I have done several articles in the past about the Roth vs Tax-deferred 401(k) contribution dilemma. If you haven't read any of them, you should start there before reading this article. When writing on this subject, I always mention that while the general rule of thumb is to make tax-deferred contributions during your peak earnings years, there are some exceptions to that rule, one of which is if you are a super-saver.

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In the past, I've just kind of left it there. One reason why is that it is such a first-world problem. For example, if you weren't a great saver for whatever reason, every little bit of extra money in retirement matters. But if you were a super saver, it just doesn't matter all that much. Sure, you have a little less money to leave to your heirs or your favorite charities because you paid a little too much in taxes, but there is no financial tragedy going on. You're not going to be eating Alpo.

In addition, most people, even doctors, aren't super savers. If you' re a doctor in your peak earnings years and haven't saved much at all, using a tax-deferred account might be the hugest no-brainer out there. However, the truth is those super-savers are highly concentrated on this website, so it is probably time I quit blowing them off and wrote a Roth vs Tax-deferred 401(k) post just for them.

Roth 401(k) Contributions and Roth Conversions Are Basically the Same

Before we get into this too much, the first thing worth pointing out is that if making Roth 401(k) contributions is the right thing for you to do, doing at least some Roth conversions of tax-deferred money you already have is almost surely also something you should be doing. Yes. Right now. In your peak earnings years. The equation is basically the same.  You're saying — I'm going to be taking out my money from my retirement accounts in retirement at a higher or similar tax rate than I am saving putting it in now. If that's the case, Roth conversions make just as much sense as Roth 401(k) contributions. So if you're making Roth 401(k) contributions, you should be asking yourself why you're not doing Roth conversions too.

Basic Housekeeping

There are three other concepts you should keep straight as we get into this.

The first is the Backdoor Roth IRA. This is a great way to get a little bit of money ($6K for you if < 50, $7K if $50+ and you can do the same for even a non-working spouse) into a tax-free (Roth) account every year. Since you have access to a retirement plan at work, you can't deduct traditional IRA contributions AND you make too much to directly contribute to a Roth IRA. You are much better off doing Backdoor Roth IRA contributions than investing in taxable.

The second is the Mega Backdoor Roth IRA. There are situations, and more now that the 199A deduction exists, where it can make sense to make non-deductible after-tax 401(k) contributions in addition to (if you are an employee whose plan allows it) or instead of (if self-employed) employer tax-deferred contributions.

The third is the idea that Roth contributions and conversions, at least when you have a taxable account, have the effect of having a larger percentage of your after-tax money in a tax and asset protected account. A Roth conversion essentially takes tax-deferred money and taxable money (to pay the taxes) and moves it all into a tax-free account. In essence, some of the money in that tax-free account would have been invested in a taxable account if not for the Roth conversion/contribution. This is the reason why if your marginal tax rate at contribution and withdrawal are exactly the same that you are probably better off in a tax-free account–more of your money is protected from creditors and from the tax drag inherent in a taxable account.

The Reasons Why Roth is Better for Super Savers

Housekeeping out of the way, let's go through the reasons why a tax-free account works out well for a super saver. The critical concept to understand when trying to decide between tax-deferred and tax-free 401(k) contributions (and conversions) is the concept of filling the brackets, illustrated for a typical doc below:

Tax-deferred vs Roth

So why is a super saver different? She is different because she has filled all the brackets with other income! In fact, it is entirely possible, although admittedly quite rare, to contribute to a tax-deferred account at 22% and then withdraw at 37%!

Now, it takes a heck of a lot of income to fill up all those brackets, but it can certainly be done. Maybe it's done because you're still working after 70 because you just like to work. Maybe you have a younger spouse who is still working. Maybe you and your spouse get a ton of Social Security. Maybe you have 200 doors worth of rental properties? Maybe you just have a massive tax-deferred account. Maybe you inherited a huge taxable account at some point and it is kicking off lots of ordinary income. It is different for every super saver.

