401(k)

The choice between contributing to a traditional or Roth IRA. It’s been a long-running debate ever since the Roth IRA was created at part of the Taxpayer Relief Act of 1997. As we discussed in the last post, both types of IRAs have valuable tax advantages. Utilizing a traditional IRA allows you to avoid taxes on contributions and gains, but you are taxed on withdrawals. In contrast, with a Roth IRA you are taxed on your contributions, but your gains and withdrawals are tax-free. So which is better? (In this article I’ll be comparing traditional and Roth IRAs, but the principles also apply to traditional and Roth 401(k)’s as well.)

Why aren’t we discussing taxable brokerage accounts in this argument? I think the decision whether to contribute to an IRA vs a taxable brokerage account should be obvious. Max out your IRA before putting money into a taxable account, since in an IRA you don’t have to pay tax on capital gains. But the choice between a traditional IRA and a Roth IRA is a little harder. Both are good options for investing your savings, and either should be used before contributing to taxable account. For my analysis on which is better for tax avoidance purposes, I assumed:

• Taxpayers are married filing jointly
• They are in the second tax bracket ($19,901 to $81,050)
• They take the standard deduction ($25,100)
• Inflation affects costs evenly

There is a Definitive Winner

I crunched the numbers and it turns out that the answer is based on your savings rate. If you have a high savings rate, a traditional IRA is better, and if you have a lower savings rate, a Roth IRA is better. The break even point mathematically comes out to be when your IRA contributions can drop your effective tax rate by half. When that happens, you should pick a traditional IRA over a Roth.

If your IRA contributions are less than a certain amount, then it’s better to contribute to a Roth. For example in 2018 the median income for a Midwest family was $64,069/year and their effective tax rate would be 6.6% (after the standard deduction). If this family was regularly contributing $10,000 to a traditional IRA, their effective tax rate would drop to 4.8%, saving them $1,200 in taxes. But when they retire, they would withdraw $54,069/year and incur $3,078 in taxes. This equates to a loss of $1,878 per year due to taxes. So as you can see, we haven’t reached the break even point yet.

If they were contributing $17,900 to a traditional IRA [This is more than the IRA limit, but you could do this with a traditional 401(k) which we already said works in practically the same way], their taxable income drops to $21,069 for an effective tax rate of 3.3%. If they contributed the same amount to a Roth, their taxable income would be $38,969 for an effective tax rate of 6.6%. This is where the break even point is, where contributing to either a traditional or Roth is equally beneficial. If this family were to contribute more than $17,900 they should contribute that money to a traditional IRA, if there were to contribute less, they should opt for a Roth IRA.

What about Inflation?

Again, this is assuming married filing jointly, and taking the standard deduction which is pretty common in the Midwest. This means that all income is taxed in the 10%-12% bracket. The tax code is pretty kind towards Midwest families in that between $19,901 and $81,050 you are only taxed at 12%. And if you include the standard deduction of $25,100 a family can make up to $106,150 before reaching the next tax bracket!

This is also ignoring inflation. Normally I’d get mad at any accountant who ignores inflation, but in this case I think the math works out. The variables that change with inflation are:

• Income
• Cost of living
• 401(k) contributions
• The standard deduction
• 401(k) contribution limits
• Withdrawals (Cost of living in retirement)

Inflation should affect all of these factors evenly (or close enough to be negligible). Below is a table of incomes and which retirement accounts to contribute your savings towards. If a family makes $40,000/year they should contribute up to $5,800 to a Roth 401(k), if they’re saving more than that they should contribute the rest to a traditional.

Income	Roth	Traditional
$40,000	<$5,800	>$5,800
$60,000	<$15,800	>$15,800
$80,000	<$25,800	>$25,800
$100,000	<$35,800	>$35,800

Try it for Yourselves

I uploaded the spreadsheet I created. If you want to test it out with your own income and savings just download it and fill in the two green boxes. The result in the yellow box is how much you’ll save in taxes by choosing a traditional over a Roth IRA. If the result is negative then you’re better off contributing to a Roth IRA.

I have read a few articles stating that a traditional IRA is better, but they are usually assuming dual incomes, large salaries, and high savings rates. However here in the Midwest $80,000/year is considered a high salary and it’s not uncommon to have only one working spouse and the other stays home to take care of the children. So in our case a Roth is almost always a better option.

Tax Rate	Married Filing Jointly
10%	Up to $19,900
12%	$19,901 to $81,050
22%	$81,051 to $172,750
24%	$172,751 to $329,850
32%	$329,851 to $418,850
35%	$418,851 to $628,300
37%	$628,301 or more

Roth IRA Conversion

There’s also the option of a Roth conversion, which is using a traditional IRA then slowly converting it to a Roth after you retire. If you only convert enough to reach the standard deduction each year, you’ll never have to pay any taxes on it. Of course in 2021 that’s assuming you don’t need more than $25,100/year. Living off that little income is hard, but not impossible, especially if you’ve already paid off your house.

Again this is assuming you have an extremely high savings rate, something that’s hard to do when you only make the median Midwest income of $64,069/year. If you can do it, more power to you! But if you’re closer to the normal end of the savings spectrum, after running the numbers, I’d recommend using a Roth when you can. These principles also apply to 401(k)’s, but as I mentioned in my previous post on what order to contribute to your various retirement accounts, if your company offers a 401(k) match contribute enough to your 401(k) to get the match regardless of whether it’s a traditional or Roth 401(k).

What do you think? Do you agree with my analysis? Do you contribute to a traditional IRA, Roth IRA, or both? Let us know in the comments below!

