Over the last few weeks I have received a few queries from readers on whether my opinion of a Roth 401K has changed in light of the new Tax Laws. I would like to explore that question a bit more.
My Prior Statements on a Roth 401k
In previous posts I have stated I do not really favor the usage of a Roth 401K. You will note my point was less about the value of a Roth 401K alone, and more about the opportunity cost of losing traditional tax advantaged space. I noted the plethora of options for tax advantaged accounts and that I favor diversification in tax advantaged assets. However, laws have changed since I wrote that post.
Tax Reform Sunset Provisions
Some of my readers phrased their question regarding a favoring of a Roth 401k based on the personal tax cut sunset provisions in the 2018 Tax Reform Law. For those who do not know, most of the personal tax cuts seen in the law expire in 2025 if not renewed. This generally is a trick of accounting to make the bill seem more revenue neutral. So at least in theory tax rates will be higher in 2025 and beyond.
Here is the thing, tax laws change all the time. The last time we did a sunset provision, George Bush’s tax cuts, almost all the provisions were renewed before expiration. After all, most politicians do not want to be seen as the person raising taxes. So provision or not does not change the fact that future tax law is a complete uncertainty. So I have no crystal ball I will not be changing my distribution between pre and post tax accounts wholesale anytime soon.
Chained CPI and Tax Reform
The second concern referenced by my readers is the provision to index changes in brackets to Chained CPI. Well let’s start with CPI. CPI means Consumer Price Index. The idea is you use a basket of goods and monitor their change in price over time. That change represents inflation. In order to keep tax laws at the same levels as today they need to adjust for inflation. Otherwise laws meant to work on people with higher incomes will gradually impact those lower and lower on the rungs. Alternative minimum tax (AMT) was a great example of something not adjusted for CPI. When it was first released only impacted about 155 people. Before it was adjusted in 2008 it impacted millions. So obviously adjusting for inflation via a mechanism like CPI is a good thing.
What is Chained CPI?
Chained CPI is a version of CPI where the basket of goods also changes over time. Huh? Well the concept is that over time people may substitute more expensive items for cheaper ones due to changing tastes. So for example if people shifted from cable to cord cutting then having cable in both baskets of goods would in theory incorrectly report inflation for the average household. The impact is that chained CPI is invariably lower than standard CPI.
Chained CPI Means Slower Increase In Tax Brackets
This means that over time the brackets will be outpaced by some types of inflation. This is especially true if you are slow to substitute or if the substitute is slightly inferior. It also means they will move from their current position slower than they have in the past. Altogether it means you likely will be in a higher bracket twenty years from now then you otherwise would have all other things being equal. Of course again my comment about laws changing all the time applies again. I do not feel you can guarantee these brackets will be in place when you retire 20-30 years down the road. As such I would not use them as a criteria for your tax advantaged accounts.
Despite All This My Roth 401K Strategy is Changing
But…. I just spent most of this article telling you that future tax rates are unknowable. I pointed out that I am not adjusting my tax advantaged space movements because of sunset provisions or chained CPI. However, I am changing them slightly due to my personal situation.
In past years I have been in the 28% tax bracket. For those who recall though the 2018 28% bracket starts at $153,100 AGI and goes to $233,350. At this point it made sense for me to defer as much taxes as possible. Based on our current tax structure I’d be almost guaranteed to be in a lower bracket in retirement. Now whether the 15% or 25% bracket was paying 28% in 20 years might be another question, but at least I had some guideline that suggested I would not be paying more in retirement then I was saving now.
2017 Tax Rates Were:
|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|
2018 Tax Rates will be:
|Taxable Income Bracket||Tax Owed|
|$0 to $19,050||10%|
|$19,051 to $77,400||$1,905 + 12%* of Amount > $19050|
|$77,401 to $165,000||$8,907 + 22% of Amount > $77,400|
|$165,001 to $315,000||$28,179+ 24% of Amount > $165,000|
|$315,000 to $400,000||$64,179 + 33% of Amount > $315,000|
|$400,001 – $600,000||$91,379 + 35% Amount > $400,000|
|> $600,001||$161,379 + 37% of Amount > $600,0000|
The New Tax Brackets
The new laws however have 22% tax up to $165,000 AGI and 24% from $165,000 to $315,000. The thing is, my wife income now qualifies for both a solo 401k plus the new 20% small business deduction. These two items mean I might be able to limbo into the 22% bracket. Essentially my marginal tax rate drops from 28% to 22% from year to year. See I told you in my tax reform post my family will benefit significantly from this bill.
Pay 22% Tax Today or Pay Unknown Rate Tomorrow
Now if I look at it, my choices are now pay 22% tax today using a ROTH 401K or expect I’ll pay less than 22% in retirement by deferring taxes using a Traditional 401K. The thing is, one aspect of the tax laws has not changed over the last 2 decades. The first or second tax bracket always pays 15%. Even in 2000 the lowest bracket was 15%. I’m fairly certain I will never be able to drop my tax rate below 15%, I just don’t see it happening. That means in my best case scenario I save my self 7% in a Traditional 401K over a Roth 401k. (Excluding of course income limit provisions like Roth IRA, ATM, etc which will not apply for me if I stay in my expected bracket).
Roth 401K: 7% Versus Unlimited Downside
So the question becomes is it worth the unhedged risk to save 7%. After all, taxes tomorrow could be infinitely higher. So there is no upper bound to what my tax rate will be in retirement. Therefore, posttax accounts have a higher value to me in 2018 then in 2017.
Still Diversified, Only a Slight Shift Towards a Roth 401K
So why if they have a higher value am I not just shifting it all to a Roth 401K? Well it comes back to that tax diversification point again. You never know what may happen in the future. The government could even choose to confiscate one type of 401k and leave the other. Diversification decreases your likelihood of getting hosed by the vagaries of politicians.
What this means is I’m not doing a conversion of my existing tax advantaged accounts. In fact I’m not even moving all our contributions for 18 from Traditional 401k to Roth 401k. Instead I am shifting our new money towards post tax, from 50-50 pre to post to 60 percent post tax. This is similar to a tilt in stock investing terms, where you don’t abandon any class. You might think small caps will perform better then large caps so you hold more of them to take advantage, but you are still diversified. The same goes for my tax movements.
Roth 401K Represents the Easiest Way to Tilt For Me
The easiest way to enact my plan, without any conversions or other hoops, turned out to be contributing to a Roth 401k for some of our investments. As such I have shifted a portion of our 401Ks from traditional to Roth 401Ks.
My Shift is Primarily Psychological, But That is Fine
The risk of choosing wrong is small, the reward in monetary terms is probably just as small to be honest. Even all of one years 401K contributions pales in comparison to our exist accounts. But it also makes me feel like I’m doing something. That psychology, as it allows me to otherwise stay the course, is really the main reason I am acting at all. By doing something minor it keeps me from doing something stupid and major.
Have you made any changes in your tax advantaged investing in response to the new tax laws?