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.
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.
- 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.