There are a ridiculous amount of different retirement accounts. To name a few: the Traditional IRA, 401(k), 403(b), and 457(b). There are also Roth variants of each of them. Another that is fairly common is the taxable brokerage account. Which ones should you use as your investment vehicle? And in what order should you contribute your savings into each one? If you need a refresher on financial terms, I have a glossary here. Image source: History.com

For tax purposes the three main types of investment accounts are the Traditional IRA and 401(k), the Roth IRA and 401(k), and the taxable brokerage account. The question is, “What is the best way to use these three accounts to minimize the amount you owe in taxes?”

Three Different Retirement Accounts

Taxable Brokerage Account

The red parts are taxed and the green parts are tax-free. It’s obvious from this graphic that both kinds of IRA/401(k) are better than a brokerage account when it comes to taxes because you are not taxed on gains.

The first thing we have to discuss is availability. The 401(k), 403(b), and 457(b) are all basically the same thing, but only government workers have access to a 403(b) or 457(b). In order to simplify things I’ll only discuss the 401(k), since all of the principles that apply to a 401(k) also apply to a 403(b) and 457(b).

Everyone has access to a taxable brokerage account. There are two different kinds of accounts you can open, an individual account and a joint account. You can have any number of either (although I can’t see any reason why you would need to). You can open one up at any brokerage firm.

Everyone also has access to an IRA as long as they have earned income. As the name implies, you can only open an individual IRA, but a non-working spouse can also open up an IRA and fund it with their joint money (as long as they file taxes jointly). There are age limits for a Traditional IRA and income limits for a Roth IRA.

Traditional IRA:	Roth IRA
Pre-Tax	After Tax
Must be under age 72	No age limit
No income limit	$198,000 (married filing jointly)

A 401(k) is like an employer-sponsored IRA

Like an IRA there are also traditional and Roth variants of the 401(k). The difference (other than the contribution limits) is that there is no income limit for the Roth 401(k). The real question is whether or not your employer offers a traditional 401(k), or Roth 401(k), or both. Most large employers offer a traditional 401(k). Roths are less common, but they are gaining traction. Also smaller employers are less likely to offer a 401(k).

Traditional 401(k):	Roth 401(k)
Pre-Tax	After Tax
Must be under age 72	Must be under age 72
No income limit	No income limit

According to the Bureau of Labor Statistics 56% of companies offer a 401(k). Of those companies, 70% offer a Roth 401(k), and half (51%) match a certain percent of your 401(k) contributions. The average 401(k) match is 3.5%.

If you happen to be one of the lucky people whose company sponsors a 401(k) and offers a 401(k) match, the first thing you should do is contribute enough to get your full 401(k) match. If they match everything you contribute up to 4% of your salary, then you need to contribute 4% to get your full match. That’s free money! Don’t just leave it on the table. If you contribute $3000 and your company matches that $3000, that’s a 100% return on investment. There is no other investment that will give you a 100% return in a year!

Example – Use a 401(k) and a Roth IRA

Let’s pretend you’re a typical Midwestern family with a single income earner that makes $60,000/year. Your company offers a traditional 401(k) and will match your contributions up to 3.5% of your salary. If you want to save 15% of your income that would be $9,000/year. My first suggestion after setting up your 401(k) would be to open up a Roth IRA for both you and your spouse.

1. First 3.5% goes in your Traditional 401(k)
2. The next $6,000 goes into your Roth IRA
3. Any leftover savings go into your spouse’s Roth IRA
4. * (If you are really saving a lot or make a higher salary, after maxing out both of your Roth IRAs, the next step is to put any leftover savings into your 401(k) again.)
5. ** (If you still have more savings after maxing out your 401(k), put the rest into a joint taxable brokerage account. This is probably not applicable since you would have to be saving more than $31,500.)

I believe this is the most efficient way to save for retirement. For the first step you get to claim your full company match in your 401(k) and you get to decrease your taxes by 3.5%. In the second and third steps you max out your Roth IRA and put the leftovers into your spouse’s IRA. This doesn’t decrease your taxes this year, but allows you to take out all your money (including gains) tax free at 59½.

But that’s not all. Before you’re 59½ you can take out any money you’ve contributed to a Roth IRA. (You can’t withdraw the gains without paying a 10% penalty, but you can withdraw contributions because you’ve already paid the taxes on that money.) This makes the Roth IRA the perfect tool not only for retirement, but also for an emergency fund or college fund etc. You get the interest of the stock market, but you can withdraw the money you’ve contributed whenever you need it.

What if your company offers a Roth 401(k)?

If your company offers a Roth 401(k) I would pick that over the traditional 401(k), but I would keep the steps the same:

1. First 3.5% goes in your Roth 401(k)
2. The next $6,000 goes into your Roth IRA
3. Any leftover savings go into your spouse’s Roth IRA

The advantage of a Roth 401(k) is that you can roll it over into your Roth IRA and not have to pay any taxes in retirement.

The other advantage of maxing out your IRA before your 401(k) is that you have more control over what funds you can invest in. With a 401(k) you only have the investment options that your company provides. Sometimes these options aren’t great, or have high management expense ratios. There was a bit of a scandal a few years ago when it was exposed that many 401(k) providers charged unnecessarily high fees. Since that scandal broke and the lawsuits followed, most 401(k) providers now offer a regular S&P 500 Index Fund with lower fees so they are much better than they were before.

So that’s my recommendation. I have read a few articles that claim a Traditional IRA/401(k) is better for tax purposes but most of those are Silicon Valley types making the assumption of high salaries. For a typical Midwest family I believe a Roth IRA/401(k) is the better option. I go into detail about the math of that claim in Roth or Traditional IRA, Which is Better?

What do you think? Do you agree with my analysis? Do you contribute to a 401(k), IRA, or both? Let us know in the comments below!