By Dr. Jim Dahle, WCI FounderI 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.
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 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:
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.
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.
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.
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?
Would you please do a show on the impact that the passage of the SECURE ACT, and the elimination of the stretch IRA, is going to have in estate planning?
This is a big deal for supersavers and those who plan on building international wealth, as inherited IRAs are going to need to be fully depleted within 10 years of the person’s death and all taxes paid within that period (Roth tax free), but the tax acceleration will push the money (and the beneficiary) into higher (or the highest) tax bracket. At the end of the 10 years, all of the money left is now in taxable accounts and has lost the lawsuit protection that it had as a stretch IRA. .
Has anyone else heard about this recent change and what are your strategies to deal with it?
Yes, I heard the bill became law yesterday.
So now I don’t have to take RMDs until age 72. That’s a good thing for me to save taxes.
But now the heirs (other than spouses)of tax deferred accounts have to take all of the money out over a ten-year period, increasing their taxes. I didn’t review the law very carefully, but I believe this is true for all types of tax-deferred accounts.
Here’s a Forbes article about the new law.
https://www.google.com/amp/s/www.forbes.com/sites/leonlabrecque/2019/12/21/the-secure-act-and-your-401k–ira-5-things-you-need-to-know-right-now/amp/
I really don’t think it’s a big deal honestly, but when it becomes law I will do a blog post about it and probably mention it on the podcast. Don’t kid yourself, most recipients of an IRA are spending it in far less than 10 years. Like 1. I won’t be doing a thing differently, it’s just the stretch IRA became less valuable for the select few who would maximize its benefits, that’s all.
Thanks for your reply.
I believe it takes effect Jan 1.
For those supersavers with large 401ks and cash balance plans who planned to defer RMDs for both tax and estate planning reasons, it’s going to have a big impact. I think it has the potential to change the recommended sequence of assets that someone should draw down in retirement, further bolster the Benefit of doing Roth conversions, and will be used as an argument that insurance agents use to sell permanent life insurance products as being relatively more tax efficient now. The Act also emphasizes and expands the role of annuities in 401k’s now as well.
It it’s being called the “stealth death tax” and I think it will effect a lot of docs who follow the WCI.
Janes Lange, a CPA and attorney and podcaster of Retire Secure, has written about it and might be a good guest.
I look forward to hearing you cover the topic. And as other frequently tell you, thanks again for all that you do.
James Lange has been warning about this for most of a decade. I suppose it makes whole life slightly more attractive than it used to be when compared to a retirement account, but it still compares so poorly it shouldn’t really change anyone’s decision. Maybe it might make someone a little more likely to do more Roth contributions/conversions. Yes, many WCI readers will leave IRAs and Roth IRAs behind. But don’t kid yourself that most of their heirs would have stretched them beyond 10 years anyway. People are people.
The funny thing is that it goes both ways on this- the IRAs/RMDs will be larger because RMDs are delayed by two years but then they can’t be stretched as long.
Sandy,
I tend to agree with WCI on this, especially as it relates to the SuperSavers or high-income community. It’s not going to affect them at all. Maybe it affects their heirs “slightly” but let’s be realistic when thinking about this. Is it really necessary to distribute $10 million to your heirs? Maybe there is a better worthwhile use of the money by some needier recipients that wouldn’t cost you anything in taxes at all. It’s just a thought.
WCI,
I know I am only one vote but I vote NOT to have James Lange anywhere near this idea. IMHO no one has lost the greater public more millions in unnecessary taxes paid to do conversions than this one person. I have read his books and not only was his math flawed because he doesn’t follow the money from when it was earned to when it is spent, but his predictions on taxes have been absolutely wrong for over 10 years and they are STILL wrong.
What’s the math issue?
WCI,
Not sure how much page space you want to devote to this,, but I have spent hundreds of hours on this topic and written numerous professional articles around this topic. Don’t know if you can access all of Seeking Alpha, but I started getting serious with this article in Jan of 2018:
https://seekingalpha.com/article/4140837-risk-of-roth-ira-revolution
A few people who were obvious readers of some of the misinformation out there tried to sway me on some of my points, but in over 300 comments, the math is still intact. If you search on the word “James” in the above article and you will find one such paragraph in a comment reply:
“Also, much of his math is misguided at best, mainly because he does not follow the money from when you earn it to when you spend it and neglects essentially the taxes paid upfront on taxable accounts plus the added taxes as you own them over the years.”
