Roth 401k — Why these retirement plans may be bad for your wealth

Let’s get right to the point. Saving for retirement in a Roth 401k likely will leave you with less money in retirement than if you had invested in a traditional 401k.

Roth 401k

There are some exceptions to this rule. For example, a Roth 401k may be the right choice if you make more than $1 million a year or if you make so little that you pay no income tax or very little income tax. But for the majority of us, the Roth 401k is better left alone. Here’s why.

Roth 401k Basics

A Roth 401k is a retirement plan set up by employers that allow employees to contribute to their retirement. Unlike a traditional 401k that is tax deferred, however, money invested in a 401k Roth account is included in an employee’s taxable income. For example, if an employee is in the 25% federal tax bracket and pays 5% in state income tax, he or she would have to make $14,285 in gross income to invest $10,000 in a Roth 401k.

Here’s the math: $14,285 x 30% = $4,285 in taxes. $14,285 – $4,285 = $10,000.

The benefit of a Roth 401k is that your investments grow tax free. If by retirement that $10,000 has grown into $50,000, you pay no tax on the $40,000 gain. With a traditional 401k, the initial investment is excluded from your taxable income, but you do pay taxes on your entire 401k balance as you make withdraws from the account.

Why contributing to a Roth 401k is probably a mistake

Determining whether a Roth 401k or traditional 401k is best requires a bit of guess work. Traditional analysis asks whether your tax rate will be different when you contribute to the Roth 401k than it will when you make withdrawals from the retirement account. If your tax rate will be the same, the argument goes, than it makes no difference whether you invest in a traditional or Roth 401k. A tax rate that is higher when you make contributions than when you take withdrawals favors a traditional 401k, while a tax rate that is lower favors a Roth.

The problem with this analysis, however, is that it glosses over the difference between the marginal tax rate and the effective tax rate. The federal tax rate is progressive, meaning that the tax rate increases as your income increases. For example, here are the 2008 federal tax brackets as released by the IRS:

2008 Tax Brackets

Tax Rate Single Married Filing Jointly
10% Not over $8,025 Not over $16,050
15% $8,025 – $32,550 $16,050 – $65,100
25% $32,550 – $78,850 $65,100 – $131,450
28% $78,850 – $164,550 $131,450 – $200,300
33% $164,550 – $357,700 $200,300 – $357,700
35% Over $357,700 Over $357,700

As you can see, the tax rate increases as an individual or couple’s income increases.

Now the marginal tax rate is the highest rate that an individual or couple pays based on their income level. For those with taxable income over $357,700, their marginal rate is 35%. In contrast, the effective rate is the average income tax rate paid. Somebody with taxable income of $357,701, for example, only pays 35% income tax on the $1. An individual would pay 33% for taxable income over $164,550, 28% for the portion of their taxable income over $78,859, and so on. In the end, their effective tax rate would be the total tax paid divided by gross income, which would come out to a lot less than their marginal rate of 35%.

The key point for our purposes is that contributions to a traditional 401k reduce an individual’s tax liability at their marginal rate, not their effective rate. In contrast, withdrawals from a traditional 401k will be taxed, along with other retirement income, at your effective rate. So unless you expect your current marginal tax rate to equal or exceed your effective tax rate at retirement, the Roth 401k is not the best choice.

If you’d like to read a detailed analysis of the Roth 401k, check out Thinking About a Roth 401(k)? Think Again

Is a Roth 401k the right choice for anybody?

Sure. For those making in excess of $1 million, their effective tax rate and marginal tax rates begin to converge. Furthermore, they are likely to amass sufficient wealth such that their retirement income could exceed their current income, which could favor a Roth 401k. Also, if you live in a state that doesn’t have an income tax, but expect to move to a state that does during retirement, the Roth 401k may be the better choice. And a teenager who doesn’t earn enough to pay taxes but wants to save for retirement would be better off choosing a Roth account.

So choosing the right investment vehicle is not a one-size-fits-all proposition. And it should be noted that you can invest in both a Roth and traditional 401k. But for most, sound retirement planning suggests that we pass on the Roth 401k.

Here are some other Roth 401k articles worth reading:

Should You Choose a Roth 401k or a Regular 401k?

The Case Against Roth 401(k)

Published or Updated: March 23, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Debbie M says:

    Very interesting. Thanks for pointing that out.

    The Roth 401K might also be good for people who will be receiving a lot of taxable income in retirement, in which case the extra income from the 401K might be taxed at the marginal tax rate. Or a small Roth might be good for someone with a big regular 401K.

    I have a taxable pension, and I expect the income I could get from my Roth IRA and 403(b) to be about 25% of what I will get from my pension, and thus be 20% of my total income.

    Also, I think my tax rates are going nowhere but up in the future, so I’m inclined to lean toward Roth.

