Some people argue that there is a rule of thumb for which account is more attractive when saving for retirement (both early retirement and “normal” retirement). Jeremy over at Go Curry Cracker likes the 401(k) and is skeptical about Roth IRAs, while someone on Kiplinger recently recommended the Roth and trash-talked the regular 401(k) in light of higher projected future tax rates. Who is right? Nobody. There are likely no universally true answers to the following (and many other) questions:
- Taxable account vs. Roth IRA?
- Roth 401(k) vs. regular 401(k)?
- After-tax 401(k) contributions or a taxable account?
- Should I invest in a high-fee 401(k) at work or a low fee taxable account?
- What is the drag in after-tax returns from having to pay taxes on dividends throughout the accumulation phase?
- If you have a lot of money to invest and already max out the regular 401(k), should you shift more money into a Roth 401(k), to get more “bang for the buck?”
- Should I roll over an IRA to a Roth IRA?
- Should I use a deferred variable annuity to boost tax-deferrals?
- Pay down credit card debt first before saving for retirement?
It all depends on the individual situation, tax rates, expected return assumptions, account fees/expense ratios, etc. The only way to tell which account is more attractive is to get out the spreadsheet, punch in your particular parameters and compare. But how do you do that? Others did it before but sometimes we have the feeling they compare apples and oranges. A Roth 401(k) is best because you can withdraw tax-free? Not necessarily because you have to take into account the taxes you pay upfront when contributing to the Roth IRA.
We came up with an easy way to make sure you compare apples to apples to gauge the relative attractiveness of different accounts. For all accounts, we make sure that after-tax cash flows today and throughout the accumulation period are identical. Then we can compare the after-tax distribution in retirement for all accounts on a level playing field.
The different account types we consider:
- The 401(k) including the company match
- The 401(k) beyond the company match
- A Roth 401(k) including the company match
- A Roth 401(k) beyond the company match
- 401(k) contributions beyond the $18,000 annual maximum (made with after-tax money). This would also apply to a variable deferred annuity (after-tax contributions, taxes deferred until retirement, then the gains are taxed as ordinary income)
- Health Savings Account (HSA). Note that this is not a retirement account because you can withdraw funds tax/penalty-free only for health-related expenses. Use this only up to the amount that takes care of future health expenses. We predict that health expenditures will be large in retirement especially post age 65, so we max out our HSA.
- Roth IRA (direct or backdoor)
- Regular IRA (post-tax)
- Regular IRA (pre-tax)
- Taxable brokerage account.
- (NEW on 9/23/2020) An Employee Stock Purchase Plan. The option to purchase the company stock at a certain discount. The discount is taxed at your year 1 marginal ordinary income tax rate. So, the initial investment is normally a bit larger than $1,000 to account for the discount. After 2 years of enjoying the same returns as in the stock index, you liquidate the company stock and shift your investment into the index fund.
File location:
Google Sheet Link
Methodology
The spreadsheet we post on Google Sheets/Google Drive is pretty self-explanatory. You can’t edit it in the current location (we wouldn’t want dozens or hundreds of people editing this all at once) so in order to use it you’d have to download it to your own Google Sheets page or open the xlsx file in MS Excel.
You enter the parameter values at the top and read off the results below. We already include a few sample scenarios but please go ahead and play with your own numbers. Also please notify us if you see any errors in the sheet or want to propose improvements.
In order to make the different accounts comparable we make the following assumptions:
- Every dollar we invest in the various accounts is translated into after-tax dollars. Thus, for the before tax accounts, such as the regular 401(k), the financial commitment is only 1-TaxRate per dollar contributed.
- We assume this to be a one-time investment with no further cash-flows until withdrawal. This means that in the taxable account we reinvest only the dividends net of taxes and all capital gains are deferred until retirement. We also allow the marginal tax on dividends to change over time. For example, the dividend tax could be very low initially (a medical doctor in training) but very high later when reaching a higher tax bracket. Or it could be the other way around; we currently face a very high marginal rate on dividends but we will retire in 2 years and then let the taxable account sit for another few years and (hopefully) pay zero taxes on dividend income during that time.