He makes such mathematically incorrect statements such as:
“I rarely recommend converting unless you have money from outside the IRA to pay the tax.”
From reading most of your articles on this subject I am pretty sure you know how the math works and granted money in a taxable account is “tax-inefficient” at best so getting rid of it is probably a good thing. However, it is certainly no reason to build a taxable account just to convert an IRA, unless of course you want to do so before 59.5. Whether you pay the tax from the IRA or a taxable account has very little to do with the “math” on having more spendable income in retirement. Also the longer you hold a taxable account the worse off its tax drag becomes.
He also makes many statements that at least leads me to believe he thinks the TIME your money is in the Roth somehow cures the evils of making the wrong decision to begin with. This is sort of the same problem I have with people thinking their APPLE stock in their Roth and cash in the IRA, is going to be better than putting cash in the Roth and APPLE stock in the IRA. This only happens if you made the right choice to begin with on the Roth / tIRA decision. Otherwise, you are only magnifying your error. For most of the readers of this site there are plenty of other reasons to own some Roth and having less spendable income in retirement doesn’t hurt them one bit. Even having less for their heirs to spend will not be any big hardship over the security of knowing the taxes have already been paid. When I talk about the “math” of the Roth / tIRA decision that is what I am talking about, but you have to understand only half of the math is known until you spend the money later in retirement. If you run out of tIRA funds in retirement then that is where I see a serious loss in spendable income will occur because of our progressive tax brackets – in most cases and especially for the high spenders.
FinancialDave,
Thank you for your input.
I did notice when I read some of Lange’s stuff was that he didn’t provide enough detail with respect to taxes paid vs taxes avoided vs opportunity cost of predicted growth on post-tax money used to pay taxes on Roth conversions, as well as a full set of different assumptions for growth rates which, in a well diversified integrated portfolio, may differ between Roth IRA, taxable IRA and post-tax accounts which would significantly effect the math in each of these various calculations. Complicate this further by incorporating income tax rates at deferral, at conversion, at RMD, as well as long term capital gains rates and how they may be influenced by AGI. Tax brackets are not static and cannot be predicted with any certainty. I spent countless hours creating a comprehensive spreadsheet that I think incorporates many of these issues but I am not confident that I haven’t forgotten something important….and I certainly can’t predict the future. Perhaps the software that he uses to “run the numbers” is accurate.
With that said, I did find his strategy of incorporating permanent life insurance (which is not anything new of course) an interesting potential way of transferring wealth in a more tax efficient manner by minimizing the impact of accelerated taxes on IRAs in the SECURE Act and in avoiding inheritance taxes (which goes back to $5 mil in at the end of 2025).
Now without arguing the philosophy of leaving that much money to heirs vs. giving it to charity, one cannot fault someone for wanting to create generational wealth for their children and grandchildren. Perhaps there are children / grandchildren who are learning disabled or suffer mental illness or other conditions which limit their earning potential, create uncertainties regarding their health or financial independence but don’t qualify them to be considered legally disabled. Perhaps a child is in an insecure marriage or is a spendthrift. In such cases, people may have planned on utilizing trusts with the intention of stretching out the money and not having it consumed within 10 years. Now I understand that it is not “consumed” but rather taxed and converted to a taxable account, but the impact on long term growth is substantial.
There are plenty of docs who are great savers / high earners / entrepeneurs / successful equity and real estate investors and the possibility of facing the issues of significant estate tax liability and leaving behind large value IRAs subject to accelerated taxation is not such a rare occurrence…particularly when current estate tax rates sunset.
You seem to have spent a considerable amount of time contemplating this subject. I would welcome any other perspectives that you have regarding other strategies, including the use of permanent insurance in such scenarios.
WCI,
I don’t know if you remember, but I have been following you since before you published your first book and helped review it, along with others.
