Reader Chris asked an interesting series of questions in a post the other day. How should you allocate your funds between a 401K and a Roth IRA? Should the amount you have in a 401K influence that allocation? What about if you can not max out both?
Which Should You Prioritize: Roth or 401K?
Some very interesting questions here. Let’s start with the basic choice between a Roth and a 401K. As noted in our earlier post, at it’s most basic level 401k and Roth outcomes are the same if tax rates are the same at withdrawal and deposit. If we assume your tax rate remains unchanged then the question is unimportant. But we live in the real world, where tax rates and brackets change all the time, so the question is definitely more complex.
What If Tax Laws Change?
Now the easier question in the real world to mitigate is what about if tax laws change. Quite simply tomorrow the government could increase the tax rate, make withdrawals from Roth accounts taxable, or any number of things that will blow any analysis I can do out of the water. For this reason it is always important to diversify your tax exposure. Holding Roth, 401k, and even HSA accounts in some proportion mitigate some of the risk of these changes. Congress is unlikely to change the taxation of all of these at once, so diversity increases the possibility you can adapt to future tax law changes, or at least reduces some of the associated volatility.
What if Tax Laws Stay The Same?
But what about the scenario where Roth and 401k tax treatment stay as they are? We started to answer this question a few weeks ago with the post too much in tax advantaged accounts. The table is republished here for reference.
Taxable Account 
Year

401K  
Deposit  Principal  Interest – taxes  Deposit  Principal  interest  Return after 10% Penalty  
$12,960  $12,960  $771  0  $18,000  $18,000  $1,260  
$12,960  $26,691  $1,588  1  $18,000  $37,260  $2,608  
$12,960  $41,239  $2,454  2  $18,000  $57,868  $4,051  
$12,960  $56,653  $3,371  3  $18,000  $79,919  $5,594  
$12,960  $72,984  $4,343  4  $18,000  $103,513  $7,246  $64,178 
$12,960  $90,286  $5,372  5  $18,000  $128,759  $9,013  $79,831 
$12,960  $108,618  $6,463  6  $18,000  $155,772  $10,904  $96,579 
$12,960  $128,041  $7,618  7  $18,000  $184,676  $12,927  $114,499 
$12,960  $148,620  $8,843  8  $18,000  $215,604  $15,092  $133,674 
$12,960  $170,423  $10,140  9  $18,000  $248,696  $17,409  $154,192 
$12,960  $193,523  $11,515  10  $18,000  $284,105  $19,887  $176,145 
$12,960  $217,997  $12,971  11  $18,000  $321,992  $22,539  $199,635 
$12,960  $243,928  $14,514  12  $18,000  $362,532  $25,377  $224,770 
$12,960  $271,402  $16,148  13  $18,000  $405,909  $28,414  $251,663 
$12,960  $300,510  $17,880  14  $18,000  $452,322  $31,663  $280,440 
$12,960  $331,351  $19,715  15  $18,000  $501,985  $35,139  $311,231 
$12,960  $364,026  $21,660  16  $18,000  $555,124  $38,859  $344,177 
$12,960  $398,645  $23,719  17  $18,000  $611,983  $42,839  $379,429 
$12,960  $435,325  $25,902  18  $18,000  $672,821  $47,097  $417,149 
$12,960  $474,187  $28,214  19  $18,000  $737,919  $51,654  $457,510 
$12,960  $515,361  $30,664  20  $18,000  $807,573  $56,530  $500,695 
$12,960  $558,985  $33,260  21  $18,000  $882,103  $61,747  $546,904 
$12,960  $605,204  $36,010  22  $18,000  $961,851  $67,330  $596,347 
$12,960  $654,174  $38,923  23  $18,000  $1,047,180  $73,303  $649,252 
$12,960  $706,057  $42,010  24  $18,000  $1,138,483  $79,694  $705,859 
$12,960  $761,028  $45,281  25  $18,000  $1,236,176  $86,532  $766,429 
In essence we analyzed a taxable account investment versus a 401k investment including the 10% withdrawal penalty. What we found is a 401K investment incurring the 10% penalty that returned 7% would come out ahead of a taxable investment after 25 years. This was assuming an individual stayed in the same tax bracket. In essence not paying capital gains on the return would offset a ten percent penalty after 25 years. In that analysis I also assumed a conservative 7% return on investment. This is roughly in line with more recent estimates of average S&P 500 returns. As such at least historically this is a good starting point.
