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.
|Deposit||Principal||Interest – taxes||Deposit||Principal||interest||Return after 10% Penalty|
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.
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.