I did spend some time reading some of the actual text of the new extension to HR1865 as it relates to the SECURE ACT and I don’t think it is as bad as it seems. If I understand it correctly (and that is hard to do in only an hour or two) there are still exceptions that bypass the 10-year rule for special needs, such as the disabled, and even children until they reach what they call the “age of majority” (?) So if you were so lucky as to designate a 1 or 2-year old grandchild your IRA, they could literally convert a major portion of it in the 30 years or so they might have to do so. Split that up between two or three and what are they complaining about. Merely conjecture after maybe an hour spent on the bill – most of it to find the right section, which I think can be found by searching on “DIVISION O” in the most recent text of HR 1865. Also on the plus side for estate planning, where the old IRS rules made you liquidate a trust IRA designation in 5 years that has been extended to 10 years. So all in all not that bad. Certainly, from a retiree perspective, it gives them a couple more years before RMDs and really doesn’t change anything else for them, as far as retirement spending goes. My feeling is generally if the retiree does better while living the heirs will take care of themselves.
As far as permanent insurance goes I have a small policy myself that is totally funding my long-term care, which is mainly a function of when I bought it in my 20’s. I can see where it can have some value to park some tax-free wealth, but the returns on it are down the scale such that it could be one of those tools after all others had been exhausted or merely a diversification strategy for generational wealth. The fact that heirs receive it without it being in any kind of retirement plan leaves them to essentially “waste” it if they aren’t careful.
If you’re worried they’ll waste it, stick it in a trust. Really no different from an IRA or Roth IRA or taxable assets. The main problem is you’ll likely leave them less if you use WL as an investment due to the low returns.
As a general rule, a Roth conversion is dramatically better if you are not paying the taxes from the IRA because it has the effect of sheltering additional taxable money. So I probably agree with Lange there. And the longer it is in a Roth IRA instead of a taxable account, the more advantageous it is. You don’t need math to show you that, that’s just common sense.
It’s been a few years since I read Retire Secure, but I don’t recall disagreeing with much of it. If anything it should help motivate people to max out their retirement accounts. The most controversial thing I recall in it was his recommendation to spend all the taxable money before tapping into the IRAs.
WCI,
“You don’t need math to show you that, that’s just common sense.”
Boy, if there is one statement that gets me in trouble more than I would care to admit it is the above one.
Yes, you do need to do the math to understand the magnitude of the errors you are making, so that is why I do the math in as many ways as I can, but in the above case, its all about whether you are on the right side of the Roth / tIRA decision and NOT about the taxable account. A taxable account is already “almost” a Roth account to begin with and especially as it relates to a stepped-up basis at your death. If it is managed correctly it can actually be very close to the performance of a Roth. Here is a recent article on the subject:
https://seekingalpha.com/article/4265876-taxable-account-roth-substitute
In case you can’t get down to the conclusion here is what I said:
“Even though everyone’s tax situation is different, I would hope the takeaway from this article is something that is not often stressed by advisors, other authors, or those commenting on these articles. When deciding just how much tax diversity you should have or can afford, it is important to understand that the taxable and Roth accounts are very much in the same situation as they compare to the IRA. Both have their place but are generally inferior when you don’t have enough IRA funds to fill up the bottom couple of tax brackets. Finally, the taxable account is almost always inferior to the Roth account. The taxable account actually starts out equal to the Roth account on the day you put the money into the account, but once you start paying tax on additional dividends and capital gains, the taxable account is the clear loser.”
Note how I said the taxable account is “almost always” inferior to the Roth.
It is quite possible to actually make the taxable account quite like the Roth if you just keep any dividend and interest generating investments elsewhere and you don’t need to spend any of it.
You are certainly welcome to your opinion, but when I see people saying that Roth conversions are “dramatically better in any way it just seems like we have a difference of opinion on what the word “dramatically” means.
What does seem to make “common sense” to me is if you make the “wrong” tax assessment in the Roth / tIRA decision, then having “more” of it (the Roth) will just compound your mistake over time and not the other way around.
If your goal is to rid yourself of an ineffective taxable account, maybe a better solution is to fix that problem rather than compound a different one.
If you are convinced your assessment of how much Roth you need is that you need more, then by all means using the taxable account is one way to do that. It’s just not going to make that much difference and you certainly can go too far.