Penalty or Change in Tax Rate of 10%, Same Thing
But what does this have to do with changing tax brackets? Well remove the word penalty and insert the words bump in tax brackets. That means over 25 years the 401K is a better investment than a taxable account given the tax bump from deposition in the 401k to withdrawal is less than or equal to 10%. There is our floor.
But what does a tax bracket jump of 10% really mean in the context of todays tax laws? For a married individual they are:
Married Filing Jointly Tax Bracket 2017
Taxable Income Bracket  Tax Owed 
$0 to $18,650  10% 
$18,650 to $75,900  $1,865 + 15%* of Amount > $18,650 
$75,900 to $153,100  $10,452.50 + 25% of Amount > $75,900 
$153,100 to $233,350  $29,752.50 + 28% of Amount > $153,100 
$233,350 to $416,700  $52,222.50 + 33% of Amount > $233,350 
$416,700 to $470,700  $112,728.25 + 35% Amount > $416,700 
> $470,700  $131,628 + 39.6% of Amount > $470,700 
For a single individual they are:
Individual Tax Bracket 2017
Taxable Income  Applicable Tax 
$0 to $9,325  10% 
$9,326 to $37,950  932.50+15%* of Amount > $9,325 
$37,950 to $91,900  $5,226.25 + 25% of Amount > $37,950 
$91,900 to $191,650  $18,713.75 + 28% of Amount > $91,900 
$191,650 to $416,700  $46,643.75 + 33% of Amount > $191,650 
$416,700 to $418,400  $120,910.25 + 35% Amount > $416,700 
> $418,400  $121,505.25 + 39.6% of Amount > $418,400 
Higher Tax Brackets will Never Exceed a 10% Rate Jump With Today Tax Laws
So with current tax laws the top 3 brackets in income will never have to worry about a 10% bump from income to withdrawals. Simply put they can never increase their tax rate by more than 10%. The 28% and 25% bracket only has to worry about this if they jump all the way to the top bracket. So unless you suspect your 401K withdrawals will exceed $418K for individuals or $470K for married these folks should never worry about the amount they have in a 401K based on current tax laws. I’ll show you the math later in this post on RMD, but I seriously doubt anyone will ever experience this issue.
Exploring the 15% and 10% Brackets
This really only leaves the bottom 2 brackets with any real concern under current tax laws. If the 15% income bracket jumps to the 28% bracket or higher or the 10% bracket jumps to 28% via withdrawals then they would be better off with taxable investments. Let’s explore how likely that is.
Worst Case Assumptions For Stable Tax Rate and RMD
Let’s assume the worst case scenario here. The hypothetical investor will deposit 18K a year, the current maximum for a 401k employee deposit, with no employer match, or yearly increase in deposit amount. We will continue with our 7% return assumption which results in 766K in a 401k after 25 years. Let’s double that assuming you have an employer contribution and the government increases the contribution limits over time. So for this purpose we’ll assume you have an even 1.5 million dollars in the account 25 years after starting.
I am assuming 25 years to keeps our tax bracket jump support at 10%. Longer periods would support bigger jumps. In fact at 38 years it supports a 15% jump which would make this whole analysis ridiculously easy as it’s very unlikely your RMD would leave you in the 33% tax bracket (RMD equal to $191K or $233K respectively). So we’ll stick with 25 years. We’ll also assume you are in the 15% tax bracket. If you can max a 401k and are in the 10% tax bracket you are such a corner case I’d like to shake your hand. Finally let’s assume you are withdrawing at 70.5 so Required Minimum Distributions (RMDs) are now in effect. What will be your tax bracket in retirement?
Required Minimum Distributions (RMD)
RMD calculations start from a table for your life expectancy. These tables estimate your expected life expectancy. They then determine a life expectancy factor. The factor is then divided into your account balance to decide your current year annual RMD withdrawal amount. The amount is recalculated every year. For simplicity you can get an estimate of your expected RMD here.
