank you,
Alex
Great article, thank you. One question though in the section Paying Tax Never. I always thought that the sequencing rules for taxable income were:
1) ordinary income
2) deductions
3) capital gains
If you had no other income, wouldn’t you be able to do a Roth conversion of the full standard deduction ($24,800), which would be offset by that deduction, and still take long-term capital gains and dividends up to $80,000 and pay $0 in taxes?
Thanks!
Yes, you can.
I like to run scenarios through TaxCaster when looking at such scenarios.
Cheers!
-PoF
If I’m going for PSLF, should I contribute to a Roth or traditional IRA??
Does this matter if I live in a state with no-income tax?
Assuming you’re on an income-driven repayment plan like PAYE or REPAYE, you want your Adjusted Gross Income (AGI) to be as low as possible. Therefore, traditional contributions, which lower your AGI, would be a good option.
Best,
-PoF
Hi there, how does the traditional IRA benefit high earners? My understanding is that it’s not done through payroll deductions. You would use money from your bank account to fund the IRA. Then your contributions would be deducted from your income when calculating your AGI and tax liability…but there’s an income limit to whether or not you can get the deduction. Our combined income is 400k so we wouldn’t qualify for the deductions. Would appreciate any clarification, thanks.
High income earners cannot make traditional IRA contributions. The only sensible option for an IRA is the backdoor Roth at your income.
However, many of us will have the option of making Roth or traditional 401(k), 403(b), and/or 457(b) contributions. That’s the subject of this post.
Cheers!
-PoF
Current wages (before itemizing) is ~210k. Employer offers both 401k and Roth 401k and will match 5% across your total contribution. Is it a reasonable play to max out 401k first, then get to my 19k max for the Roth 401k as well. Plan is to retire at age 45 (13 yrs from now) so my thought is that at that point I could convert all of the Roth 401k funds over to Roth IRA and have tax free access to my total contribution amount at that time. Is this a worthwhile plan or am I missing something? Employer does not allow after tax 401k contributions so the mega backdoor is not an option.
19k is max combined Roth vs traditional 401k, can’t do 19k in both
I converted more of our 401k to Roth in response to the tax law changes this year. The qbi 20 percent made it a stronger positive for us.
Way to take advantage, FTF. Strike while the iron is hot!
-PoF
One thing discussed in pretax saving is “low tax bracket at retirement”. Lets say you and your wife max out 401K and IRA savings starting at age 30 and work till age 50. That 48K per year compounds to 1.9M in 20 years (age 50) Lest’s say you’ve figured out a side gig/income stream to carry you to RMD. That 1.9M at age 70 will now be 6M.
Even if you take out 100K per year starting at 60 you will have 4.7M at 70 when RMD kicks in. RMD on 6M the first year is 219,000 rising to 378,000 by age 80. On a paltry 4.7M its 171,000 at 70 and 297,000 at 80. So much for the “low tax bracket” argument. By the end of 10 years the 6M portfolio will pay 359K in taxes for single in the first 5 years and 251K in taxes the first 5 years if married (age 75), and 735,000 in taxes single and 528,000 in taxes total, ten years into RMD (age 80)
The above portfolio is entirely possible and the tax burden is calculated using the schwab RMD calculator and taxplancalculator. If you aggressively Roth convert, your tax bill will be dramatically reduced. Spender, saver, butcher, baker, Indian chief the government is coming for you. You best understand exactly what is coming.
Great article
The numbers you present are perfectly realistic for a high-earning, high-saving doc. As I’ve mentioned in comments above, I think the 24% bracket up to $315,000 is a great place in which to do some large Roth conversions.
If you’re currently in a high-tax state, you could cover your rent or mortgage in a tax-free state with the tax savings you’ll have by moving to sunny Florida or another of the other half-dozen states that don’t tax income.
Cheers!
-PoF
I too think 24% is the ideal conversion. Choice #3 is 22% Choice #2 is somewhere between 22% and 24%.