Doesn’t this change a bit if you’re investing in both tax-protected space and taxable since Roth would give you additional tax-protected space? For example, imagine I want to invest $100k in pre-tax dollars and my current marginal rate is 37% while having only $50k in tax-protected space. Let’s just take one year of investments invested over 20 years, assuming 6% real returns and 1% tax drag on taxable accounts.
Tax Deferred:
$50k in 401k for 20 years = $160,357 plus $83,579 in taxable ($31.5k for 20 years)
Roth:
$50k in Roth for 20 years = $160,357 plus $33,946 in taxable ($12.8k for 20 years)
To break even (ignoring LTCG), I’d need $160,357 + $33,946 – $83,579 = $110,724 from the 401k after taxes or a 31% total tax rate on the 401k distribution. If I do it over 30 years, it’s down to 27%. Are we assuming that the lower brackets filled by the 401k lowers our total retirement income tax rate to the point that any retirement marginal tax rate < our current marginal helps the math still work? Thanks!
Yes, if brackets at withdrawal are equal to brackets at contribution, Roth wins due to that effect. But that’s not the case for most docs.
Roth also wins if the withdrawal tax rate is “somewhat” lower than the contribution tax rate, provided a taxable account is needed alongside the traditional account for a fair comparison. The higher the tax drag on the taxable account, the larger “somewhat” becomes.
Agreed.
I hate to beat a dead horse on this issue, but when you combine apples and oranges all you get is mixed fruit.
All that is going on here is you are putting unequal earnings in one tax-advantaged account over the other. The whole question of whether doing tIRA or Roth is not being answered. When you put each Roth dollar into the Roth it is taxed at 37%. When you spend each pre-tax 401k dollar it is taxed at 37%. Neither account wins. Whatever you are doing with your money saved in a taxable account does not alter those inherent facts.
The only way to look at these three components – tIRA, Roth, and Taxable, is to understand how each of them works, then you will know what happens when you start putting them together, such as in this “mixed fruit” example above. Lower tax rates in retirement are going to favor the tIRA, higher tax rates in retirement are going to favor the Roth. Taxable can’t ever beat the Roth, but of course it could be favored over the tIRA, just as the Roth is for very high tax rates in retirement.
In the example given tax rates were 37% both pre and post-retirement, so your best bet for your spendable income is to spend down the less efficient Taxable account 100% of the time and let the other two grow. Realistically you will have spendable income in multiple tax brackets, which means you need to spend down from multiple tax brackets – tIRA in lower brackets and Taxable in higher tax brackets. Then hoping that you don’t run out of tIRA funds before you deplete both Taxable and Roth (in that order,) for reasons which I hope are obvious.
Fairest comparison is
– same gross income
– same pre-tax amount directed toward Roth vs. toward traditional plus taxable.
Using WCI’s 42% marginal rate and some round numbers in the ballpark of https://www.whitecoatinvestor.com/new-mega-backdoor-roth-ira/:
Gross Income = $850K
Pre-tax amount = $200K
Roth contribution would be $116K
A $116K traditional contribution leaves $84K pre-tax or $48,720 after-tax going into taxable.
Using either of the two spreadsheets mentioned in https://www.bogleheads.org/wiki/Traditional_versus_Roth#More_complicated_situations with the following inputs…
Return from dividends in taxable 2%
Return from growth in taxable 5%
Tax rate on dividends 28.8%
Tax rate on capital gains 23.8%
Number of years invested 26
Current marginal tax rate 42%
…gives a withdrawal breakeven rate of 31.08%.
In other words, if those inputs look reasonable and if WCI expects to pay a withdrawal marginal rate of 39%, switching to Roth now will be better for WCI because 39% > 31.08%.
Dave,
I agree it doesn’t matter UNTIL you’re saving more than can fit into a tax-deferred account. With equal tax rates at contribution and withdrawal, all Roth beats some tax-deferred plus some taxable. That’s all. Whether that’s “apples and oranges” or not, it’s true.
WCI,
I might be missing what you are saying when you say “all Roth, beats some traditional plus some taxable”, because that couldn’t be further from the truth. The higher your Roth taxes are the harder it is for 100% Roth to win. That is in the real world of the progressive tax system like we have. When you approach $4m in traditional that starts to change a bit, especially if it also turns out you are single in retirement. The answer is rarely 100% Roth.