RMD on a Worst (Best) Case 401K, $1.5M Balance 401K beats Taxable
So let us run the numbers. Based on the RMD calculator someone turning 70 this year can expect a RMD of $55K per year from a $1.5M balance in their first year of withdrawal. Referring back to our tax brackets, that means they will still only be in the 25% bracket for individuals or the 15% bracket for married couples with some space to do additional withdrawals while staying in this bracket. Both results represents less than or equal to the referenced 10% bracket jump, in fact resulting in jumps of 0% or 10% for married or single. Therefore we can conclude that those in the 15% income tax bracket are also unlikely to have issues with the size of their 401k account in their first years of retirement.
Future Years
In future years their RMD withdrawals would likely increase simply because their RMD is so small compared to the amount in the account. How much? Well the RMD calculator will give you an estimate. But does it matter? The individual tax filer would pass into the next tax bracket of 28% at $92K. RMD would not exceed this point until 81. After accounting for deductions you would need to be 83 before entering the 28% bracket. (See our note at the end of this post for why this breakeven point is actually even later). The single filer at 15% has the most likelihood of running into an issue. But the average life expectancy of an American is 79 years, so I would not count on an issue.
The Married couple would pass into the 28% tax bracket at 153K. That would be somewhere around 96. Anyone overly worried about their tax rate at 96 I would suggest has too much time on their hands.
Changing Tax Brackets Diversification
Which leads us to one more possibility. What if the tax brackets change. This is a highly likely scenario as they have changed dramatically over the last few decades. Unfortunately predicting how they will change is not feasible, so similar to a change in ROTH or 401k treatment I cannot give you a detailed analysis here. But I can lead you to the same conclusion. This is a good case for tax diversification. Having a mix of all types of accounts decreases your risks as tax brackets or even laws change.
What does this Mean for 401K Versus Roth?
We can conclude the 401K is superior to the taxable account in almost any conceivable scenario. From this data we can make some determination on the Roth versus 401K question we asked initially. A caveat before we continue, below assumes your 401K is your sole source of income.
We established up front that a Roth and a 401K have equivalent returns provided tax rates equal between input and withdrawal. Even in our $1.5M balance scenario the 401K initially only enters the third tax bracket of 25% for individuals and 15% for married couples via a 55K RMD. RMDs do not push the holder into the 28% bracket until well past the average life expectancy. Therefore if current tax laws stay the same, if you are in 25% brackets or higher you are still likely investing in a scenario where these 2 are equal or the 401K is superior.
So when does the Value of a 401K Become an Issue?
Ignoring deductions or other income sources, increasing beyond these initial withdrawal brackets would require balances of $2.5 Million to get the individual to 28% or $2.1 Million to get the married couple to 25% in the first year of RMD. After deductions the number is closer to 2.5 Million for a couple. I doubt most of us will ever need to worry about a 401K of those sizes. That all being said, one last time for emphasis, tax laws change so diversification is key.
Do you have any more questions about tax advantaged accounts, 401Ks, or Roth IRAs? Are you surprised that 401K amounts do not have a large influence on whether you should use them versus a taxable account?
A note: This post does take a bit of liberty by utilizing effective and marginal tax brackets interchangeably. However, the assumption of a marginal tax bracket immediate jump in tax rate at a given income make the analysis easier while giving a more conservative result, so we will stick with it. In reality significant additional income, beyond the amounts in this analysis, would be needed to increase your tax rate by 10%.
Full Time Finance is neither an accountant nor your financial advisor. This post is provided for entertainment purposes only. Any and all actions taken as a result of this article and others are your’s and your’s alone.
If only we could predict future tax rates, then we’d be set. 😉
Related to your post, I’m trying to figure out whether I should max out my 401k as a traditional 401k or Roth 401k next year. If I max out as a Roth 401k, then my income will be too high to contribute to a Roth IRA. Only if I contribute near to the max as a traditional 401k will be income be under the Roth IRA full contribution limits. Assuming a 28% current tax rate, 25% upon retirement, and a taxable account to contribute to to make the scenarios even, what is the best course of action?
I’d definitely favor the traditional over the Roth in your scenario. Creating more tax advantaged space via a Roth IRA makes it a no brainer. I’m also somewhat hesitant to utilize the Roth 401K due to the pro rata rule. Essentially you have to withdrawal post and pretax in proportions equal to the account proportions once they inner mix. Now you can get around it somewhat as the IRS does allow you to roll the Roth to a Roth and the 401K to a traditional or 401k at the same time, but it’s still a scenario I’m not keen on dealing with in case laws or IRS interpretations change.