- When calculating our own financial commitment we look only at our own marginal after-tax cash flow excluding any company matching. We call this number the After-Tax Equivalent of Own Savings (ATEOS). Of course, when calculating the final portfolio value we do factor in the company match.
- Upon retirement, we calculate the net of tax value of the accounts (including company match, if any). Since all the after-tax cash flows before retirement are identical we can rank their attractiveness by the final value after tax per $1,000 of ATEOS. This criterion correctly ranks the attractiveness of the various accounts on a level playing field. Also, since there are only two cash flows in each case, we can easily calculate the internal rate of return (IRR) of the different options.
- As an additional robustness check, we also include the rate of return and ranking of the accounts when jacking up the marginal tax rates (ordinary income and long-term capital gains) during retirement by 5 and 10 percentage points, while keeping the Roth tax free.
Here’s a sample parameterization, not too different from our personal situation:
- Moderate return assumption: 7% total equity return, 2% of which is dividends (needed for the taxable account).
- Company match in 401(k) is 50%.
- Account fees are low for the equity index funds (0.05% p.a.), a little bit higher in the 401(k) and still a bit higher in the HSA, 0.10%, and 0.20%, respectively.
- High marginal tax rates while working, from both federal and state taxes: 35% federal, 8% for state and 15%+3.8% federal tax on dividend income (income tax plus Obamacare) while working.
- 15% marginal taxes on ordinary income and zero taxes on capital gains in retirement and no more state marginal taxes after moving to a zero income tax state.
- The withdrawal is in 10 years but the marginal taxes on dividends in the taxable account go down already in year 3.
Baseline case results:
- The 401(k) with company match has by far the highest final payoff due to the company matching being rolled into the equation. The 15.86% IRR is astronomical (even higher when using shorter horizon) and may even be higher than some credit card rates. So for people who have credit card debt (we don’t), it may be worthwhile to start with 401(k) up to the company match before paying down debt.
- The HSA is the second best, due to the tax arbitrage: tax-exempt contribution and tax-free growth – the best of both worlds!
- The third most attractive option is the Traditional IRA (before-tax), though we’re not eligible for it. And neither should be anybody who is in the 35% federal bracket.
- Fourth is the 401(k) beyond the match up to the $18,000 annual contribution limit. The double-digit IRR (11.26%) is due to the tax arbitrage, i.e., avoid 42% tax today and pay 15% later.
- Fifth is the Roth IRA (through back door), with an annualized return of exactly 6.95% = 7% equity index return minus 0.05% expense ratio.
- Sixth is the taxable account. Despite the preferential tax situation (zero tax on capital gains), it comes in behind the Roth IRA due to taxes on dividends while working (even if it’s only two more years!). The drag is a pretty significant at 0.10% p.a. Also if marginal taxes during retirement were to increase by 5% or 10%, we’d lose another 0.19% and 0.39%, respectively. The peace of mind of the Roth IRA puts it solidly ahead of the taxable account.
- None of the other accounts are attractive to us. The Roth 401(k) is attractive, but not used due to the annual contribution cap. We found that even when maxing out our $18,000 annual contribution limit, shifting more into the Roth 401(k) is a bad idea. See further analysis below.
- The after-tax 401(k) contribution is the worst option and will never be used since the taxable account has no annual contribution limit. For the same reason, we will also stay away from the deferred variable annuity option. The after-tax IRA without a Roth rollover is also significantly dominated by the taxable account.
Overall we’re pretty close to the Go Curry Cracker ranking, with the exception of the Roth IRA ranking before the taxable.