Even a $1.5M IRA RMD will soon run you out of the 12% bracket once mixed with SS.
Great post, we always maxed out the 401k at work and Roth’s also except as my career progressed I earned too much to do Roth’s, then we started doing after tax conventional IRA’s. We never did any back door Roth conversions but now my side gigs allow me to continue to do Roth’s for me and my wife even though we are mostly retired. Now I have about equal amounts of tax free and tax deferred investments so when and if I ever withdraw any of it I’ll have a lot of flexibility. I also have some inherited IRA’s and Roth’s. The fact that my hobby side gigs bring in six figures limits my ability to be creative on capital gains and health insurance hacks. But I guess I can’t really complain about that because the gigs are only for fun and they keep my withdrawal rate at zero.
I think that’s where I’ll be if and when I give up my primary gig as a physician — making too much from the fun hobby gig to avoid income taxes altogether like I once dreamed of. It’s a “problem” I can live with.
Cheers!
-PoF
Great perspective, it doesn’t bother me at all that too much income spoils some life hacks. Income solves most money problems! Firey Doc you rock!
I didn’t have the choice for most of my career. So all my money is in traditional. I’ve realized it really doesn’t matter much which one you choose. If you max out your savings, you will have plenty of money either way. If you are a saver it won’t matter if you end up with $3M or $4M taxable or not taxable. It will be enough and you will likely have the account keep growing during your retirement. (The saver in you will be afraid of spending all the money) The biggest difference is how much will be left over to pass onto your heirs. And again, either way it will be a lot and they will be thankful.
Keep saving with either method and you will retire well. They are both good choices.
Dr. Cory S. Fawcett
Prescription for Financial Success
Good thoughts Cory.
Having retired (or repurposed) early, you’ve got a good 15 years until RMDs kick in. So there’s time to do some Roth conversions if you do find yourself in a lower tax bracket.
Given the success of your books and the efforts you’re putting in with video and other media, you may not have that opportunity. And yes, your kids will thank you.
Cheers!
-PoF
You are right about that PoF. I made a mistake last year, my first year without medical income, by not realizing I could make Roth conversions for 0% tax. I didn’t know until April that my tax bill would be zero. I needed to make the Roth conversions before December 31st. I wrote about that in a recent blog.
( https://drcorysfawcett.com/tax-surprises-my-retirement-year/ )
It would have been nice to do that with no taxes. Now that my new gig is picking up steam, I may not have that opportunity again. Oh well, live and learn. I’m still going to be fine even though I missed a really sweet deal. Another first world problem.
Dr. Cory S. Fawcett
Prescription for Financial Success
Great post PoF,
“Should you invest in Roth or Traditional 401(k)?” seems to be one of those questions that has no right answer that applies to everyone. Similar to the “Should I pay down my debt or save and invest?” the correct course will vary from person to person depending on your individual situation. Having all the pros and cons laid out neatly like you have in this post should be helpful to anyone trying to decide which vehicle best fits his or her given situation.
On the other hand, its probably not worth losing a lot of sleep over. If you’r maxing out your tax advantaged accounts and saving aggressively in a taxable account, you will likely be just fine even if you don’t get the exact ratio of Roth to non-Roth savings just right.
– Ray
It is a lot like the pay off debt vs. invest debate. Either way, you’re building net worth. The mistake would be to do neither, and we’ll only know the best answer years from now with the benefit of hindsight.
Cheers!
-PoF
I’m all for diversity. I put $18,500 in Roth 401k contributions, $5,500 in back door Roth contributions, and $36,500 in Keogh Tax savings retirement account. We also fully fund my wife’s back door Roth IRA ($5,500), governmental 457 ($18,500) and 401k ($18,500). That’s $103,000 of tax advantaged money right there!
And we save about $50,000 to $100,000 in a taxable account a year (depending on various expenses). Both my wife and I have employer pensions that are considered safe.
Trying our best to diversify!
