New tax laws in 2018 have resulted in new tax brackets. As a result of these changes, you may be reconsidering how you are saving for retirement. Regardless of these changes, when it comes to choosing between a Roth 401(k) and a traditional 401(k), our planning recommendations have remained the same. A traditional 401(k) is a significantly better choice for most people and it could save you from running out of money during retirement.
An Example: Traditional Versus Roth for a Married Couple
In the following example, a traditional 401(k) is a better choice for a married couple (we'll call them Joe and Jane) that files jointly and makes $100,000 per year in taxable income because they will face this situation: every dollar that they make in 2018 above $77,400 is taxed at their marginal rate of 22% and their effective rate on their entire taxable income is 14%.
This difference in taxation (marginal or effective) is the key difference between a Roth 401(k) and a traditional 401(k), and is why the traditional 401(k) account is preferable. Although unlikely as a real-life scenario, this chart illustrates what would happen if you only spent one year saving for retirement, in 2018, and then took out the entire balance of your retirement account. (For related reading, see: A Closer Look at the Roth 401(k).)
This chart shows that both the traditional 401(k) and the Roth 401(k) start with the same amount, $10,000. The traditional 401(k) doesn’t pay any taxes right away while the Roth does, so the starting values are different. Each account doubles every 10 years for 40 years, at which point the entire balance is taken out. In the traditional 401(k), we take all $160,000 out and pay 17% in taxes, ($27,000, the effective rate). In the Roth, nothing is paid using the 2018 tax bracket at the date of retirement date. The result is $8,000 better for the traditional than the Roth.
Even if the taxes are higher than in the past 50 years, the lowest brackets (10% and now 12%) have never been higher than 15%. The chart below shows 10% and 15% for those and increases the 22% bracket to 30% which historically is above average.
This is an extremely unrealistic and worst case scenario for the traditional 401(k) but even so, the net result is the same. It's more likely that Joe and Jane will save each year for retirement, and once they retire, they will pull out only a portion of their retirement accounts annually. Using the 2018 rates for the entirety of Joe and Jane’s life, this is the actual scenario they would encounter:
The traditional 401(k) has an 8% advantage over the Roth. Assuming that taxes go up in the future, it’s highly unlikely that the Roth would ever be the better choice. There has only been one time in the past 40 years where Joe and Jane’s effective tax rate would have exceeded 22% and that was in 1981. Even if you only made one retirement contribution in 2018 and waited 40 years to start taking it out, the odds that the traditional 401(k) is better than the Roth are very high. (For related reading, see: How to Get the Most Out of a 401(k) Program.)
What Happens If Taxes Increase
What typically happens is that you save money each year for retirement which only increases the advantage of the traditional 401(k) over the Roth. This is because you will get increased pretax savings at your highest marginal tax rate each year when taxes go higher, while getting to withdrawal money in retirement at your effective tax rate, which will be lower. The example below shows what would happen if taxes increase.
The last example is the most realistic scenario that Joe and Jane would choose. They save $10,000 per year for 30 years, retire and then spend $40,000 per year in retirement until they die 30 years later. For simplicity, we will keep the 2018 tax rates for the entire duration of the example.
Choosing a traditional 401(k) over the Roth made a significant difference. The Roth almost leaves Joe and Jane penniless.
Example of a High-Net-Worth Couple
Below is the same scenario for a high-net-worth couple. This couple will save the maximum of $37,000 per year for 30 years, retire and then spend $100,000 per year in retirement until they die 30 years later. We will also use 2018 tax rates for the entire duration of this example.
Choosing between a traditional 401(k) or Roth 401(k) will make a significant difference in your future net worth. If you are single and have more than $40,000 of adjusted gross income (AGI) or if you are married and have more than $80,000 of AGI, choose the traditional 401(k). (For more from this author, see: Which Type of 401(k) Is the Best Option?)