Calculating the Tax Difference Between Traditional 401k and Roth 401k

by Kevin on July 19, 2009

Last week I shared some ideas of how to prepare your finances for higher taxes. I am of the mind that higher taxes are inevitable.

In that post I mentioned avoiding using tax-deductible retirement accounts like a Traditional 401k or IRA. My thought is if you take the known tax-break today, you pay an unknown tax-rate at retirement.

I’ll be the first to admit I am not a tax guru. Your situation will likely be different from mine. And I also understand there are strategies you can use to severely limit your taxes during retirement. I’m not well versed in those strategies, so I can’t comment on them.

That having been said I had a reader leave a comment that challenged my thinking.

CLB: “I struggle with the Roth IRA versus 401K question and would like your take on this thought process. I like that in the 401K the government’s money works for me until years later, when I give them a cut. More money early on has more time to compound so that even if I pay more taxes later (very likely!) I have a larger pool of money take from.

Putting in, say, $1,000/year pre-tax vs $750/yr post tax means a larger pot at retirement. Since I’ve no plans to withdraw it all at once, that larger pot continues to grow at a faster rate then the post tax dollar fund, making up for the larger withdrawals needed to pay my taxes.

I also hope that I don’t outlive the funds in my 401K, meaning when I die, there will still be funds that I haven’t withdrawn and paid taxes on.”

Today I’m going to run the math on the difference between the $1,000 pre-tax and $750 post-tax. This is assuming a 25% top tax bracket for the individual. In 2009 the 25% tax bracket kicks in for individuals with income from $33,950 to $82,250 ($67,900 to $137,050 for married filing jointly).

I’ll be using my Excel-based Roth IRA calculator to run the math on the investments. It isn’t 100% perfect, and it can be used for calculations other than for the Roth IRA. The calculator’s various fields can be changed so you can run your own calculations. I’ve thrown in an expense ratio of 0.21% — something you might find in a Vanguard Target Retirement fund like the one I am invested in. It also assumes a (hopefully) conservative growth rate of 7% per year.

Pre-Tax Investment

If you start contributing $1,000 per year at age 24, incur expenses of 0.21% per year, and earn a 7% return on average until age 65 you end up with $231,592.

I’m also going to assume you withdraw all the money in a lump sum because it makes the calculation easier.

  • Tax rate: 15%; After-Tax Amount: $196,853
  • Tax rate: 20%; After-Tax Amount: $185,273
  • Tax rate: 25%; After-Tax Amount: $173,694
  • Tax rate: 26%; After-Tax Amount: $171,378
  • Tax rate: 28%; After-Tax Amount: $166,746
  • Tax rate: 30%; After-Tax Amount: $162,114

Post-Tax Investment

Since we are assuming the individual is paying a maximum 25% tax bracket today, we’ll invest only $750 rather than $1,000. If you invest $750 per year with the same assumptions as above, you end up with $173,694.

Note that this amount is exactly the same as the pre-tax investment at a 25% bracket — and it should be.

The difference is when that 25% bracket suddenly becomes 26% or more. Then you are losing out.

When Traditional Retirement Options Pay Off

Of course there are instances when traditional investment methods (pre-tax 401k/IRA) pays off: when your retirement tax bracket is lower than your pre-retirement tax bracket. I absolutely agree with this, but it is hard to know where the tax brackets are going.

The kicker here is many people don’t have as much income in retirement than they did during their working years. If you’re earning $80,000 per year at your job, you may only have retirement “income” (from withdrawals) of $40,000. At today’s rates that is still in the 25% bracket, but not by much.

A better example is a married couple earning $100,000 today and withdrawing $60,000 in retirement. Their current tax rate is 25%, but the retirement tax rate (again, at today’s rates) would be 15%. They would save money by putting money into pre-tax retirement accounts.

Can I assure you that the tax brackets will change dramatically? Of course not. I do think it is inevitable that tax rates are going to go up. And I like the feeling that the amount sitting in my retirement account is the actual amount in my retirement account. No fancy tax planning needed.

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Stephanie PTY July 19, 2009 at 10:20 am

This is definitely a topic of interest to me right now! We just found out that my boyfriend’s new job is offering both Roth and Traditional 403(b)s. I explained the difference to him (although I still have a lot to look up before I’m sure I know all the implications of the Roth 403(b)), but I’m still wondering which is the better way to go.

On the one hand, I agree with you that tax rates are probably going to go up. Your ideas and conclusions about it match mine very closely! So that Roth sounds good from that perspective.