I don’t hold nor qualify to contribute to a traditional IRA, so I do not have this problem with my IRAs.
Good analysis. Like YAPFB said, its difficulty to predict future taxes. My perception is that they will be higher (much higher) in the US. Still, you can base all your investment decisions on fear – or you’d stay in Savings accounts your entire life.
Mr. 39 Months
So very true. I have much the same prediction, with a caveat. I suspect as always there will be a million loopholes created by congress. So I tend to favor flexibility and diversity so I can hopefully utilize those in the future.
In building a model for my own situation, I have come to a similar conclusion: Once one is in the 25% marginal tax bracket, the traditional 401(k) is either superior or at worst it is equal to a Roth. We can no longer contribute to Roth IRAs. So I have been contributing the IRS max to my Roth 401(k) and the max to my wife’s traditional 401(k) to get some tax diversification and flexibility. But now as we approach the 28% marginal rate, I am starting to convert my contributions from Roth back to traditional. It makes no sense to pay a 28% marginal rate today when I will be in what is today’s 15% or 25% brackets in retirement.
One clarification: you claim that 401(k) and Roth outcomes are the same if tax rates are the same at withdrawal and deposit. This is only true if one doesn’t have the wherewithal to pay the Roth tax now in order to have year 0 deposit dollars be the same. In your example from May 19, one has $143 pretax dollars to invest. The investor can put $143 pretax into a 401(k) or $100.10 in a Roth after paying $42.90 or 30% tax upfront. The outcome is the same if the same 30% tax is paid on the 401(k) at withdrawal ($54.75 in tax paid if withdrawn 5 years later). But the investor could opt to take $42.90 out of his takehome pay to make the initial deposit in the Roth the same $143. With the Roth, the earnings are never taxed so the lifetime amount of tax paid is less ($42.90 now versus $54.75 in 5 years).
For investors with the wherewithal to max out $18,000 annual contributions to either traditional or Roth 401(k)s, the Roth can be advantageous. With the Roth, you invest the same deposit, but lower your takehome pay by paying tax now. The lower takehome pay is in essence an investment at the same rate of return as your 401(k) but without ever paying tax on those earnings. That’s an afteretax return hard to duplicate except maybe in an HRA.
So I think we have the same conclusion on Roth vs Traditional, but only because I expect to be in a lower tax bracket in retirement. The benefit of never having to pay tax on earnings in a Roth is easily overlooked in a simple example.
Hi Torch Red,
True, one could argue the roth gives you more space in tax advantaged accounts since 18K in a roth does not equal 18K in a traditional, but the efficiency of the specific set of funds does not change. I.e. your spending more net money to get the roth to 18K then you are to get the traditional. You’ve invested in the Roth IRA 18K + the amount you took from your paycheck. You’ve invested in the traditional 18K. If you could invest 18K+ the amount from your paycheck the traditional would be equal again.
The net present value of the two accounts using only $18K at investment is the same. There are other more efficient ways to increase your tax advantaged space then choosing a roth over a traditional.
We are almost on the same page. The disconnect I have is that you assume the invested upfront tax savings from going with the traditional 401(k) would compound taxfree. Conversely, I assume the extra investment would be in a fully taxable account where even index funds would create some degree of tax each year on capital gains and dividends. My view is aligned with this article from nerd wallet.
https://www.nerdwallet.com/blog/investing/rothira/rothtopstraditionalirasuptosixfigures/
The article assumes the tax savings from each contribution to a traditional IRA is invested in a taxable account with 15% capital gains tax applied to the return. Perhaps this is too simplistic and conservative? Do you assume the extra investment is in something like an aftertax contribution to a 401(k) which would compound without taxes?
I like reading posts that challenge my thinking or preconceived notions. Keep up the good work. A future article idea may be to elaborate on how you rank the ways to increase one’s taxadvantaged space in terms of efficiency.
It’s a toss up between assuming the tax savings is invested or you only have 18k to save, not 18k plus tax. In my case I currently use an after tax 401k contribution conversion to a Roth IRA for the fall outs beyond our other tax advantaged accounts. Thanks for the post idea, we’ll write on that for an article in about two weeks.