Throwing “taxable” into the mix, just means you have a higher ratio of “expensive” after-tax (roth-like) funds in your account, which is NOT helped by putting all your money into a Roth.
Yea, you’re missing the few words right before your quote.
WITH EQUAL TAX RATES AT CONTRIBUTION AND WITHDRAWAL….all Roth, beats some traditional plus some taxable
Yea, but those words don’t help your statement and your statement suggests it has something to do with the Roth. In this case it doesn’t because 100% traditional will also not lose to Roth plus taxable.
Also, the words “All” and “beats” cannot be used in this “theoretical” case without the proper qualifiers on the taxable account. You do know that a lot of people do and can get negative returns out of their investing and that taxable returns can exist and be spent with ZERO tax drag?
Let’s try a better statement that I think will cover all these theoretical cases:
“With equal tax rates paid on contributions and withdrawals, and equal earnings saved in both portfolios (Roth vs Traditional), the portfolio with the larger pre-tax earnings base will not lose to the one with the smaller pre-tax base, when some taxable savings are involved, IF the taxable gains are positve. If the taxable gains are negative the opposite portfolio wins. If the taxable gains are ZERO, then neither side wins.”
Further qualifiers:
1. Doesn’t matter what the Roth & Traditional growth rates are as long as they are the same. They can be plus or minus, barring one account going to zero and all is well.
2. Taxable growth rates do matter, but only if taxable is taxed.
Regarding qualifier 2.
How much of an impact does it make if you taxable traditional IRA holds exclusively bonds and has more limited growth than the Roth held in equities (and taxable is a mix of equities and tax-free bonds)? I would assume that this is probably a more common scenario with super savers
Putting bonds in taxable and stocks in Roth just takes on more risk (with higher expected return) on an after-tax basis. It doesn’t change the question of whether you should contribute to Roth or not.
That’s a very precise statement. Now all you have to do is figure out how to get people to read it.
WCI,
Where you put your bonds doesn’t change your risk one bit on an after tax basis, if once again you compare equal earnings and tax rates. This is evidenced by the math which can prove that your after-tax spendable income will not change one bit if you put all your 3% bonds in your Roth and your 10% equities in your tIRA or you reverse the scenario and put your 3% bonds in the tIRA and 10% equities in the Roth.
As an example at a tax rate of 37%, you can take that $100k of earnings and put half of it in the Roth and half of it in the tIRA and let it grow for 20 years.
Investor1 puts bonds in the Roth growing at 3% and equities in the tIRA growing at 10%.
Investor 2 swaps the location of bonds and equities.
Both Investors have $268,809 at the end of 20 years, so I think their risk was the same. In other words whatever happens to one will happen to the other. If equities only do 5%, both their totals will be $140,471 after-tax.
The risk here is in the real world and not the theoretical. In the real world one person will have more spendable income than the other because their tax rates aren’t equal, I just can’t tell you who that will be.
However, if you think you will have to pay less marginal taxes on your retirement withdrawals then the proper place to put your bonds is in the Roth. In the 3% / 10% example, if you shave 2% off your retirement tax rate (to 35%) then you have roughly $5000 more dollars if you put the bonds in the Roth or 1.9%.
I agree it doesn’t matter where you put them if you look at all the money on an after-tax basis. But most people don’t, so to them it matters. Thus bonds in Roth is less risky with lower expected return than bonds in tax-deferred because the overall after-tax AA is riskier.
WCI,
You say; “I agree it doesn’t matter where you put them if you look at all the money on an after-tax basis.”
Then you say it does matter to people who essentially are not looking at it properly??
I don’t get that logic?
It sounds like you are saying they are going to compare $50k pre-tax in the IRA to $50k after-tax in the Roth, which just means they are looking at it wrong NOT that it is riskier one way over the other.
Maybe you can explain why if investor 1 puts half their earnings in a Roth with bonds and the other half in a Traditional IRA with equities and investor 2 does just the opposite and the result is they both will have exactly the same amount of spendable income why one should consider their portfolio riskier?
No they won’t, not unless they adjust contributions for taxes. You need me to run the numbers for you? I’ve done it before many times, but I would assume you’ve done this yourself at some point. Let’s see….I’m pretty sure I did it in this post:
https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
WCI,
If you want to make the point that the person who has $40k (after-tax) in equities in his portfolio has a riskier position than the one who has $25k (after-tax) in equities , then I will certainly agree with you. You don’t need to post the math.