A note on the Roth vs. Regular 401(k)/IRA discussion:
How about the “more bang for the buck” argument in favor of the Roth? Go Curry Cracker (and many others) allude to this and say that because you can contribute more in after-tax dollars (ATEOS), the Roth IRA and/or Roth 401(k) become attractive again. But that is highly dependent on the parameters and it turns out that in this baseline case the Roth 401(k) is not worth it because of the additional commitment of cash flow to pay the income taxes. Compare the following two options with an identical ATEOS of $1,000 today:
- Option 1: you save $1,000 in pre-tax money in a 401(k) and $430 in a taxable account. This yields $2,490.24 after tax in retirement
- Option 2: you save $1,000 in after-tax money in a Roth 401(k). This yields $1,948.84
Going with the Roth 401(k) you just threw away 21.7%! It’s not even close. Similar arithmetic applies to the Roth conversion. Lesson learned: always do your own math and don’t rely on a rule of thumb.
But for the record, we came across one case where the regular 401(k) was as attractive as the Roth 401(k) in a side-by-side comparison (see case 4 below) but once you max out the $18,000 contribution limit, you actually strictly prefer the Roth, for exactly the reason people pointed out: you get more bang for the buck. In this case, the initial and final marginal tax is 28%, time horizon 20 years. After-tax values of $1,000 invested in:
- 401k: $2,734.55 ($3,797.99 per $1,000 of ATEOS)
- Roth 401(k): $3,797.99
- Taxable account: $3,333.13
Even though you’d be indifferent between the Traditional and Roth IRA, you’re better off with the Roth once the $18,000 annual limit kicks in:
- Option 1: you save $1,000 in pre-tax money in a 401(k) and $280 in a taxable account. This yields $2,734.55+0.28*$3,333.13=$3,667.83 after tax in retirement
- Option 2: you save $1,000 in after-tax money in a Roth 401(k). This yields $3,797.99, which is 3.55% more than under the Traditional 401(k) scenario, see table below
Here are the rankings for other parameter values:
- Case 1: the baseline case described above
- Case 2: typical retirement scenario: long time horizon, moderate taxes while working slightly lower taxes when retired. You get the exact same ranking as in the baseline scenario.
- Case 3: same as case 2 but very high management fee at work 401(k): almost the same ranking, though the 401(k) contributions are pushed lower in the ranking. But you still prefer the 401(k) over the taxable account. And this assumes that you are stuck with this stingy employer for 40 years and you never roll your bad 401(k) into a low-fee IRA at Vanguard or Fidelity.
- Case 4: same marginal tax rates in retirement as current: Traditional IRA is out, and you move towards the Roth 401(k). Also, notice that this is the peculiar case where at the margin you’d start with the regular 401(k) with company match but replace that with the Roth 401(k) once you hit the annual contribution limit.
- Case 5: very low tax rates now but much higher rates later, e.g. a medical doctor in training: maximize the Roth 401(k) and IRA.
- Case 6: Constant low tax rates: Use 401(k) to the maximum match (but not beyond that!). After that HSA, Roth IRA and taxable. Because you pay zero taxes on capital gains and dividends throughout the taxable account dominates the 401(k) after the match!
A few (almost) universal results
- Depending on the parameter values the ranking is all over the map. But for people who are aggressive savers and who have the necessary savings budget to max out all the tax-advantaged plans, the rule of thumb is pretty clear: if taxes are lower in retirement than today, max out the regular 401(k), HSA and Roth IRA, then save the rest in a taxable account. If taxes in retirement are higher than or close to today’s rates, replace the 401(k) with the Roth 401(k).
- 401(k) contributions up to the employer match are likely the priority number one. They indeed give you the best bang for the buck, even with relatively high expense ratios
- The Health Savings Account (HSA) is very attractive, but only up to the amount you actually plan to spend on health expenses (e.g., copays during retirement, Cobra coverage during early retirement).
- Contributing to the 401(k) with after-tax money (beyond the $18,000 max) is probably not a good idea if you keep the money in that 401k until you retire (Option 5 – After-tax 401k Buy & Hold).
- But if you were to contribute to the 401k after-tax and then convert your after-tax contributions into a Roth IRA after only a few years, then let the Roth grow for a few more years (Option 6 – After-tax 401k + Roth Conversion) you’ll likely come out slightly ahead of the taxable account in some of the parameterizations!
- Unless fees in your work 401(k) are astronomically high (why would anybody want to work there?) you probably still would not want to forgo the 401(k) plan completely.