Another reason why tax-free accounts are great for super savers is that super savers tend to spend less money. They get annoyed that the government makes them start taking Required Minimum Distributions (RMDs) at age 70 1/2. Unlike most people, who are spending the RMD (and more), they are just moving money from a tax-protected account into a taxable account.  Better to be in a Roth IRA (not a Roth 401K of course) where RMDs are not required.

Finally, as noted under the housekeeping section, tax-free accounts provide tax-protected growth and, in most states, additional asset protection to a larger percentage of your money.

So Are You A Super Saver?

So how do you know if you are a super saver? Well, first of all, you're probably a very high earner. That's not absolutely mandatory, but it's the most common scenario. If you're making $150K, you're probably not a super saver. Even the average physician making $275K is not going to be a super saver very often. This is usually someone with a household income over half a million, a million, or more.

The reason why is that it just takes a lot of income to be able to save enough money that you will have enough income to fill up all those brackets in retirement. These are people putting $100K+ into tax-deferred accounts every year and probably a few hundred thousand more into taxable accounts. They don't tend to have mortgages or debt of any kind and are only spending a tiny percentage of their income. They also tend to work for a long time — that allows for more savings, more time for their current savings to compound, and higher social security payments. They are also often fairly aggressive investors. High rates of return make those investment accounts worth even more, and thus they provide even more income in retirement.

Let's walk through a step-by-step process to help you determine if you are a super-saver.

Step # 1 Determine your current marginal tax rate

It is important to know your marginal tax rate now because that determines how many brackets you will need to fill up in retirement to make tax-free contributions (instead of tax-deferred contributions) now a better option. This is most accurately done with tax software by adding another $100 of unearned but ordinary income to your income and seeing how much your taxes go up. If they go up by 42% like me, you have a 42% marginal tax rate on unearned but ordinary income. (Don't use earned income because that will include payroll taxes and throw your answer slightly off.) If you don't want to go through that hassle, well, just look at these 2019 tax brackets.

Marginal Tax Rate

Remember this is based on taxable income, not gross income, so take your deductions including the standard deduction out first. And of course don't forget to also include your state marginal tax bracket.

My current marginal tax rate is 42%.

Step # 2 Make Any Adjustments Needed

Some people plan to move from one state to another in retirement. This is where you would make an adjustment for that fact. For example, if you're going from the 10.3% bracket in California during your working years to the 0% bracket in Nevada as a retiree, you will need to adjust for that by subtracting that amount from your future marginal tax rate.

Likewise, if you have a deep, burning fear/conviction that tax rates will go up significantly. Just add however much you think they will go up. No one would call you unreasonable to include an increase of 2-5%. If you're thinking of doubling the tax rates, well, just save yourself the time and do Roth contributions (and convert everything you have, quick!)

I'm not planning on moving and I would guess that long term tax rates are likely to be a couple of percentage points higher than they are now, so maybe I would add 2% in retirement.

Step # 3 Estimate Social Security

Now go to the Social Security Website and get your statement. It'll give you an idea of how much Social Security income you (and your partner) are likely to have in retirement. If you are pursuing an early retirement, or just want to be more accurate, consider using a tool like Mike Piper's Open Social Security. There are others out there as well. But you need to figure out how many brackets you're going to be filling just with Social Security, at least after age 70. By the way, if you can't delay Social Security to age 70, you're probably not a super saver.

The maximum Social Security Benefit in 2019, assuming 35 years of maximum contributions, is $3,770 per month, or about $45,000 per year. Your spouse will get a minimum of half of your benefit. So two earners could have a maximum of about $90,000 per year and a one-earner family could have a maximum of about $68,000 per year. My best guess for my family would be about $55,000 per year. Of course, only 85% of your Social Security benefit is currently taxable, so the real number for my family would be $55K*0.85= $46,750. Feel free to adjust that number if you think Social Security benefits will go down or if you think more of it will be taxed or whatever.

