On taxes, Roth vs. traditional, and why you probably shouldn’t max out your 401(k)
“WAIT… WHERE’S THE rest of it?” I said in shock. In my hands was my first paycheck ever. As I stared blankly at the page, I was sure that there had been a mistake. My mother, who was standing nearby, overheard me and started to laugh.
But it wasn’t my mother’s normal laugh. No, this was a laugh that came with a sense of wisdom. She had known something for a long time that I was about to learn.
“Taxes, honey. Taxes,” she said with a grin.
I’m guessing you had a similar experience after getting your first paycheck as well. The moment of confusion followed by disappointment. “Wait… where’s the rest of it?” is a universal reaction.
So far we have ignored how taxes can affect your investment decisions, but this chapter changes that. In the following pages we will examine some of the most important tax-related investment questions including:
· Should I contribute to a Roth (post-tax) or a traditional (pre-tax) retirement account?
· Should I max out my 401(k)?
· How should I organize my assets?
These questions will provide general guidance on where you should be investing your money. Though the account types covered in this chapter will focus on those found in the U.S. (401(k), individual retirement account (IRA), etc.), the principles discussed apply anywhere where investing and taxation cross paths.
The Changing Nature of Taxes
Benjamin Franklin once said, “There are only two things that are certain in life—death and taxes.” Unfortunately, Franklin’s popular phrase is less true than it initially seems. You only need study the history of income taxes in the U.S. to see why.
Though the modern iteration of the U.S. income tax started in the early 1900s, income taxes in the U.S. have a much more complicated history. The first proposed income tax in the U.S. occurred during the War of 1812, but was never enacted.
The next time an income tax appears is in the Revenue Act of 1862 as a relief measure during the Civil War. This one passed, but was abolished a few years after the war in 1872.
Over two decades later, Congress imposed a peacetime income tax with the Revenue Act of 1894. Unfortunately for Congress, the tax was ruled unconstitutional by the Supreme Court a year later in Pollock v. Farmers’ Loan & Trust Co.
Despite these setbacks, popular support for the income tax continued. And in 1909, the 16th Amendment was passed. When ratification occurred in 1913, Congress officially had the power to “lay and collect taxes on incomes, from whatever source derived.”
Before the 16th Amendment, Congress could only legally receive revenue from tariffs and excise taxes on specific items, like alcohol or tobacco. However, with the 16th Amendment, they could now tax individual incomes as well. The modern version of the U.S. income tax was born.
However, it still was nothing like the income tax we know today. Not only were the rates lower (only 1% in 1913), but the exemption limit was so high that only 2% of American households paid the income tax.96 As you can see, we’ve come a long way since then.
I tell you the history of income taxes in the U.S. to illustrate the changing nature of U.S. tax policy. Unfortunately, this constant evolution in tax policy is what makes it so difficult to write about. As laws change in the future, the optimal decisions around those laws will change as well.
This is why I recommend getting professional help from a tax advisor. Why? Because, when it comes to taxes, individual circumstances matter a lot. Your age, family structure, state of residence, and much more will impact how you make investment-related tax decisions. Unfortunately, there is no one-size-fits-all solution when it comes to taxes.
Even so, the discussion that follows should provide a useful framework for thinking about taxes.
To start, we look at the age-old question: Should I contribute to a Roth or traditional retirement account?
To Roth or Not to Roth?
One of the most asked questions in personal finance is whether to sign up for a 401(k) or a Roth 401(k) retirement plan through your employer. As a reminder, a 401(k)—also called a traditional 401(k)—is funded with pre-tax money while a Roth 401(k) is funded with post-tax money. The only difference between these account types is when you decide to pay your taxes.
To illustrate this, below I will do a simple walk-through on how each of these account types work. Before we do that though, I should remind you that while I am discussing traditional vs. Roth 401(k)s, the same logic can generally be applied to 403(b)s and IRAs as well.
Let’s begin.
