It’s becoming more common for employer retirement plans (ex. 401(k)) to offer the option of Roth contributions. For those wondering whether to make Roth (after-tax) contributions or traditional (pre-tax) contributions, the **general (oversimplified) rule** is that:

- If you expect your tax bracket to be lower in retirement, then take the tax savings now while you are in a higher bracket and make traditional contributions.
- If you expect that your tax rate will be higher in retirement, then pay tax now and make Roth contributions.
- If you think your bracket will be the same, then it’s a wash. Except that each may have some additional advantages in certain situations.

In truth, it’s a little more complicated than this, because the funds can be taxed in more than one bracket. So it’s better to ask about the average rate at which the contributions or withdrawals will be taxed rather than the “tax bracket.”

## General Benefits of Tax-Advantaged Accounts

Using tax-advantaged accounts, such as an IRA or 401(k), will help build wealth by lowering your tax burden. Tax advantaged accounts always come out ahead of taxable investing.

Specifically, traditional contributions to a 401(k), 457, IRA, or equivalent account have the following benefits:

- Pre-tax money goes in (lowering your tax burden for that calendar year); and
- Money grows tax-free (avoiding the typical 15 or 20% tax rate that applies for qualified dividends + the 3.8% additional Medicare tax for high income individuals)

A Roth IRA or Roth 401(k) has the following benefits:

- Money grows tax-free (just as described above); and
- Money can be withdrawn tax free (again avoiding the capital gains / dividend taxes)

As an aside, note that a HSA (health savings account), when used for qualified medical expenses, has all of the benefits above, which is what makes them so valuable.

## Preface on running the numbers

So how does this play out with real dollars? First things first, here are 2018 tax rates:

Remember that we’re talking ordinary income here. Capital gains and dividends from a taxable brokerage account are a separate issue. See here for further reading on those rates. For most reading this, 85% of social security income counts as ordinary income.

### Apples to Apples Comparison

Remember that we need to calculate equivalent values to make a fair comparison. There are a couple of blog posts out there that completely miss this important point. For example, let’s say a married couple falls in the high end of the 22% marginal tax bracket, and they contribute a total of $30,000 to 401(k)s, reducing their AGI from $160,000 to $130,000. They put that money in pre-tax (meaning that it’s excluded from that year’s income for tax purposes), so that 401(k) account grows by $30,000. Had they chosen *not* to contribute to their 401(k)s, then the $30,000 would have been taxed at 22%. $30,000 x .22 = $6,600. So they would have been left with $23,400 to invest in a taxable brokerage account or a Roth account. In other words, in that example, all else being equal, $30,000 pretax = $23,400 after-tax.

## Criteria for all examples

For all of the following examples, I’ll use the following criteria:

- A single filer
- A 30 year investment horizon
- Starting with a zero balance
- 6% return rate during accumulation phase and 5% return rate during retirement

## Example #1 – same tax rate

Let’s assume an individual with an income of $90,000 (minus the standard deduction of $12,000) = $78,000. She wants to contribute $18,500 per year of traditional contributions or the equivalent after-tax amount to a Roth 401(k) ($18,500 x 22% = $4,070; $18,500 – $4,070 = $14,430). She expects to be in the same tax bracket in retirement.

As you can see, although the dollar value of the traditional 401(k) ends up higher, the final result is the same. This is because the tax bracket remained constant during the accumulation and distribution phases.

## Example #2 – higher tax rate in retirement

Let’s take the same example above, but now assume that her tax rate will be higher in retirement. Specifically, 24% in retirement vs. 22% during accumulation phase.

Here, the Roth 401(k) comes out ahead. Again, because the Roth money can be withdrawn tax-free, while the traditional 401(k) is still subject to ordinary income tax, it’s necessary to look at the after tax income that can be generated, and not simply the account value.

The above example compared a 22% to a 24% tax rate. But of course if there’s more of a gap between rates, the disparity will grow. For example, if the 24% rate during retirement was changed to 32%, then the annual income generated from the traditional 401(k) would drop from $76,647 to $68,579.

Finally, I’ll omit example #3 “lower tax rate in retirement” because the result will be the reverse of example #2. In that case, a traditional 401(k) would be the way to go. This all makes sense because you are avoiding taxes during your high-tax working years.

## Run the numbers yourself

The calculator can be found here: 401(k) vs. Roth 401(k) calculator.

