In the last episode, we reviewed regular pretax 401K. In this episode, we will dig deeper into Roth 401K. We will also analyze whether it is better than a pretax 401K.
Hi. My name is Vijay Mohan, and you are watching Investment Insights.
Roth 401K is another flavor of 401K. In regular pretax 401K, we don't pay tax when we contribute. But we pay tax when we withdraw after retirement like regular income tax.
As we are contributing without paying the tax, it is called pretax 401K.
Roth 401K is totally opposite to this - it is post tax. That means we pay tax for the money we contribute, but we don't have to pay any tax when we withdraw the money.
We don't have to pay even a single cent of tax when we withdraw.
That is the most important difference between regular pretax 401K and Roth 401K. Other than that, both the plans are the same.
"What? We don't have to pay tax for withdrawal in Roth 401K? That's great! Then it is clear. We can just contribute in this Roth 401K, right?"
Not so fast. To compare pretax and post tax accounts is not that straightforward. To fairly and correctly compare them, we have to make some adjustments.
As always, let's look at a sample calculation.
We will use the same example as in the 401K episode. Income: 120,000 dollars. Federal Marginal Tax rate: 22%. Illinois state tax: 5%. 401K growth rate: 8%.
In the pretax 401K, in 25 years, it would have grown to 1.6 million.
In Roth 401K, we're only contributing after paying tax, so we don't have the $5535 dollars of tax savings that we have in Pretax 401K.
That means, while we are able to contribute 20,500 dollars in pretax, in post tax, we are only contributing 14,965 dollars.
In fact, in Roth, just like in pretax 401K, we can contribute up to 20,500. But to keep the comparison accurate, we have to use the total money that is going out of our hand.
So in pretax 401K, all of the money we contributed, $20,500, goes into the 401K account. However, in Roth, 27% of the 20,500 has to be paid in tax.
So in Roth, 5,535 dollars has to be paid in tax, and the left over 14,965 is what actually gets contributed into the 401K account.
In 25 years, it will grow to be 1.18 million.
Or in other words, if we remove the tax savings growth 437,000 dollars from the pretax balance 1.61 million, that will result in 1.18 million as well.
The math works out right?
So how can we compare the pretax balance 1.61 million and the Roth tax free balance of 1.18 million?
If we were to withdraw the same amount of money from each each year, how many years will these accounts last? - would that help us to compare? Definitely.
So in the regular pretax account, if we were to withdraw $150,000 each year, what is the tax that we have to pay for that 150,000?
The standard deduction we get in married filing jointly is $25,900.
We have to pay tax on the remaining income. For 20,000, 10%, for 63,000, 12%, and for the remaining 40,000, 22%.
A total of $18,542 in federal tax, and $6,205 in state tax (5%). So the total final tax is $24,747.
So after paying for taxes, we get $125,000 in our hand every year. The money left in the account still grows at the 8% growth rate.
If we continue to withdraw like this ever year, our balance will last for 25 years.
Now, let's do the same $150,000 withdrawal every year for the Roth 401K account. Remember - our balance here is only 1.18 million.
"Now wait a second! In the pretax account, we were only able to get $125,000 in hand each year. Shouldn't we use the same amount here for Roth as well, right?"
That's right! I was checking if you were keeping up with the math. So, we can use the same $125K withdrawal here as well.
If we do this, then this account will last for 18 years. So which one is better? The pretax 401K, which will last 25 years, or the Roth 401K, which will last 18 years? Pretax, of course.
"Wait, wait. What if, instead of contributing $14,965, we max it out instead? Then what will happen?"
Well, after 25 years, the balance will be the same as pretax 401K - 1.61 million. But we still have to pay the 27% tax when we contribute.
To compensate for this, we can do something in the pretax scenario. We can take that extra $5535 and invest it in a brokerage account.
We can buy an index fund with that savings to get the same 8% return. Now our comparison is balanced. The result will be fair.
In this new scenario, the balance of both the pretax and Roth accounts will be 1.61 million. But in the pretax scenario, there is also 437,000 in the brokerage account.
Now let's say that we are withdrawing 175,000 each year. Then, in the pretax scenario, with 31,000 going to tax, we get 143,000 in hand each year.
This account will last 17 years.
If we do the same thing in Roth, it will last 30 years. Clearly, Roth is the winner here.
But wait - did you forget about the money in the brokerage account for the pretax scenario?
The brokerage money (437K) will be growing at 8% for 17 years.
In the first 17 years, our need will be withdrawn from the pretax account, and once that is gone, our 143,000 need will be withdrawn from this brokerage account.
The long term tax for capital gains is 15%. Assuming that we don't have any other income for that year, there is 0% capital gains tax on the first $83,350 dollars.
You may be surprised to hear that. Yes, if our source of income is just long term capital gains, the first $83,000 won't be taxed.
The rest of the money gets taxed at 15%. So for our $143,000 need, we would need to withdraw $154,000 dollars (with tax) every year.
When we do this every year, this brokerage account balance will last another 25 years. So, the pretax scenario will last 44 years.
That is definitely better than the 30 years that Roth was able to last.
You can do the math for your own situation. For 99% of people, pretax is the better option.
A general rule to follow is: If you are in 10% marginal tax rate, definitely choose Roth 401K.
If you are in 22% marginal tax rate, then you can split the contribution 50/50 between Pretax and Roth.
Folks with marginal tax rate higher than 22%, should definitely contribute in pretax.
For people in higher tax brackets, the savings that they earn by doing pretax are higher. Saying that, there are some exceptions where Roth could be a better option.
Let's say that you are expecting 2 million or more in your 401K account after retirement. Then it is better to have whatever is higher than that 2 million in Roth.
Because our goal is to withdraw in such a way that we stay below 22% tax bracket.
Any need above that amount, we should plan to keep in Roth so that we can withdraw tax free.
Next, let's say that you are expecting income after retirement from different sources.
That extra income along with the withdrawal from pretax, could push you into a higher tax bracket.
If you could be in a situation like that, you should consider Roth.
Lastly, because the money you withdraw from Roth is tax-free, you can withdraw as much money as you want.
After retirement, if you are planning to buy a yacht that will cost millions, then you would have to withdraw a lot of money at once.
If you would like to have an option like that, then you can consider Roth.
If you don't know for sure, then always go with Pretax 401K. That should be your default option.
In the next episode, we will look at After-Tax 401K and what funds to invest in for 401K. Thank you.