· Traditional 401(k): Kate earns $100 which she contributes directly into her traditional 401(k) without paying any income taxes. Over the next 30 years let’s assume that the $100 grows by 3x to $300. In retirement, Kate withdraws the $300 but has to pay 30% of it in income taxes. The final (post-tax) money that she can spend in retirement is $210 (or 70% of $300).
· Roth 401(k): Kevin earns $100 and pays a 30% tax rate on it today to have $70 after tax. He contributes the $70 directly into his Roth 401(k) where, over the next 30 years, it grows by 3x to become $210. In retirement, Kevin is able to spend all $210 without having to pay any additional income taxes.
Both Kate and Kevin end up with $210 in retirement spending because they had the same contributions, the same investment growth, and paid the same effective tax rates over time. Mathematically this makes sense because when multiplying a bunch of numbers together, the ordering of the numbers doesn’t matter.
3 × 2 × 1 = 1 × 2 × 3
Or in Kate and Kevin’s case:
(100 × 3) × 70% = (100 × 70%) × 3
The only difference between the two of them was when they paid their taxes, with Kate paying her taxes at the end while Kevin paid his at the beginning. This is why the traditional 401(k) vs. Roth 401(k) decision is irrelevant if your effective income tax rate is the same in your working years and in retirement.
Note that I say effective tax rate for simplicity’s sake, because in the real world marginal tax rates are what matter. For example, if Kate had taxable income greater than $9,875 in 2020, her tax rate would only be 10% for the first $9,875 in earned income and would increase to more than 10% for every dollar afterwards. For the rest of this chapter, you can assume that any mention of a tax rate is an effective rate (the average rate of tax across all income) unless specified otherwise.
To reiterate, it won’t make a difference whether you choose a traditional or a Roth if your effective tax rate is the same over time. However, if you do expect some variation in your income tax rate, then we can simplify the decision.
Simplifying the Traditional vs. Roth Decision
Given that the timing of taxes is the most important thing when deciding between a traditional 401(k) and a Roth 401(k), we can reduce this problem down to answering a single question:
Will your effective income tax rate be higher now (while working) or later (in retirement)?
All else equal, if you think your income taxes will be higher now, then contribute to a traditional 401(k), otherwise contribute to a Roth 401(k).
Yes, this answer is simple, but it ain’t easy. It’s simple because the goal when making retirement contributions is to avoid paying taxes when your tax rate is highest. However, this isn’t an easy question to answer because you have to consider how your federal, state, and local income taxes might change over time.
Thinking About Future Tax Rates
Given that future tax rates are what’s important when choosing between a traditional 401(k) and a Roth 401(k), your next question might be, “So Nick, what will future tax rates be?”
Unfortunately, I have no idea!
But neither does anyone else. You can try to use historical trends to think about whether federal or state tax rates will be higher or lower over the next few decades, but this is harder than it seems.
For example, in 2012, I was under the impression that U.S. federal income tax rates were likely to increase in the future to be somewhat closer to that of their European counterparts. But then, to my surprise, the Tax Cuts and Jobs Act of 2017 passed and lowered U.S. federal income tax rates. Predicting the future is hard.
Though I am not expecting you to forecast the future path of income tax rates in the U.S., I do think that taking time to think about your retirement situation can help clarify the traditional vs. Roth decision.
For example, let’s assume that you expect your federal effective tax rate to increase from 20% while working to 23% during retirement. All else equal, this implies that the Roth 401(k) would be the better option, as you would pay a lower tax rate now (20%) than you would expect to pay in retirement (23%).
But what if all else isn’t equal? What if you are working in a state with high income taxes now (e.g., California) and you plan on retiring in a state with low income taxes later (e.g., Florida)? In that case, using a traditional 401(k) would be preferred as the expected savings in state income tax today are likely to exceed the expected increase in federal income taxes in the future.
However, this will vary from state to state. For example, New York State residents who are aged at least 59.5 are entitled to a state income tax deduction of up to $20,000 if that money comes from a qualified retirement plan and meets some other criteria. I understand this complicates the calculus surrounding your retirement contributions, but it is worth noting.