Just like you didn’t need to post the math when the limits on the 401k let you put more after-tax money in the account. The BIGGER tax-advantaged account will always win on an equal tax basis. That however is not the point of this conversation.
Similarly, if you don’t put equal after-tax amounts of bonds in both accounts how can you say one strategy is riskier than the other. It is riskier, but it has nothing to do with which account has the bonds, because doing the math properly shows the risk is the same. It is only that one investor put MORE of his spendable income in bonds than the other person, so yes that person has a different split (stocks to bonds) on an after-tax basis.
IMHO, not knowing how to do the math on an earnings vs spendable income basis does NOT change the math. I just think it means the investor needs more education.
PEDSCCM,
This is the number one mistake Lange and others make and that is mixing up a taxable account in your decision making process. Sure, I get it that you have $100k of earnings and it needs to go somewhere but putting the taxable account in a decision where it doesn’t’ belong is what confuses people.
Your above example is the same as saying, which makes more sense putting $50k in my Roth or putting $31.5k in my Roth. I think the Roth with $50k is going to be worth more every time.
If your decision is purely “mathematical” as you are alluding to, the only question is what is my difference in “marginal” tax rates. You have to essentially make this decision each year to know which way to go. I spent many hours last year working with a “Boglehead” who has some fairly complex tools to try and do this, but in the end, it amounts to making the decision based on what is known and what you estimate as your spending in retirement.
In your case you say your retirement marginal tax rates are the same so the answer is simple – doesn’t matter where you put the funds. Now you say from the math above, surely it does make a difference to how much spendable income I have from this transaction. That is only because you didn’t make an equal comparison. The math has to “assume” you can put equal pre-tax earning in both places, without consideration to where you are going to put any other dollars.
Think about what happens if you use this logic to make your choice every year. What do you do? You do what all James Lange followers would do you would put all your money in your 401k Roth and taxable account maybe even a Mega Backdoor of anything you could. THEN in retirement what is your tax rate? If you did this your whole working career I can pretty much guess your tax-rate will be a big fat ZERO depending of course of what you had in your taxable account and how much of it you needed to spend. NOW, how far off was your original assumption on tax rates, remembering that how far you are off actually determines whether the mistake is adding to your wealth or detracting from it.
So given the facts of the math do you see where you might be going wrong?
Yes, you are exactly correct when you suggest you can’t spend ALL your money in the 37% bracket and that is the biggest factor to thinking they will have the same tax bracket in retirement. Some of those lower tax brackets are quite large usually in relation to how much money you really need to spend in retirement with no mortgage.
By the way, “marginal” tax rate does mean a combination of ALL tax rates that you are spending your retirement funds which does usually span more than one bracket. While working the contribution bracket width is much smaller.
I don’t recall Lange making an argument to always do Roth contributions.
I don’t recall saying he did! He is a CPA and I think he knows better than to say something like that.
What I did say (paraphrasing just a little) is that:
“James Lange followers would try to put ALL their money in a Roth” –following essentially his example, which he is proud to proclaim on many websites and in his books.
In fact, he did just that in 1998-2001 when he converted his total IRA to a Roth at the expense of 30% taxes, at a conservative estimate, from his quote of 27.3% (which has to be federal) + 3% for the state of PA. He freely says “the main advantage is possibly a century of tax-free growth.” That is a direct quote. If you know anything by now, it should be that TIME is not the determining factor. The main factor is rather your assessment of the tax differential for the person(s) spending the money is correct and whether it is lower or higher.
Don’t get me wrong, maybe he has enough taxable income in retirement to get him above $350k per year to make it into the 32% bracket, but do his kids have that much as well? Frankly, I am more worried about who I call his followers and I have seen them on my blog sites in the comment stream. They are the ones that are on a program to convert everything to Roth from their tax-deferred account and are happy to profess they will be in the zero percent tax bracket. Great for the IRS and our tax deficit, and maybe they will be perfectly fine doing that, but in my opinion the “math” does not support it, at least for them and their heirs, IMHO.
