Tax season is rough. For me, not only does it involve preparing tax returns for my clients, which I enjoy, but it also involves preparing my own tax return and trying to make sure all my investment clients have made their IRA/Roth IRA contributions for the prior year. This year, Christy and I have to write a rather large check to the IRS and a decent sized one to Colorado. Fortunately, we have planned for this, and so the money is available, and we did not owe a penalty because we fit in the safe harbor for not owing an estimated tax penalty (yay for being a planner!).
For 2016, however, we now need to plan on paying in more tax throughout the year to avoid a tax penalty, and, on top of that, I started to think about whether it would be better to contribute to a regular 401k or a Roth 401k for our retirement plans. The difference between a regular 401k and a Roth 401k is that with a regular 401k, you do not pay income taxes on the amount of your wages that you contribute, but you will eventually pay ordinary income taxes on that money and the growth of that money when you pull it out of the account. A Roth 401k does not reduce your taxable income when you make the contribution, but on the other hand, you pay no tax on the money when you pull it out. We have been contributing to a fairly even mix of the two, but if we move to all Roth, then our tax bill for 2016 will go up even more and we will need to pay more tax in throughout the year.
So how valuable is the Roth 401k compared to a regular 401k? Being a spreadsheet nerd, I decided to figure it out. I compared the end dollar amount after fifty years if someone maxed their regular 401k or Roth 401k for thirty years and then took $100,000 withdraws, before tax, each year for the next twenty years. In both cases I assumed a 7% rate of return each year and a $18,000 contribution per year. The only difference between the two numbers is that with the regular 401k, I added the tax saved back to the amount invested each year, as if it were put into an IRA, and then when I started making withdraws after 30 years, in the regular 401k I made an additional withdraw equal to the tax that would have to be paid in order to still have $100,000 to live off of each year.
At a 30% tax rate that does not change for the next 50 years, and applying the above parameters, a regular 401k would be about 7% greater than a Roth 401k. At a 35% tax rate, the difference goes down to 2% in favor of a regular 401k. Although most physicians are likely taxed somewhere in that range, or maybe a little lower, it is reasonable to expect that the tax rate on people making doctor-sized money will only go up in the future.
Of course, not only can the effective tax rate rise and fall based on politics, fiscal policy, etc., but in retirement, most folks go back to a lower bracket as they stop working and live off of retirement income. As a result, I ran two other tax scenarios. The first involved the applicable tax rate going up to 40% in 10 years and then to 50% after another 20 years, in which I believe is a not-unreasonable assumption. Such a gradual tax increase would result in the regular 401k having a balance that is about one-fourth the amount of the Roth 401k after 50 years. Even though tax rates are lower at lower income levels, it is possible that the taxable withdraws of $100,000, plus social security income, plus any other income could put this hypothetical retiree in a reasonably high tax bracket. The second scenario involved a gradual tax increase to 50%, but then assumed that the applicable tax rate in retirement would be back down to 35%. In that situation, the regular 401k outperformed the Roth 401k by about 20%, as this scenario played to the strengths of the regular 401k by saving taxes now at higher rates and then paying those taxes in the future at lower rates.
It is important to note that the above outcomes rely on some big assumptions. The first is that the tax saved on a regular 401k can be invested in a similar manner to a regular 401k, such as in an IRA. For some, this is realistic, but for others, they are already maxing their IRA or are ineligible to contribute, so this money would be subject to income tax on the interest, dividends and gains over the next 50 years, although the gains will largely be long-term capital gains at a lower tax rate. The second is that withdrawals become mandatory with a regular 401k but not with a Roth 401k, and there are more circumstances to get your money out of a Roth 401k early without a penalty when compared to a regular 401k.
So what is the breakeven point? That is a complicated answer because it can be calculated in so many different ways, but if the applicable tax rate in retirement increases at all from the current assumption of 35%, then a Roth 401k would likely be superior to a regular 401k. If tax rates go up now, but your tax rate in retirement stays the same or goes down, then a regular 401k would likely be superior to a Roth 401k. My take away is that a mix of regular 401k and Roth 401k is probably best to hedge against each a scenario, especially since I am looking out the next 50 years, although I would lean towards putting more in a Roth 401k than a regular 401k if you have a long time horizon. People nearing retirement or in retirement have a different analysis based on their own circumstances, and everyone’s analysis should be revisited periodically as tax rates and other circumstances change. So I will stick with my current 401k/Roth 401k split, and slowly step away from the spreadsheet.