Though we cannot predict future tax rates, what we can do is estimate how much income we will need in retirement and where we plan on taking that retirement. Having these two pieces of information can do a lot to clarify whether you should be contributing to a traditional 401(k) or a Roth 401(k).
When is a Traditional 401(k) Better?
Though there are a few scenarios where a Roth 401(k) would be preferred to a traditional 401(k), I generally prefer the traditional 401(k). Why? Because it has one thing that a Roth doesn’t have—optionality.
With a traditional 401(k) you have far more control over when and where you pay your taxes. If you couple this with the ability to convert a traditional 401(k) into a Roth IRA, you can play some interesting tax games.
For example, if you experience a year of low (or no) income, you can use this time to convert your traditional 401(k) into a Roth IRA at a lower tax rate.
I have friends who used this tactic while they were in business school because they knew they would be temporarily earning next to nothing. The taxes they paid on their conversions were far lower than what they would have paid had they made Roth 401(k) contributions while working.
But you don’t have to go to business school to use this strategy. Any prolonged period of low income (such as taking a year off to raise your children, going on sabbatical, etc.) can be utilized for greater tax efficiency.
Note that this assumes that your 401(k) balance is not greater than a year of your income. If it is, then you will be paying the same (or higher tax rates) when converting. Keep this in mind before converting your traditional 401(k) to Roth IRA.
Besides timing decisions, you can also change where you retire in order to avoid those cities/states that impose larger income taxes. This is why it probably doesn’t make sense to contribute to a Roth 401(k) while living in a high tax area like New York City, unless you know you are going to retire in an area with similarly high taxes.
Lastly, though we have been using effective tax rates throughout this chapter, marginal tax rates are what matter. For example, when you take traditional 401(k) distributions in retirement (as a single person), you pay only 10% on the first $9,875, 12% on the next $9,876 to $40,125, and so forth. This means that if you plan on taking distributions in retirement that would be lower than your current income, then a traditional 401(k) is the way to go.
For example, if you earn $200,000 while working but only plan to withdraw $30,000 a year in retirement, then the traditional 401(k) allows you to avoid the higher marginal rate while working and then pay the lower marginal rate when retired. At 2020 tax rates for single filers this would mean avoiding a 32% marginal rate to pay a 12% marginal rate instead.
Though I don’t know which of these tax tactics will be most useful to you in the future, I do know that none of these options are available with a Roth 401(k). The added flexibility associated with a traditional 401(k) is what makes it my go-to choice when it comes to employer-sponsored retirement vehicles.
When is a Roth Better?
Despite the lack of optionality in a Roth 401(k), there are a few special cases where a Roth might be the way to go. One of these cases is for people who are high savers.
Why is this true? Because maxing out a Roth 401(k) places more total dollars into a tax-sheltered account than maxing out a traditional 401(k). A little math will demonstrate this.
Imagine Sally and Sam max out their 401(k)s in 2020 by each contributing $19,500. While Sally places her $19,500 contribution into a Roth 401(k), Sam places his $19,500 into a traditional 401(k). After 30 years, let’s assume both of their accounts have tripled in value to $58,500. Unfortunately, Sam still has to pay income taxes. Assuming that he pays 30% in taxes, he will be left with only $40,950 to spend in retirement.
How did Sally end up with more in retirement than Sam? Sally placed more total dollars into her tax-sheltered account to begin with. For Sam to have $58,500 after taxes in retirement using his traditional 401(k), he would have had to contribute $27,857 into his account initially. However, since the maximum annual contribution amount into a traditional 401(k) was $19,500 in 2020, Sam is out of luck.
This simple example demonstrates that the Roth 401(k) is probably the better choice for high savers, as you get more total tax-deferred benefits.
In addition, as mentioned previously, the Roth is also better if you are reasonably certain that your tax rate in retirement will exceed your tax rate while working. If this is the case, then it is clearly better to use a Roth and pay your taxes now while they are relatively lower.
Why Not Both?