- Fill up the Roth IRA (either directly or back door) before the taxable account. This is true when you look purely at the numbers, without any regard for liquidity.
A few results that are dependent on your particular situation
- Roth 401(k) vs. regular 401(k): as a rule of thumb, the lower your current marginal tax relative to in retirement, the more attractive the Roth becomes.
- Roth IRA vs. Traditional IRA with pre-tax money and Roth conversions. Essentially the same calculation as with the Roth 401(k).
- If your employer offers a 401(k) plan but the fees are high, contributions beyond the company match may or may not be worthwhile, depending on your tax situation and the level of fees
- While the Roth IRA beats the taxable account (even if you believe your marginal tax on long-term capital gains will be zero in retirement) due to taxes on dividends during your high-earnings phase, the difference may not be that large. Depending on your liquidity preference and your projected tax arbitrage from tax loss harvesting you may still favor the taxable account over the Roth.
Caveats
- The calculations for the taxable account currently do not take into account the potential tax arbitrage in the form of tax loss harvesting (TLH).
- In the taxable account, one could use the Synthetic Roth IRA we proposed in a previous article to alleviate the drag from dividend taxes.
- The calculations for the Roth conversion currently do not take into account the optionality of the potential recharacterization back to the original IRA. We are working on that as well and write a separate post on this topic soon.
- The HSA is not a retirement account. If you use the money out of the HSA for anything else but health expenditures you face penalties and/or taxes. But for health expenses (Cobra coverage during early retirement, and out of pocket expenses both before and after Medicare kicks in) the HSA is awesome because you contribute pre-tax money into a tax-exempt account.
Interesting research! How do you deal with bond fund investments? Your spreadsheet seems to be set up for equities only.
Thanks for the question. In the tax-deferred/tax-exempt accounts all that matters is the total expected return (e.g. use the bond fund yield). One could set the dividend yield in the spreadsheet to the actual bond yield, and set the price return to zero. Also set the taxes on dividends in the spreadsheet to your ordinary income tax rates (=tax rate for bond interest).
You probably wouldn’t want to hold bonds in the taxable account.
Good luck!
We got access to our HSA account a couple years ago through Mrs PIE employer and boy it is a winner as you say.
Question – why fill the Roth IRA bucket before taxable? Thinking of an early retiree.
Aren’t there penalties for withdrawal of earnings on this account prior to age 59.5
Or are you assuming no withdrawal on this one until after that age.
Yup, that HSA is so good, we don’t even use it to pay for out-of-pocket expenditures now, but rather let it grow for as long as possible.
Great question about the Roth. You can always withdraw the principal penalty-free even before age 59.5. But there are still pros and cons. The Roth IRA has a slight advantage according to our calculations but tax loss harvesting in the taxable account could undo some of that or even reverse the advantage. Of course, a caveat is that in retirement, the marginal tax is (hopefully) only 15% for federal and hopefully 0% for the state, so TLH isn’t helping all that much any more. Ideally, we do both: Roth IRA and taxable contributions.
Yes, so far we do that also in the HSA. Double winner.
Thanks for the answer on the Roth vs taxable. Practical and pragmatic soution.
Great post. It’s clear you’ve put a lot of time and effort into this post and the GDocs. Thanks for doing this. I’ll try the docs and let you know how they perform. On a side note, great point about Roths vs IRAs. I’ve never considered opening an IRA, and investing the rest (The Roth Difference) in an after tax account. It’s an interesting idea.
Thanks for stopping by! Please let me know if you see any bugs or room for improvement! Cheers!
Wow, fantastic comparison work. Thanks!
Thanks for the compliment. And sorry for holding up your reply. It was held up in a spam folder and I only found it now.
Cheers!
Great spreadsheet! Thank you!
Took me a while to figure out not to change Equity Returns since it’s the sum of Price return and dividend return. In retrospect it should have been clear to me from color coding, but I added a little comment on that cell as a future reminder for myself.