I will leave you with another direct quote from one of his books:
“Key Lesson from this chapter
Jim [Lange] practices what he preaches but you too can benefit from three-generations of tax-free growth”
To the above I ask you two questions:
1. Is tax-free growth really a benefit if it results in less spendable income.
2. What he says just above this is; “you too could be better off”. I just don’t know how he knows he and his family will be better off. If they only have Roth funds then the ship has sailed for them already and the only thing compounding are the tax funds that the IRS owns, which was 30% of their hard earned money, and there is no way to get any of it back so they could spend it in those lower tax brackets.
The lesson to come away with IMHO is that Roth funds do NOT compound in a tax-free mode any more than the after-tax portion of your IRA compounds in a tax-free mode and that is why if there is no tax difference there is no advantage. One way to easily look at this is to divide your IRA up into two portions – the part you own and the part the taxman owns. Given equal treatment of growth and taxes, the part YOU own in the IRA is EXACTLY the same as what you would have if the money was converted to a Roth and it will stay exactly the same for one day or a hundred years, given equal tax treatment.
To be fair, there are places in his material where he displays knowledge of how the math is “suppose” to work. The problem seems to be in knowing how to apply that knowledge or actually being able to conceptualize the math problem in the proper way.
If he said that, I certainly agree with your take more as discussed here:
https://www.whitecoatinvestor.com/is-a-zero-percent-tax-bracket-in-retirement-a-good-idea/
WCI,
I think our Pet Peeves are the same you just say it in a slightly different way:
“So when you put the asset with the higher-expected return asset class preferentially into the tax-free account without acknowledging that a significant chunk of the tax-deferred account doesn’t actually belong to you, you are really just changing your asset allocation to a riskier asset allocation. Yes, over the long run that is likely to give you a higher overall return, but only because you are taking on additional risk.”
What it boils down to is not that bonds make more sense in one place or the other, just that people don’t know how to calculate the effect on an after-tax basis. IF they did then they would get the calculation correct and the risk is the same in either case.
Agreed. But I’ve always thought we agreed anyway.
Wait, if someone is such a super saver that they should do Roth as to avoid paying the taxes in retirement, should they be doing any 401k at all? Aren’t they just deferring to end up paying a higher percentage later?
They can do Roth 401(k) and/or Roth conversions of tax-deferred 401(k) contributions.
Todd,
“…should they be doing any 401k at all? Aren’t they just deferring to end up paying a higher percentage later?”
To really answer that questions involves at lot of info not really presented.
1. How much Roth, tax deferred, and taxable do they have (or anticipate to have)?
The answer is different depending on your “split” or the tax “diversification” that you have. Also just being a SuperSaver says nothing to me about your spending in retirement which has everything to do with your retirement tax bracket. IMHO, running out of tax deferred savings in retirement means you really wasted a LOT on taxes that wasn’t necessary.
So doing NO traditional 401k at all doesn’t seem like a smart option to me.
2. Also, what type of funds you have saved has a lot to do with WHEN you plan to retire. If you plan to retire at 45 that is a lot different than retiring at 65, as far as where you can pull money from efficiently and whether you have things like Social Security or pensions affecting your decisions.
Todd, I might be missing something since I refrained from reading all of the explanations in the past two comments. Doing the 401K increases the amount that you can shelter in a retirement fund. Above and beyond the IRA separate from work. Then the question is what benefits do you get from a retirement fund. First off is that you won’t pay taxes on the earnings along the way (no tax drag). And never if it’s a Roth IRA. Second off, that money because it’s in a retirement fund may be protected in a lawsuit etc. This may vary state-by-state. There may be other benefits but I do not know them all- small things like bypassing probate if you have a designated beneficiary.
I understand your critical position of cryptocurrency. However, I’m bullish on Bitcoin and if the consistent cycles since inception keep repeating, following some of the models out there, $1 invested today can become $144,000 in 10-15 years.
That aside, my family’s household income is the typical physician salary you mentioned of $200k+ and we save aggressively. 95% of my retirement is in tax-deferred accounts, with most of the rest in tax-free accounts (negligible amounts in taxable accounts). Because I don’t have a salary of $500k-$1M, I don’t fall under the category of “supersaver” under your definition.