Step # 4 Estimate How Many Brackets Will be Filled by Your Current Tax-deferred Accounts

Now you can use whatever percentage you want, 4%, 5%, 6%, whatever you'll be pulling out of that account for the first decade or so of withdrawing. But I would not use anything less than the RMD at age 70, 3.6%. Now, what do you multiply the percentage by? Well, if you're going to start withdrawing this year, you can just use the current value of the accounts. But that isn't usually the case for someone struggling with the Roth vs Tax-deferred 401(k) decision. Withdrawals are usually at least a few years away and perhaps even a few decades away. So it stands to reason that you must adjust what you have in there now for compound interest between now and when withdrawals start. This is a pretty easy future value calculation, the only question is what rate of return you use in the equation, because garbage in, garbage out, especially over a long time period. Since the tax brackets rise each year with inflation, I would only use a “real” (after-inflation) rate. So adjust whatever number you think you will earn long-term after inflation. Lots of people also have a large percentage of their bond allocation inside their tax-deferred accounts, so be sure to adjust for that.

roth vs tax deferred

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So let's say your tax-deferred accounts are 50% bonds and 50% stocks. Let's say you assume you will get a 4% nominal return on bonds and 9% nominal return on stocks and that inflation will be 3%. So your expected real return is 3.5% per year.

9%*50% + 4%*50%-3% = 3.5%

Let's use my numbers to make this realistic. I am 44 years old and have about $1.6M in tax-deferred accounts. Given the size of my taxable account and my desire to work, I think there is a VERY good chance I won't be touching that money until I am 70. So that's 26 years to compound at 3.5%.

=FV(3.5%,26,0,-1600000) = $3.9 Million

Now, ask yourself if you are still contributing to the account. If so, you also have to adjust for that. Just to keep things simple here, I'll ignore that.

If I multiply $3.9M above by 3.6% (the RMD at age 70 1/2), I get $141K.

Step # 5 Estimate Other Ordinary Income

Here is where you include other income you might have in that first decade of retirement or so. Maybe some spousal income. Your rental property income (at least the amount not sheltered by depreciation). Other investments, etc. I would not include qualified dividend or long-term capital gain income, especially if you have lots of tax losses saved up. Don't include “income” that wouldn't be taxed like borrowing against your home or life insurance policy either.

This is VERY difficult for me to estimate 2 1/2 decades away, but a hundred thousand dollars in today's money seems entirely possible to me as I look over my taxable account and real estate holdings.

Step # 6 Put it All Together

Assuming we take the standard deduction in retirement, currently a little over $24,000 (which is actually likely to be a low estimate for us given our charitable giving habits and income/property taxes), our Social Security will fill up the 0%, 10%, and part of the 12% bracket. Our withdrawals from tax-deferred retirement accounts will fill up the 12% and part of the 22% bracket. The ordinary income from our taxable account will fill up the rest of the 22% bracket and a good chunk of the 24% bracket. Even if we had another $100K in ordinary income, we would still only be a little way into the 32% bracket. Now add 5% for our state taxes and 2% for an increase in taxes over time. That gets us to 39%.

Given that our current rate is 42%, we figure we're still better off FOR NOW doing tax-deferred contributions. As we continue to work, earn, make those tax-deferred contributions, and save in a taxable account, that will gradually change. We're getting very close to being enough of a super saver that we should be doing Roth 401(k) contributions and Roth conversions.

A couple of more years of saving like we are and we're likely past that point. Certainly, the advantage of tax-deferred contributions for us is much smaller now than it was when we started saving 15 years ago. It's probably a good thing we're now doing the Mega Backdoor Roth IRA with the WCI 401(k), although that change had more to do with the 199A deduction than us being super savers.

I suppose the key principle to remember here as your future income grows is to compare your marginal tax rate now to the marginal tax rate on the dollars you are now contributing when you withdraw them. If your past tax-deferred contributions (and other income) filled up all the brackets already, then you might as well start making tax-free contributions and conversions, even in the highest marginal tax bracket.

Two Other Factors to Consider

If, for some reason, you are able to earn VERY high returns on your investments (as some highly leveraged real estate investors claim) or you are likely (due to death or divorce) to spend a great deal of retirement single after spending your peak earnings years married, those should cause you to lean a little more toward Roth 401(k) contributions (and conversions).

What do you think? Are you enough of a super saver that you should be making Roth contributions and conversions in your peak earnings years? Do you anticipate getting there before you retire? Comment below!