I was looking for whether taxable account is better than a tax-deferred (“cash balance) one with 2% fees. Your spreadsheet was helpful to see that well… “it depends” :-)… With 43% current tax bracket, 25% future one, 25 year horizon and lower returns (5% price + 1% div), taxable account wins. With higher returns, expensive tax-deferred account wins. Length of time and final tax bracket affect things too.
Hi Justin! Thanks for stopping by and sharing your experience. Glad you could make use of the spreadsheet.
Yup that’s the curse, but also the beauty of personal finance. There is no single fixed answer for questions like that. It all depends and folks have to run through the numbers and make sure it makes sense for their personal parameters.
Cheers!
ERN
On the spreadsheet you list the taxes upon withdrawal at the marginal tax rate (15% looking at case 6). In reality, based on 2017 tax rules, the first $20,800 for a married couple will be taxed at 0% due to standard deduction and personal exemptions, then the next $18,650 will be taxed at 10% resulting in an effective tax rate of 4.73% for a retirement withdrawal of $39,450. With this in mind it makes more sense to contribute to a traditional 401K/ IRA and avoid the 15% tax on the front end (the tax savings could be invested in a taxable account). After retirement using a Roth rollover up to the $39,450 each year (funding the first five years with savings/taxable accounts due to the wait period on rollovers). Worst case scenario pulling from the traditional accounts early paying the 10% penalty + 4.73% = 14.73%, still slightly better than the 15% on the front end.
In that case, feel free to change the parameters to 0% or 10% for the post-retirement ordinary income. I already know that we will have rental income, some wage income and eventually Social Security income (85% of which will count). So for us, the 401(k) withdrawals will mostly be taxed at a 15% marginal rate.
Thanks for the reply! My comment above assumes tax rates stay the same in the future and that I do not receive any additional income in retirement, both are assumptions that may or may not be true. This makes choosing between Traditional/Roth/Taxable even more difficult.
I looked at the Math when the marginal rate in retirement is only 5% (or 0%) and it looks like the HSA also becomes a lot less attractive. Yes, this goes to show that there isn’t a one-size-fits-all solution. Investors have to do their own math!
What a great tool! Is it possible to get access so I can use for my accounts?
thank you,
Keith Smith
972-916-8739
You can access this yourself. All you need to do is to save your own copy as a Google Sheet or as an Excel sheet on your harddrive. I have to keep the master sheet protected so nobody messes with my formulas. 🙂
I’m a bit confused on your analysis of the after tax 401k contribution. Those contributions can be rolled into a Roth IRA which beat out the taxable account on your analysis.
You also don’t consider the tax ramifications of additional income when drawing social security now the effects on ACA subsidies.
Good point. The calculation here is for a buy and hold after-tax 401k contribution. It’s more efficient to roll over the cost basis of the after-tax contributions to a Roth. But you’d still owe ordinary taxes on the capital gains.
I might add a column taking into account the proper tax hacking. For a lot of people who stay within the 0% bracket for capital gains and dividends in retirement, I still believe the taxable account is better than the after-tax 401k, though.
If you have access to in service rollovers the returns on the after tax contribution are negligible. But even if you have several years before you roll it over you can use the Roth ladder to avoid those taxes as well. But the basis would then be tax free for 40+ years and withdraws would not Iinvoke the SS tax penalty.
If you already know you have “in service rollovers” then ignore the calculations for the after-tax 401k. This becomes an effective (backdoor) Roth. It will beat the taxable account, no doubt.
If you already know that you can do the Roth ladder (ostensibly because you have 0% marginal tax in retirement) then you should also have a 0% marginal tax on capital gains. In the Google sheet, set the marginal tax rate in retirement to 0 and you’ll see that the after-tax 401k is not that awful anymore.
Consider someone who saves nothing in taxable accounts but save the max in 401k and ira. In today’s dollars that is about 23k each in tax deferred assuming a typical company match and 35k each in tax exempt assuming they eventually roll over the after tax contributions.
After 10 years they would have a basis of 350k in the Roth and 230k in the tax deferred. Let’s assume they did well in the market and have a total of 1 mill assets at this point. If they did less well, they would have a larger basis so good returns is a ‘worst case’ for funding early retirement in this scenario.