So far I have pitted the traditional 401(k) and Roth 401(k) against each other, as if they were a part of some sort of ancient rivalry. But they aren’t. There is nothing stopping you from relying on both of these account types in retirement.
In fact, for anyone who contributes to a Roth 401(k), if your employer matches contributions then you have a traditional 401(k) component in your account automatically, so you will have to get used to both. However, this isn’t a bad thing. Using both account types could allow for even more optionality than using either account by itself.
For example, I spoke with some retirement professionals who recommend utilizing a Roth 401(k) early in your career when your earnings may be lower and then switching to a traditional 401(k) later as your earnings increase.
This strategy is great because it avoids the highest tax brackets in your highest earning years and provides additional flexibility when making retirement withdrawals. And, as I mentioned previously, because the tax treatment of retirement withdrawals varies by state, a dual strategy might be the best solution to effectively navigate such a complex landscape.
Now that we have discussed the costs and benefits of a traditional vs. a Roth, let’s quantify how much tax benefit you get from using these accounts in the first place.
Quantifying the Benefit of a Retirement Account
When it comes to taxes and investing, there are two layers of taxation that you have to worry about. The first layer is the income tax, which we just discussed, and the second layer is capital gains tax. It’s the avoidance of the capital gains tax that makes retirement accounts so attractive.
For example, if you bought $100 of an S&P 500 index fund and sold it two years later at $120, you would have to pay long-term capital gains taxes on the $20 gain. However, when using retirement accounts (e.g., 401(k), IRA, etc.) there are no taxes on these gains, assuming you are of retirement age.
How much of a benefit do you get in a retirement account by avoiding these capital gains taxes? Let’s find out.
To do this we can simulate a one-time $10,000 investment into three different account types:
1. No Tax: A nontaxable account (e.g., Roth 401(k), Roth IRA, etc.) where all relevant income taxes have already been paid.
2. Taxed Once: A taxable account (e.g., brokerage) where capital gains taxes are only paid at account liquidation. Assume that there are no dividends to be paid and that all gains are realized at the end.
3. Taxed Annually: A taxable account (e.g., brokerage) where capital gains taxes are paid every year. Imagine that the entire portfolio is sold and re-bought once a year. This generates realized gains at the long-term capital gains rate.
All accounts will experience a 7% annual growth rate (over 30 years) and the taxable accounts will pay the 2020 long-term capital gains rate of 15% when applicable. Also, I am using a Roth 401(k)/IRA here because I only want to compare the effect of taxation that occurs after income taxes have been paid.
I have removed the first layer of taxation (income taxes) from this simulation to focus on the second layer of taxation (capital gains) explicitly. The point of this exercise is to quantify the long-term benefit of avoiding capital gains (No Tax vs. Taxed Once) and the benefit of not buying/selling annually (Taxed Once vs. Taxed Annually).
If we were to plot the growth of $10,000 for the No Tax and Taxed Once accounts over 30 years, after all applicable capital gains taxes had been paid, it would look like this:
After 30 years, the No Tax account ends up with $76,000 while the Taxed Once account ends up with $66,000. In percentage terms, the No Tax outperforms the Taxed Once account by 15% in total or by 0.50% annually over 30 years.
In other words, the benefit of avoiding capital gains taxes by using a nontaxable retirement account like a 401(k) is about 0.50% a year (assuming a 7% growth rate and 15% long-term capital gains rate). All else equal, this means that a 401(k) provides about half a percent more in after-tax return than a well-managed brokerage account.
But this comparison assumes that you will be able to buy and hold in your taxable brokerage account for 30 years. If you don’t have this level of discipline, then the calculus changes significantly. For example, if you were to trade in/out of your positions annually and pay long-term capital gains taxes along the way (i.e., the “Taxed Annually” strategy), you would lose an additional 0.55% in annual return to Uncle Sam.
Going back to our simulation, a $10,000 investment following the Taxed Annually strategy would only grow to $57,000 instead of $66,000 with the Taxed Once strategy. Trading too frequently costs you 17% in total, or about 0.55% a year.