    However, after my next raise, I should probably see if I bump into the next tax rate and, if so, I may think of moving that amount of money into a regular 403(b) instead.

    Note: these plans are not bad for your wealth; they might just be not as good for your wealth!

  2. Paul says:

    I still can’t decide. There’s alot of inputs, and 401k in general are subject to political manipulation, inflation, future taxation, forced withdrawal in retirement, means tested social benefits, etc.

    I was also trying to calculate what happens in an early retirement scenario, and whats optimal considering the 10% early withdrawal penalty. Assuming one does a very modest annual withdrawal, they will still be in the 15% tax bracket, with another 10% layered on top, which at 25% is about a wash with my current marginal tax rate.

  3. Mrs. Micah says:

    That’s an interesting analysis. I highly doubt that my retirement income is going to be higher than my general pre-retirement income. In that way, I think the traditional 401(k) makes sense.

    Still, at this point in my life I’m probably in a lower tax bracket. So we’re using a Roth. I’ll evaluate later one when we’re out of “grad-student” mode.

  4. Cindy says:

    Another advantage of a Roth is that you are not required to take minimum distributions at 70 1/2 -

    • DR says:

      Cindy, nice point. Just to clarify. A Roth 401k is subject to the minimum distribution requirements just like a traditional 401k. But you can rollover a Roth 401k to a Roth IRA when you change jobs or retire, and thereby avoid the minimum distribution requirements. This is a great way to leave money to your heirs if that’s one of your goals.

  5. Laurie says:

    There is one major flaw in your analysis. High income earners are not eligible to use Roth anyway. These are the limits (amounts are Modified Adjusted Gross Income):

    * Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
    * Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
    * Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution).

    • DR says:

      Laurie, these limits apply to the Roth IRA, not the Roth 401k. There are no income limits for a Roth 401k.

  6. Jeff says:

    You may wish to note that Pennsylvania is kinda screwy and does not allow you to deduct your contributions to a traditional 401k (thus I still pay 3% state and 3% city tax on all of my 401k contributions). I don’t have to pay this tax on distributions though (assuming that I withdraw at 59.5 or older and still live in PA).

  7. Jody Wilson says:

    I’m convinced that Congress will be raising tax rates in the future to pay for the growth in Social Security, Medicare, etc. So I’d rather pay my taxes now while they’re relatively low (Roth), in order to avoid paying them later.

  8. Tom Bob says:

    I think Laurie was on a right track with her point. Folks like myself– who are salaried and max out our pre-tax 401K plans but still fall within the Modified Adjusted Gross Income ceiling — have a viable savings option to put away taxable income using a Roth IRA.

    For instance, a single tax filer with a MAGI of $98k could put away the maximum on a Roth account to supplement his other retirement plan. In that case, it seems to be up to the individual as to whether it’s worth it or not to sock away the extra $$$. It really is a nice option to have available.

    • DR says:

      Tom Bob, I agree. And remember that the article is focused just on the Roth 401k, not the Roth IRA. The analysis for a Roth IRA is different, in my view. Unless you qualify for a deductible IRA, the extra money you have to invest has already been taxed, so a Roth IRA makes perfect sense.

    • Steve says:

      What about those limited by individual co. means testing? The Roth 401K sounds like a perfect solution since you cannot max out with traditional 401K and can only supplement with a meager $5K IRA contrib.

  9. LC says:

    This is in direct contradiction to the article you wrote 4 months ago.

    “I believe that for most people most of the time, Roth retirement accounts are best”
    http://www.doughroller.net/2008/03/03/dave-ramseys-step-4-a-visual-guide-to-saving-15-for-retirement-in-a-roth-401k/

    so which one is right?

    • DR says:

      LC, it goes to show that we should never stop learning and studying. Having spent considerable time studying the option over the last month, I’m moving away from the Roth 401k.

  10. Great post! Haven’t really looked into the details of a Roth 401k before, as it hasn’t been available to me. What an interesting option to provide employees nowadays. If it’s not as good an option as a traditional 401k except in the special cases you mention, I wonder why employers even bother to offer it.

  11. bob says:

    Hi DR,
    Thanks for your great article!

    I have a question: Does the “withdrawals from a traditional 401k will be taxed, along with other retirement income, at your effective rate” part apply to IRAs too? i.e. are Traditional IRA withdrawals taxed at the effective rate, not the marginal rate?

    • DR says:

      Bob, that’s a great question, and as with all tax questions, my first response is to consult a tax professional! That said, the article wasn’t meaning to distinguish between effective and marginal rates, but rather ordinary income versus capital gains. And assuming the IRA contributions were deductible, I believe the tax treatment is the same as a 401(k). But again, check with a tax pro to be sure!

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