My question is how do I determine how to allocate between tax-deferred and tax-free accounts with my Bitcoin investment thesis? I ask because it is a significant position in my portfolio.
That’s a big “IF”.
Impossible to know the best place to put Bitcoin without knowing its future returns. If the returns are very high, you’ll be very glad to have it in a Roth account or at least a tax-deferred one (which is really just a combination of a Roth account and a government account). On the other hand, if it goes to zero, it would be nice to have it in a taxable account where you can use the loss against capital gains and $3,000 a year of ordinary income. Another factor pushing for the taxable account is that it is extremely tax-efficient since it pays no rents, interest, or dividends. All returns are capital gains, which you don’t pay taxes on until you sell. Cryptoassets also have a cool tax loss harvesting feature-no 30 day waiting period. You can sell Bitcoin at a loss and buy it right back 2 seconds later and still count the wash. You can’t do that with stocks/mutual funds. That means you probably can’t do it with a Bitcoin ETF either, but you could with “real Bitcoin” by buying it directly. I suspect that will rule will go away over time though because it doesn’t make any sense.
Good luck with your decision.
What are your thoughts on this article? It convinced me NOT to do Roth 401k contributions at *any* income level – because the last dollar saved is taxed at marginal rate, but the first dollar withdrawn is taxed at 0%. And the effective tax rate on withdrawals will be MUCH lower than the marginal rated saved when going in. Thoughts?
The Great Roth Controversy
https://www.gocurrycracker.com/roth-sucks/
For every dollar you convert or contribute, you are comparing your marginal rate for that dollar at contribution against that dollar at conversion or withdrawal. But you’re right, assuming that you have no other taxable income in retirement, the first dollar that comes out of a retirement account is taxed at 0%. In fact, you have to take A LOT of dollars out, filling up the brackets as you go, before you get anywhere near a typical physician working tax bracket. But if you’re really a super saver, some of those dollars could come out at 37%. Imagine someone that has saved so much in cash balance plans and 401(k)s over the years that they now have a $10 million IRA and $250,000 a year in other income besides the IRA. They are 80 and their spouse died last year. Your RMD is $495,000. So the last dollar (in facdt the last 140,000 dollars) you withdraw will be coming out at 37%. If you only had a marginal tax rate of 32% when you contributed that money, you’re not winning on this exchange. The last dollars contributed, accounting for growth, would have been better off being Roth if possible or converted at some point if not.
That article is simply wrong.
Everyone easily sees that you save your marginal tax rate on contributions. It is a little harder to see, but no less true, that you should compare that with the marginal tax rate you expect to pay on withdrawals.
It would be great if the IRS would allow us to treat every dollar we withdraw from a 401k/IRA/etc. as the first dollar, but it doesn’t work that way. If you already have a 401k/IRA/etc. balance from previous years’ contributions, you can make future withdrawals based on that balance and its growth, even if you have no other income at all and make no further contributions to those traditional accounts.
Withdrawals from any further contribution you do make will come on top of – in other words, at your marginal tax rate – the withdrawals you can make based on the existing balance.
Thinking that you get this sweet deal of saving a marginal rate but paying only an effective rate is a common misconception, unfortunately promoted by erroneous articles such as the one you mention. See also https://www.bogleheads.org/wiki/Traditional_versus_Roth#Common_misconceptions.
Hi Jim
Long time reader. I really appreciate all the hard work and time you put into WCI.
There is one part of your math calculation that I think needs to be addressed. Tax brackets may go up or down 2-5% but the marginal income WITHIN that bracket increases with inflation (not exactly but more or less). So using the 2025 brackets :
10% bucket is $0-11295
12% bucket is $11926-48475
22% bucket is $48476-103350
And so on
But let’s say you’re 45 and your “retirement age” is 65, 20 years away. Assuming the tax percentages don’t change (for simplicity’s sake)
The 10% bucket will likely be $0-$22k – ish
12% will be $22-96k ish
22% will be $96-206k ish
It took me a long time to realize how important of a factor this plays for tax arbitrage. Am I correct in this assessment or am I missing something in your original argument ?
Thanks so much
Working Towards Freedom
No, that’s correct. Not sure they’ll double in 20 years, but they should go up substantially over time.