Make sure to get your accurate tax rate now from your most recent tax return. Then think about how your tax rate in retirement will be calculated. Will you be drawing social security? Do you have a pension? How much more will you except to pull from your taxable account or traditional IRA / 401(k) based on your anticipated expenses? Once you get this total dollar amount, apply the standard deduction and determine your rate.

An important point is that the rate you should use for comparison will not necessarily be your top (marginal rate) unless all the 401(k) contribution would fit within that rate. Nor should it be your average rate. Your bottom rates will be filled by other income such as pension income, spouse’s income, taxable portion of social security. So what should you use for the calculations?

Let’s say, for example, that in your 401(k) money will fully fill up the 24% bracket (17k) and barely dip into the 32% bracket (1.5k). Then most of that 401(k) income will be taxed at 24%, so it would be easy to estimate in that example that 25% is your estimated tax rate in retirement for the 401(k) money.

Here is how to do the actual calculation:

- ((Amount that completes your 2nd highest bracket x that tax rate) + (Amount that’s in your highest bracket x that tax rate)) divided by total amount contributed.
- Here that would be ((17k x .24) + (1.5k x .32)) / 18.5K = 25.3%
- If it spans more than two tax brackets, then just find the average of all of the brackets.

The Finance Buff makes this point in his article favoring traditional contributions. But the truth is that this correct methodology of not simply using the marginal rate would apply to both the front end and back end of the calculations. So while the tax hit wouldn’t be as bad in retirement (which is his point), the front-end benefit could be reduced as well, albeit as a maximum of that year’s max contribution.

Upon retirement, if you expect to have little other income than a tax-deferred account, then there is a definite advantage. You can fill up the lowest brackets and will almost certainly come out ahead!

## Other Advantages to Traditional Contributions

There is the potential to avoid state taxes in a high tax state and then move to a no-income tax state in retirement. See this article for more detail. But be careful and do your research before banking on this strategy. Some have expressed concerns that the state where you avoided taxes could argue that the deferred taxes are still owed to them.

## Other Advantages to Roth Contributions

### Important for those maxing tax-deferred accounts

If your are able to max out your tax-deferred accounts, keep in mind that a Roth option lets you put more money away. Again, this is because $18.5K pre-tax is more than $18.5K after tax. If you were in the 32% tax bracket, socking away $18.5K pre-tax is really only the equivalent of $12,580! If using a traditional 401(k), then the equivalent additional money would have to be invested in a regular taxable brokerage account (assuming you are out of other tax-deferred space such as a HSA, solo 401(k), Roth IRA, etc).

The easy way to figure this into the calculation is simply to note that **if it’s a close call deciding which option to invest in, and you are maxing your retirement accounts, then Roth gives you an additional advantage that should tip the scales in that direction**.

To be more specific, you can do the math yourself.

- First, use the calculator above to get the numbers for Traditional (18.5K pre-tax) vs. Roth (the equivalent of 18.5K in after-tax dollars). Next, find the difference between 18.5K and the after-tax equivalent for your tax rate. For example, if your current bracket is 24%, then $18,500 – $14,060 = $4,440.
- Now, run a comparison of how the money will fare in a Roth account vs. how it would fare in a taxable brokerage account (i.e., what you would have to invest the surplus in if you choose a traditional 401(k)). A calculator can be found here: Roth vs. Taxable Calculator.
**There’s also a spreadsheet here from the Finance Buff that will do all these calculations for you**. It assumes the maximum contribution. When I ran some numbers, I noticed that even those with a slightly higher tax rate now will actually benefit by using a Roth.

### Other advantages to Roth contributions

- A Roth account gives more certainty. In retirement, you will know exactly how much money that you have. In contrast, a traditional 401(k) is subject to taxation and rates can change year to year.
- Many believe that tax rates, especially for the higher brackets, are likely to increase. This is because rate cuts made effective in 2018 are scheduled to increase in 2025 unless the law is modified. In any event, it is not clear that a future administration would keep tax rates at their current rate going forward. Additionally, our country has run up a massive debt that will need to be addressed in the coming decades.

## Summary

The general rule of higher bracket in retirement favors Roth contributions, and higher bracket now favors traditional contributions holds true for the 90% of investors not maxing their retirement accounts.

But, when it’s a close call, there may be some advantages to Roth given the possibility of future rate increases. This would be less so for those who believe that a 401(k) or similar account will be their only source of funds in retirement. Also, for those maxing retirement accounts, a Roth allows more money ($18.5K after-tax vs. $18.5K pre-tax) to be put away giving it an advantage.

Finally, there can be value in **tax diversification**, i.e., having both pre-tax and after-tax money, to give you options down the road.