On the other hand, this is his first job out of school, and a Traditional 403(b) is going to put more money into his takehome pay, because of the tax break, than a Roth. I know he has some solid savings goals and that now is a time when he’ll need some start-up money to kickstart his life, and, well, to buy furniture and stuff for his apartment!

From the looks of it, it seems like he’s actually allowed to open both (assuming his total contribution for both is under the federal limit, of course), so my thinking at this point is that it would be better to start with a Traditional one, and maybe in a few years open up the Roth and switch contributions to that. (Maybe time it at the same time as a raise, so that he doesn’t notice a difference in takehome pay – it would be like investing the raise!)

So, no solid conclusions yet, but he has a few weeks before he starts work and it’s time to turn in the paperwork. I would love to hear other people’s thoughts on this!

Finance Nerd July 19, 2009 at 2:20 pm

NDP said “I absolutely agree with this, but it is hard to know where the tax brackets are going.

It’s not hard at all, they are clearly going up. Marginal rates are at historic lows, Obama has plans to raise rates in the future, and the bailout and stimulus money has to be paid back. There is only one direction for future tax rates, and that is up.

Roger July 19, 2009 at 5:14 pm

Interesting stuff. I actually ran some calculations of my own to determine whether taking out money on a yearly basis rather than all at once would make a difference in the conclusion. I tried withdrawing $20,000 a year from the Roth and a tax adjusted amount from the traditional account under the tax rates listed (and a few higher ones, to boot). Under both the Roth plan and the Traditional account at 25% marginal tax, the accounts for last for 12 years. With lower tax rates, the traditional accounts lasted longer; at higher rates, the traditional account did less well (even an increase to 26% caused the traditional account to last only 11 years).

If you withdraw a significantly large amount of money, you seem to get the same sort of results: Roth accounts and Traditional accounts come out about even, assuming constant tax rates; but Roth accounts come out ahead if tax rates rise. However, if you withdraw a small enough amount of money that your portfolio gains more than make up the difference (that is, if your account total increases each year, even including the withdraw amounts), then the traditional account ends up being more valuable when you finally kick the bucket.

Now of course, it’s far from conclusive, given the many other issues you have to juggle when comparing the types of accounts. For example, you have to consider marginal versus average tax rates, since your contributions to a traditional 401(k)/IRA will come from the last dollars of your income whereas your withdraws may make up a larger proportion of your income. Trying to figure out exactly how to minimize your taxes can be hard, even assuming tax rates stay the same.

Rich Smart July 19, 2009 at 7:30 pm

Two nice thing about the solo 401k plan that the people at the Solo-k Retirement Group brought to my attention are that if you are a W-2 employee for someone else and have your own side business:
1. The clock starts ticking on the Roth 5 year holding requirement with your first Roth contribution so if you make pretax deferrals because of the immediate tax benefits make at least one Roth contribution so the 5 year clock begins. Then stop the Roth and continue with the Pre tax deferrals. The Roth clock keeps on ticking.
2. The total contribution limit of Section 415 ($49,000) in 2009 is a plan limit not an individual limit like the $16,500. deferral . So if your employer gives you a profit sharing contribution of $25,000 , your side business can give you a profit sharing contribution of 20% of your net income up to $245,000. This is an additional $49,000.
So your total benefit would be $16,500 in deferrals, $25,000 in W-2 profit sharing and $49,000 in your side business profit sharing. for a total in excess of $90,000.
Then consider the tax savings on the reduced net income from your side business after reducing your income by the $49,000 profit sharing contribution you make to yourself
It was a no brainer for me

Lin Lo July 19, 2009 at 9:52 pm

Here is another consideration. In retirement, you will be drawing Social Security income also. The applicable tax bracket is determined by adding together all income sources…pension, SS, dividends, interest, capital gains, withdrawals from tax-deferred retirement accounts, etc. That total is used to determine how much of your SS is taxable…up to 85%, I think. However, withdrawals from a Roth are not included in that total, so would reduce or eliminate the taxes due on the SS portion of retirement income.

Also, consider what happens when a tax-deferred IRA is inherited by your kids. They will have to pay the taxes due at THEIR tax rate, not yours.

I vote for the ROTH.

CLB July 22, 2009 at 9:37 am

Thanks for the post on my question! It seems that there is a lot of unanswered questions about what retirement will look like. I like the idea of hedging my bets and am thinking to aim for 401K/Roth mix. Ideally, I’d throw as much in as allowed, but for now I’ll just toss in as much as I can to both.

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