Retirement Complexity Made Simple: Younger Than 40? Choose the Roth 401(k)
Why it’s probably better to pay some tax now, rather than in retirement
If you’re younger than 40 and saving for retirement, well done. An early start is a huge advantage.
But if you are saving through a workplace 401(k), chances are you’re blowing a great opportunity to maximize savings. Most 401(k) plans offer both a Traditional 401(k) and a Roth 401(k). The Roth 401(k) is the better option when you are younger, based on the long-term impact of taxes.
Yet most young people don’t save in a Roth. Vanguard, a major administrator of 401(k) plans, says 75% of the plans it operates offered a Roth 401(k) option in 2019. Yet among those between the ages of 25 and 34 with the ability to save in a Roth, just 16% did. Among those 35 to 44, it’s just 13%.
What gives? It’s employers who are screwing this up. The majority of plans automatically enroll new employees in a Traditional plan.
The good news is that it's super easy to switch. Ping HR and switch your future contributions to the Roth 401(k).
The big difference between a Traditional and Roth 401(k) is when you pay tax. With a Traditional you contribute tax-free dollars now and pay taxes on the income you withdraw in retirement. With a Roth, you contribute after-tax dollars now and pay no taxes on withdrawals in retirement.
An online calculator can show you how it works. A web search of “Traditional 401(k) or Roth 401(k) calculator” will spit out some candidates.
Like all retirement calculators, their value is based on the quality of the assumptions they (or you) choose. To be honest, there’s no online calculator that takes into account every possible factor at play. That said, you can play around with plenty of scenarios and get a sense of what is best for you long-term.
Your current tax rate. If you used online tax prep software this year, your rate was likely shown on the summary page. Or search “individual tax rates 2020.” If you’re single and have income between $40,126 and $85,525, or are married and file jointly with income between $80,251 and $171,050, in 2020, your top federal tax rate is 22% (If you pay state income tax, add that in.)
Your expected rate of return. Better calculators ask for two estimates: what you expect to earn while working/saving, and what you expect to earn in retirement, when the smart advice is to invest more conservatively. Try 8% for working years and 5% in retirement.
Check yes when asked if you want to invest the tax savings from the Traditional. This is the best way to make an apples-to-apples comparison. Better calculators automatically do this for you.
How many years you expect to need the money in retirement. Subtract your target retirement age from 95, the minimum age you should plan for.
Your expected tax rate in retirement This is the big question. But there are ways to make a smart guess if you weigh a few key factors. The old-school advice was to assume your tax bracket will be lower in retirement, and that favors saving in a Traditional.
But for a variety of reasons, there’s a good probability your tax rate in retirement won’t be lower. According to a PayScale survey, women typically hit peak earnings around 44, men at 55. When you’re at peak earnings, using the Traditional may make sense; the tax break is worth more when your tax rate is highest. Until you reach 40 or so, your yet-to-peak earnings are a good reason to consider the Roth 401(k).
Keep in mind that tax rates themselves change. Right now tax rates we’re all paying are near historic lows. The federal deficit is on the rise — even before coronavirus spending. So tax rates in the future could rise.
If you save well, your income in retirement mightn’t drop much. If you save in a Traditional 401(k), every dollar you withdraw is taxed as income. A chunk of Social Security may be taxed as income. If you are in line for a pension, that’s taxable income too. Add that up and you could very well stay in the same tax bracket.
So to figure the expected tax rate in retirement, start by plugging in your current rate, then rerun at lower (and higher) rates to see what really matters: the actual after-tax value of your money in retirement.
Consider a 25-year-old who expects to retire at 70 and live until 95. If they invest $10,000 a year (earning 8% now and 5% in retirement) and we presume the same 22% tax rate now and in retirement, the Roth will generate around $30,000 more a year in income over a 25-year retirement.
Drop the retirement tax rate to 12% and it’s a wash. (Roth is still a wee bit better.)
Finally, know that the lower your taxable income in retirement, the lower your Medicare premium. Withdrawals from a Traditional can mean a higher Medicare premium. Advantage: Roth. And if you end up rocking the finances and have more money than you need come retirement, Roth accounts can be converted and left untouched for the kids and grandkids. With Traditional accounts, the IRS will require annual withdrawals starting at 72, so it can collect tax.