Is there a Roth IRA & Roth 401k Paradox?

I’ve been thinking about the new Roth 401(k) a bit, and running some numbers to figure out whether or not it is a better option than the regular 401(k). Originally, this post was going to be a post about those results, with an eye towards helping people who are making the same decision. Instead, however, I feel like I stumbled on a financial planning paradox.

Let me explain.

A Roth 401k is a relatively new option that some employers have started to offer as a retirement benefit to employees. With a Roth 401(k), like a Roth IRA, you do not get a tax deduction from your income on contributions. However, when you retire, you do not have to pay taxes on your withdrawals. In fact, when you leave the company, you roll it over into a Roth IRA, and it behaves just like any other Roth IRA.

If you exclude the estate planning benefits of Roth IRAs (which are significant in some situations), running the numbers shows that basically the Roth 401(k) is a big bet on your tax rate. With the Roth 401(k) you are betting that your tax rate when you retire will be higher than your tax rate now.

For example, let’s take an employee, Bob, who is 35-years old and has been able to save $5000 a year in his normal 401(k). In 2007, his company launches a Roth 401(k). Bob has a 31% marginal tax rate. Bob has the uncanny ability to generate exactly 8% on his investments, year-in, year-out. Should Bob switch over?

Well, Bob has been able to contribute $5000 to his old 401(k), so let’s just assume that’s the pre-tax cash he has available for retirement, period. If Bob contributes $5000 to his normal 401(k), he will have accumulated $566,416.06 by the time he is 65 years old. If we assume Bob can safely withdraw 4% of that per-year in retirement, he will generate $22,656.64 in income per year. However, he needs to pay tax on that income. Assuming his tax rate stays the same at 31%, he’ll get $15,633.08 per year after tax.

But what if Bob switches to the Roth 401(k)? Well, he no longer gets the deduction from his income, so Bob can’t afford to put $5000 per year into the Roth 401(k). With a 31% tax rate, Bob can only afford to put in $3450 (yes, I am grossly oversimplifying all the payroll taxes for this example). At $3450 per year, Bob will accumulate only $390,827.08 by the time he retires at 65. Sounds like a bad deal, right?

Wrong! That $390,827.08 is tax-free. If Bob pulls out 4% per year, he will pull out… $15,633.08 per year! That’s right, the same exact number! The Roth 401(k) is a wash.

Well, as usual, it’s not that simple. If the tax rate at retirement is only 28%, then the regular 401(k) wins. At a 28% rate, Bob gets to keep $16,312.78 per year. If the tax rate is 35%, then the Roth 401(k) wins. At 35%, Bob would only keep $14,726.82 per year.

So you could argue the Roth 401(k) is a big bet – will your tax rate be higher or lower in retirement? Some young people might believe it will be higher. When you start working, often you are at the bottom of your earning potential, and you might have big plans for your accumulation of assets over the next 40 years. Also, if you’ve read the Ben Stein book, you know that neither the US Government nor individuals are saving enough for retirement. That means higher tax rates in the future as the US Government tries to close the gap.

But they could be lower too, right? Are you really going to save enough to replace your current income? Do you need too? After all, in retirement, you aren’t paying off a mortgage, you aren’t putting kids through college, and you aren’t spending as much on clothing or consumables.

Tough call.

Now, there is a special case that doesn’t come down to this bet. What if Bob actually had $30,000 per year to save, but the 401(k) maximum is only $15,500 in 2007? Well, in that case, the Roth 401(k) is the better bet for sure, because saving $15,500 per year tax-free is better than saving $15,500 per year in an account that will eventually pay taxes.

But let’s ignore that case for now, because I want to explain the paradox. It’s really bugging me.

Let’s say you believe your tax rate is going to be higher in retirement. You put your money into Roth accounts to protect them. In fact, you manage to get all of your retirement assets in there.

Well, in that case, all of your retirement income is tax-free, which throws you into a lower tax bracket. In fact, the lowest tax bracket. And that makes your initial assumption false – you would have been better off taking the tax deduction when you were working.

BUT if you don’t put your money in Roth accounts, you’re back to square one, where it looks like your future tax rate will be higher than now.

This loop does have a solution – basically you should put some of your money in Roth accounts… enough to bring your taxable income in retirement down to a level that is equal to your current tax rate. That’s a really complex calculation when you consider issues like Social Security and predicting the tax structure of the US in 2040.

So, if you are fortunate enough to have high enough savings where you max out your retirement accounts, you probably don’t worry too much about this. Stuff your Roth 401(k) to the brim, and use other savings vehicles to cover the excess.

But if you don’t have that much money, the right answer is likely a mix of both taxable and non-taxable accounts. What that right mix is will be based on your estimation of how high your tax rate will be when you retire.

Don’t forget, this logic also applies to that famous 2010 loophole in Roth IRA conversion that I wrote about last year. The question of whether or not to covert is all about this bet on future tax rates.

If it helps, here are a few more articles I found on this topic. I hope my explanation above helped more than it hurt. 🙂