First, let me say thank you for writing so in depth about this topic. I read it 3 times and hung on every word.
I think the assumption about guessing future taxes is a good idea to assume are the same, because what else can we do. However I will say, for the past 5 years I assumed that federal taxes would have to go up, but I am starting to wonder if they really can to a great extent. Our local taxes especially school taxes literally have no limit. They go up and up, with no end in sight. I have heard 1 proposal about not allowing you to deduct local and state taxes but I find it hard to believe that gets through. My point being I think they be relatively the same.
I very respectfully disagree with your other assumption that this will be your only income. I think you did that to keep the article on track and I can accept that. I am not fortunate enough to have a pension, nor will I. That said, I am however 46 and despite some gloom /doom I expect social security. Not only do I expect it, I expect a lot more than my parents have received, because well, my wife has worked her whole life as well. My mom only worked maybe 1/2 to 2/3 of here working life. So I would expect at least $30003500 per month combined maybe more. So $36,000 per year on the low end / .04 is $900,000 benefit. I know there are no guarantees but I think is more likely someone my age will receive social security than for the program to go away.
I think that assumption changes the game a little bit. So lets say I would like a nice round $100,000 a year to spend. Well that is a net of $74,000 after SS. $74,000 / .04 if $1,850,000. IRA @$1,000,000, 10 years at 7% gets to $1,967,151
So maybe someone that is 52 years old with a million bucks, should think about splitting future contributions between 401K and Roth ?
If that 62 year old doesn’t draw down between 62 and 70, the pretax nest egg could be getting close to 3.5 million which will be a challenge for RMD.
Again, awesome article, really has my wheels turning. Plan to read it a few more times !
It’s a fair point that social security and other sources of income change the story in some respects. In the scenario your referenced it comes down to your current tax bracket. The 28 percent married tax bracket is still likely better off with the 401k. Depending on social security payouts and other options the 25 percent bracket may shift in favor of a Roth.
Nice article. I don’t understand how the Roth and traditional IRAs would come out even. If your sole income when you retire is coming from your IRA, then you would be taxed at your effective tax rate after taking deductions and filling all of the lower tax brackets. Wouldn’t this make the traditional IRA and 401k far superior every time? Also, you wouldn’t need to pay the 10% tax penalty if you use the substantially equal periodic payment exception.
Hi Zack. Imagine next week your gross pay will be 1k. You have two choices, deposit the whole 1k into a 401k or after paying taxes on the 1k put the remainder in a Roth. In the 25 percent bracket the Roth investment would only be 750 dollars. Both accrue interest at the same rate of 1 percent. After one year they are worth 1010 and 757.50 respectively. Then pay 25 percent tax on the 401k 1010. They become equal again at 757.50. Super simple example but it works no matter how long the period or rate so long as they are in sync.
Still trying to digest this article so like others I might benefit from rereading. In any case, I wanted to ask the following. Married, one source of income, higher that minimum for contributing to Roth IRA. Have been maxim out Roth 401(k) at work, maxim out HSA and have been maxim traditional IRA but then have been using back door Roth IRA strategy. I know all these decisions are driven by tax assumptions. If I assume I move to higher tax bracket then Roth might be best today; however, if the opposite is true then traditional might be the way to go. I have no idea what will happen in the future. My personal situation indicates income will continue to increase so going for Roth. What are your thoughts? What would you do in this particular situation. The mad fientist is a big advocate of things like the ladder conversion and minimizing taxes even if investing in traditional and then you convert to Roth but I’m just not sure. If you’re thinking about retiring early it seems traditional is more tempting but if that’s not the case what do you do? Appreciate your comments. Thanks JJ
You should probably be looking at a Traditional 401k unless you plan on having significant outside income in retirement. The conversion, like the Mad Fientist mentions, comes in after you retire. When you have low income you convert to the Roth. I plan on something similar in retirement. However, even if you do not do so the worst case scenario is RMD at 70 (the focus of this post). In that scenario I find it unlikely you will encounter an issue if tax laws remain constant. If you were living just off your 401k in retirement you would need millions in there for your RMD to exceed your current tax bracket (assuming you are likely in the 28% bracket). At 18K a year thats a lot of years of contributions before it would be an issue.