Impressive! I enjoy the tax (and many other) benefits of having a non-working spouse due to the better income tax brackets, but a spouse earning enough to max out retirement accounts under his or her name gives you a leg up, too.
Cheers to a solid marriage!
-PoF
My wife and I have put every dollar we can into post-tax accounts because we expect higher earnings (and taxes) in the future. Basically everything except my 401(k) match which has to be pre-tax. So we don’t know what the future will be, but we’ve got a Roth to Traditional ratio of something like 20:1.
Lately I’ve been thinking that it might be sensible to get this closer to 1:1; it gives us more options in the future, and if we’re wrong about the theory that tax rates will be higher when we retire it won’t sting so much. If you’re on the fence about Roth vs Traditional based on the factors PoF described above, I think it makes sense to diversify and get a little balance between the two.
I would still use the guidelines I outlined — if you’re checking more boxes in the list of factors that favor Roth, keep doing what you’re doing.
If your combined federal, state, and local marginal tax bracket is under 30%, I would not hesitate to go all in with Roth.
Cheers!
-PoF
I agree with nearly all commenters that this is a very good analysis. And the future is certainly unknown. Tax rates and methods can change in a heartbeat with the political winds. Traditional approach could be stymied by higher tax rates, Roth approach by implementation of other forms of tax such as VAT, and both methods by nationalization (confiscation) of retirement type accounts in exchange for government determined retirement payments (or universal income payments – or no payments). The latter hopefully unlikely but possible.
Personally, I look for somewhat higher tax rates in the future. As an above-average? income self employed professional (low six figures) and not-so-early soon to be retiree, my approach has been traditional 401k contributions. I’ve contributed for many years but only maxed out the last 4-5 years. This year I’ve reduced my hours to half time. The plan is to withdraw from my IRA while just staying in the 12% bracket (factoring in SE tax deduction, 20% business income deduction, and max HSA deduction) and to either convert to Roth or just move it into taxable investment account. I’ll scale back to full retirement in a couple years while continuing to withdraw and convert at reasonable tax hit.
I had originally expected rather meager income in retirement, but now that I am close and look at our expectations (for me and non-working wife), I am pleasantly surprised that between social security here, my wife’s foreign social security, a small pension from a former employer, a little rent, and a 3.5 to 4% withdrawal rate from retirement and investment accounts, it looks like six figure income is entirely feasible and we may struggle to stay in the 12% tax bracket (though converting traditional to Roth over the next 6 years should help). Of course, there could still be risks but as always we will just have to adapt and deal with them. Again thanks for the article and for letting me give my views.
Thank you for sharing your thoughts, Jeff. You’ve set yourself up quite nicely for a comfortable, low-tax retirement. Multiple income streams can merge to form a pretty strong current if you plan well, as it appears you have.
Cheers!
-PoF
I hadn’t considered the natural spender vs saver part of the equation, but that makes a lot of sense. We’ve mostly gone the traditional IRA route, but that money is just a small chunk of our overall investments, so either way would probably be fine for us.
Yes, some people like the Roth because it’s “forced savings.”
But there are lots of ways to automate savings and if you’re afraid to make traditional contributions because you’re afraid you’ll spend the tax refund, you need to change your spending behavior, not your investment type.
Cheers!
-PoF
Another consideration to consider Roth contributions. I am one of those rare folks these days who will receive a pension, somewhere between 90-120k depending on how long I continue working. This seems to favor Roth contributions now, especially after 70 if social security pays what they estimate now (which is unlikely without some fixes sooner than later).
I agree. The pension alone fills up the lower tax brackets in retirement.
Best,
-PoF
Maybe I missed it but you forgot one scenario. I get a pension (military retirement) and my income is past the limit to make the contribution deductible, so I get no tax benefit benefit from a traditional contribution. So I do a backdoor Roth contribution every year for myself and my wife. Not a lot of folks get pensions anymore but some folks do, which changes the equation (as I understand it).
Scott I think you may be talking about a Roth IRA, not Roth 401k.