At a 3.5 wr they could live for 10 years just on the Roth basis with all returns accruing. But an appropriately sized 72t or Roth ladder would enable them to extend that more than 2x.
For higher absolute withdraw levels you would either be saving longer, saving with a working spouse, or investing excess savings on a taxable account.
I don’t see how a taxable account preference can beat this scenario. It can do as well in the 0% cap gains bracket but I don’t think it can beat it. And for withdraw levels above the 0% cap gains rate bracket it should always win.
And again this ignores any ACA subsidies or taxation of SS benefits which further favors maximizing Roth over taxable.
Of course I did this in my head as I was typing so I may have made some errors but this largely aligns with my strategy.
I don’t disagree with that. Take the Google sheet and plug in the numbers for that scenario and look at the new option I created (just for you): After-tax 401k contribution with an eventual rollover of the cost basis into a Roth IRA and the rest into a taxable IRA. Yes, absolutely, in that situation, the 401k after tax may be more attractive than the taxable. Even before considering the ACA and SS benefits.
Re . HSA, It may be a much more powerful device for non-health spending than you give it credit for. Check out below link from MadFientist.com. Essentially, if health expenses are paid for in after-tax dollars, than, any # of years later, the HSA may be withdrawn, tax-free, for non-health purposes, so long as you can demonstrate that you are reimbursing yourself for prior, after-tax funded health expenses (regardless of the fact that these expenses might have occurred many years prior to the HSA withdrawal).
Thanks again for another of your insightful articles (and note, I have come to your blog only recently. I rue the day when I have caught-up to your inventory of articles and have to read you on a weekly basis, rather than “binging” as I am doing now!).
https://www.madfientist.com/ultimate-retirement-account/
That’s why the HSA gets very high marks in my calculations. Usually #2 ranked only after the 401k contributions with matching (can’t beat 100% instant return from matching). The triple tax-free treatment (tax deductible when contributing, tax-free growth, tax-free withdrawals) in the HSA is very powerful!!!
I loved the article. Thank you. Have not seen such a free comparison resource before! Well thought out, good on you to share it. I appreciate it!
To add to the HSA pitch, I did not notice you tout other positive features: the fact that no one is penalized at all after age 65 to use the HSA funds on anything you want beyond qualified medical; they’re taxable expenses but not penalized at that point.
Another fact to keep in mind for Californians (if not also a couple other U.S. states still), is we do not enjoy the HSA fully with triple tax-free treatment; taxes at the state level are still assessed on these accounts, going in, growing, and coming out, even when spent on qualified medical (legislation to get the tax treatment aligned to the feds never passes in CA). Some nickname this disparity “The Sick Tax.”
I still love my HSA nearly as much as my 401k, and anyone incentivized by an employer to move to an HSA should max it out and let it grow (pay for stuff on your mileage card, pay that off, then leave your HSA to grow and reimburse yourself in the future to take the money back tax free – something extra to enjoy (mileage) since the contributions aren’t matched). Further lower your taxable income by pairing your HSA with a LUFSA for the dental and vision expenses that don’t have to hit your HSA at all.
Another nice thing to mention is that the working parent carrying the health plan can have their health plan dependents (so basically your children up to age 26, and your spouse) max on the savings opportunities too. Your spouse can fund their own Catch-up amount toward the family max in your HSA, and your children, so long as they are dependents on your health plan and you don’t claim them as tax dependents on your tax return, can each max their own health savings account up to the family max separately. The family still shares one high deductible on the same health plan, but the parents can be funding their HSA and the children can be funding their own HSAs. This gets the whole family building money for one of the costliest expenses peeps will have in life. I discuss my love of HSAs here: https://www.themoneymattersclub.com/post/leverage-health-to-build-wealth-minutes-from-oct-17th-s-lunch-n-learn-club-session
Thanks again for the article.
Thanks for the great insight. I didn’t know about the multi-gen HSA option. That’s really great.