Definitely the pension also takes away a lot of room on the conversion ladder. #firstworldproblems, right?! ?
Thanks – true, thanks for clarifying. I did mean backdoor Roth IRA, but I think the point is still valid.
Also, thanks for making think we do have our own 401K (the TSP) which follows the 401k rules, so that is another point. Those of us over the deduction limit should contribute to Roth TSP (rather than traditional TSP).
I welcome thoughts on where I have it wrong.
Correct: IRA – make Backdoor Roth
TSP – if still higher income now despite future pension, consider traditional TSP. If pension plus other income likely to keep you in the same bracket, weigh pros/cons of Roth TSP
Thanks – I forgot I do get the income reduction using traditional TSP. It takes a village!
Thanks PoF – great article!
We can all agree the Roth space is extremely valuable (no future taxes, no RMD, better for heirs) – the questions are surrounding timing and how much in taxes to pay in order to access this space.
As an aspiring early retiree who is currently in the 37% tax bracket (plus 5% state and local), we are using our regular 401k, and plan to serial Roth convert once retired.
In full disclosure, I already have a fair amount of diversification secondary to a large Roth conversion from a 401k in 2010.
We’re rowing the same boat, GXA.
If you retire before the current tax brackets expire, you’ll have lots of room to convert in the 24% bracket, which I think is attractive.
Cheers!
-PoF
POF, knowing that your future tax rates will very likely be (much) lower than they were during your peak earning years, would you still have done a mega ROTH conversion in 2010? In hindsight seems quite sub optimal.
Wasatcher
I wrote a post about that, coming to a similar conclusion as you, but the commenters seemed to think I was being too hard on myself.
What I didn’t have at the time was the benefit of knowing what the future would hold. If I had, I would not have made that conversion, but it made sense to do so given the information I had at the time. For more info, see My Mega Roth Conversion: a $212,000 mistake?
Cheers!
-PoF
Another thing to think about is RMD optimization. At 70.5 when RMDs kick in you will be screwed unless you start thinking about this at least 10 years before it happens. In fact I wrote a post about it http://doctoroffinancemd.com/2018/03/15/rmd-rmd-why-do-i-care/ If you have a huge tax deferred account you better plan for this along the way. I am Roth converting. I am really proud of the $107000 in my Roth account. My income was too high to directly contribute and my large SEP/IRA prevented backdoor Roths so conversions for me.
My math tells me you’ve got about 10 years to make those conversions, but with a multimillion dollar retirement account, just converting the market returns in a good year will bump you into the upper tax brackets.
I don’t suspect I’ll have that problem, but if I were to choose a problem to have, that would be a nice one.
Cheers!
-PoF
I mitigated the tax hit last year by donating to a DAF the amount that I converted.
Do you participate in a 401(k) Plan at work? If so, does your 401(k) Plan accept rollovers? Assuming the plan accepts rollovers, have you considered rolling your SEP money into your 401(k) Plan so that you can make the backdoor Roth contributions going forward?
We did similar with my wife’s IRA into her Solo 401k. Easy way to empty out her IRA so that we could being backdoor Roth contributions.
This is an excellent post, POF. I’ve been aware of the trade offs, but you summarized the pros and cons of traditional vs Roth so elegantly!
I have a higher income and max out 401k, HSA, Roth IRA, and contribute to a taxable account. I do blend my 401k with a majority traditional (~$14k) and minority Roth (~$4k).
I would guess you’re in the 24% bracket (but a high state income tax, too) with a marginal tax rate over 30%. I think you’re wise to do mostly traditional, but some “tax diversification” via Roth contributions is reasonable at that tax rate.
Cheers!
-PoF
I was in the traditional bucket until a recent discussion with my business partner. I think future tax rates are not as predictable as some claim.
We are in a time period with lower taxes and no change in spending so we can expect higher tax rates in 8 years when TCJA expire.
To give an example … if you take $100k retirement income and back time it to 1975 you would have $22k. Any guess on the marginal tax rate for 22k? 50%.
You can’t predict the future and that’s why I’m a fan of diversifying into both buckets. Mrs. Linus does a Roth and I do Traditional.
Also I have a feeling that some of this money won’t be touched and end up being left for future generations and if that’s the case then Roth is the better vehicle.
The further you are from retirement, the more it’s a guessing game. Having one spouse go traditional and the other Roth is a good way to ensure you get a composite of the two potential outcomes.
Cheers!
-PoF
This is helpful! I am 32 and my wife is 31. I am a Medical Device Rep in the OR she works in finance. Together, we make about $200k per year. I am finding that I am spinning on which option is best for us. I started with 401k and then switched to Roth 401k, but am now doubting it again. It seems for people pursuing FIRE heavily, 401k makes most sense. For people retiring at a traditional age, it seems Roth makes more sense. I think we are somewhere in the middle, and will hedge our bets and put contributions into both.
Great analysis PoF. Like you, I always took the traditional 401(k) route for similar reasons. Here’s one more to consider: if you plan to be in a no-income-tax state by the time you start drawing down your traditional 401(k) balance (as I do), you can achieve a “no tax ever” result (for state income tax purposes) even if you weren’t able to convert to Roth in earlier years. Contributions to a Roth, on the other hand, lock in the state tax hit right now.
Very true, Joe.
State income tax can be a big consideration for some retirees. I look at people I know who have sold blogs for a 7-figure sum or entertained such offers. They could buy a cheap condo in Florida or Texas that could pay for itself in save state income tax if they established residency there before selling.
The same could be said for large, serial Roth conversions. The 24% bracket currently goes as high as $315,000 for a couple. You could convert a over million dollars in four years while staying in what I would consider a fairly low tax bracket.
Cheers!
-PoF
Previously we’ve split the difference. Currently we’re only doing traditional as a form of resistance. The US government is going to need our taxes to help fix the mess being made now.
I don’t want to ruin an upcoming post that I have on this exact topic, but I think a couple other reasons to favor Roth contributions are the following:
1) Stretch Roth IRA for your heirs. It’s the best way to leave money after you kick the bucket.
2) Your employer contributions are always pre-tax. So, if you have a good employer contribution/match, then Roth money will be diversifying your dollars.
I am a fan of having as much Roth money as I can, but am making pre-tax (standard) contributions for now so that I can pay down my student loans faster with the extra money I get each month.
Thanks for laying out all of the arguments either way!
TPP
Agreed, The company match provides a bit of tax diversification. I also like the idea of knowing the tax-free money is there. My 401(k) is getting jammed with the Roth contributions and my wife’s is traditional.
As a young(er) couple in this conversation, and seeing some of the movements in politics. I wouldn’t be surprised if 401(k)s get a cap or a penalty tax for being over a certain value. It has been floated a couple times already, and I sure hope that doesn’t happen. The Roth money would have been taxed already so **hopefully** it would be kept out of that calculation.
Good post.
Excellent points, TPP.
Note that if you plan to retire early, you should have plenty of time to convert what were once traditional contributions into Roth money to get that stretch IRA. Then you have the best of both worlds — tax arbitrage if converting in a lower tax bracket, and an RMD-free inheritance.
Cheers!
-PoF
The one thing that may work against me when I retire early and try to do the roth conversions at that point (even though I would have at least 20+ yrs to do it most likely) is that by building up a passive income stream as my primary goal currently, my likely income before conversion will not allow much if any conversion in the lower tax brackets (definitely a first world problem I know). But I figure there still will be some tax arbitrage to take advantage of regardless as I am currently in the top tax bracket). Before I knew what I was doing I thought it would be smart to do 1/2 traditional 401k and 1/2 roth 401k but only did that for 1 yr before came to my senses and now all traditional).
I do believe roth 401k are subject to RMD (not sure the rationale of why they did that) but that issue can be avoided by rolling over into a roth ira