Obviously, some of the idiosyncratic issues with the HSA, like the CA State taxation must be implemented by hand. For example, you still pay the 1.45% for Medicare. Since CA also taxes your HSA contributions you must add the CA marginal tax to that. See the field in the parameter section: “HSA only: FICA marginal and State (if applicable)”
Does anyone know why he used the marginal tax rate instead of the effective tax rate on the 401k withdrawals? Im not following that part.
The rational thing is to check if the next $1 (or $1,000) of additional investment has to go into account X or Y. Hence the use of marginal rates.
Thanks for the reply Karsten! I’m following that line of thinking for the contributions to the account, however, I’m still not understanding why it would be taxed at the marginal rate on withdrawal. Aren’t withdrawals from a traditional 401k taxed as ordinary income? For example, if you withdrew $50k from your 401k, you wouldn’t pay 22% on all of that. I believe you would pay your effective tax rate on it. I suppose the exception would be if you were doing roth conversions and in that case the conversions would be taxed at whichever tax brackets you are filling up.
I trust your math a lot more than mine, so I just want to make sure I’m understanding your spreadsheet correctly. I’ve seen many forums mention 401ks are taxed at effective tax rates and saw it mentioned in this article as well: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.617.6155&rep=rep1&type=pdf but I feel like I may be missing something.
For your own personal enjoyment, feel free to put in your effective rates, but the results will be sub-optimal that way.
My calculation is very explicitly for the attractiveness of investing another $1,000. Where would you want to put that additional $1k? The proper thing to do is to look at the marginal taxes. You don’t pay the average rate, you pay the marginal rate on that.
The author of that study writes: “. A conversion only makes sense if the future effective rate is likely to be higher than the current marginal rate applied to the conversion;”
No, you compare both rates at the margin. That author doesn’t know what he’s talking about. Which doesn’t surprise me: It’s a common occurrence in the CFP crowd.
Specifically, I have a bunch of income already baked in when I’m retired to fill up the standard deduction and much of the 10% and 12% bracket (Social Security, pensions, etc.). When I determine if I want to do a Roth conversion, I have to take marginal today vs. marginal tomorrow. If I took effective tomorrow, I’d make clearly suboptimal decision.
Thank you for the clarification, that makes sense. I missed how you were calculating the benefit of an additional $1k invested. In my mind you were calculating the taxes on the entire 401k, which in hindsight doesn’t make any sense (especially once you factor in the additional income from other sources outside of the 401k). In practice it seems it’s likely to have income from other sources to fill up the lower tax brackets (in my case I expect this to come primarily from my taxable brokerage account) so the 401k is taxed as whichever brackets you fill during your roth conversion. Based on your post, it seems like the traditional 401k is the best option when you have a high savings rate since your marginal rate is so much lower in retirement!
Thanks for all the work you do. I’m a big fan of the blog.
Yeah, that sounds about right. 401k up to the match and even beyond the match enjoy a huge advantage for most folks. There are exception, as always.
The calculations for the Roth conversion currently do not take into account the optionality of the potential recharacterization back to the original IRA. We are working on that as well and write a separate post on this topic soon
ERN – did you ever write this article? Isn’t this no longer an option for new contributions?
The recharacterization is no more. The 2017 tax reform bill canceled that option, I believe.
Revisiting this article (like many!) again – is there any way to extrapolate this to considerations for contributing to Cash Balance Plans? Being in high marginal rates (both federal/state) would seem to be highly in favor of CBP contributions, but the low (approx 3%) return on the contributions make it challenging to weight the pro/con in detail. Assuming early retirement, I would also think the prolonged ability to convert pre-tax space to Roth and smooth RMDs would be beneficial. So thankful for you sharing your insights! It might take me forever to understand all the details but I feel like I’m learning something every time – thank you!
You can certainly “hack” this and compare your baseline results with a scenario where you assume a lower rate of return (3%) and look up the IRR of the 401k plan (with/without the match, not sure what kind of a setup you have). I doubt that this beats the taxable account with an equity investment.
But the CBP also has low/no risk. So, it’s not so much about comparing just expected returns but also risk-adjusted returns. 🙂