When you combine this with the 0.50% lost by using a taxable account instead of a nontaxable account, that’s over 1% a year you lose to capital gains taxes. About half of that loss comes from using a brokerage account (instead of a retirement account) and the other half comes from trading in and out of that taxable account too often.
Why is the Taxed Annually strategy so disastrous for your investment returns? Because frequently trading in and out of your taxable account prevents your gains from compounding on themselves. Mathematically you only get 85% of your expected return when you realize gains annually at the 15% rate [1 – 0.15 = 0.85]. This is equivalent to compounding your wealth at 5.95% a year instead of at 7% a year because of the annual tax hit [0.85 × 7% = 5.95%].
For people who are too tempted to trade in and out of their positions each year, having that money in a 401(k) can boost after-tax returns by over 1% annually. This can be significant over longer periods of time.
However, for those who are more disciplined, putting as much money as possible into a retirement account may not be your best option. This is why, counter to mainstream financial advice, you probably shouldn’t max out your 401(k).
Why You Probably Shouldn’t Max Out Your 401(k)
I know that you’ve heard the advice many times before—if you can, max out your 401(k). It’s an almost universal recommendation among personal finance experts. In fact, I used to preach this advice as well.
However, since running the numbers, I’ve changed my tune. Maxing out your 401(k) is far less beneficial than it initially seems. Don’t get me wrong though. You should always contribute to your 401(k) up to the employer match. The employer match is basically free money that you do not want to miss out on. However, anything beyond the employer match needs to be considered more carefully.
As I highlighted in the prior section, the annual tax benefit of having your money in a nontaxable account compared to a well-managed taxable account is about 0.5% per year. However, that comparison assumed that you only make a single contribution into your account, and you earn no annual dividends. But we know that both of these assumptions aren’t likely to be true.
Most people will add money over time and will have to pay taxes on their dividends in their brokerage account. If we make these adjustments by using a 2% annual dividend and annual contributions for 30 years, then the after-tax benefit of a 401(k) increases to 0.73% per year.
While this is a somewhat sizeable premium, it doesn’t adjust for 401(k) plan fees. So far we have assumed that you would pay the same fees in a 401(k) as you would in a taxable account. But we know that this isn’t always the case. Because the investment options are limited in a 401(k) and there are administration and other plan fees, you will probably have to pay more in your 401(k) than in a taxable account.
And with the calculation above, if the investment options in your employer’s 401(k) plan are just 0.73% more expensive than what you would pay in a taxable brokerage account, then the annual benefit of your 401(k) would be completely eliminated.
This isn’t a high bar to hit. For example, if we assume that you would have to pay 0.1% per year in fund fees to get a diversified portfolio in a brokerage account, then paying anything more than 0.83% [0.73% + 0.1%] per year in your 401(k) would eliminate its long-term tax benefit entirely.
TD Ameritrade found that the average all-in cost for the typical 401(k) plan in the U.S. was 0.45% in 2019.97 This means that the average American gets a 0.38% annual benefit [0.83% – 0.45%] from their 401(k) plan (beyond the employer match).
Unfortunately, that’s not a lot considering that you have to lock up your capital until you are 59.5 years of age. While you can withdraw your money from a Roth 401(k) in certain circumstances, for all practical purposes you should act as if the money inside your 401(k) is inaccessible.
And what if your plan fees are higher than 0.45%? If you happen to be at a smaller company where the all-in 401(k) fees typically exceed 1%, then the long-term benefit of contributing beyond the match would be negative! Every dollar you contribute beyond the match would actually cost you money relative to putting that dollar in a well-managed taxable account.
On the other hand, if the all-in costs of your employer’s 401(k) plan are low (0.2% or less), then there is still some monetary benefit to maxing out.
But, before you do, you should ask yourself: is an extra 0.6%–0.7% a year worth locking up a decent part of your wealth until old age? I’m not necessarily sure.
I ask this question because I feel like I made a financial mistake by contributing too much to my 401(k) when I was younger. While my retirement projections look great now, I also placed some limits on what I can do with my money.
For example, because I maxed out my 401(k) throughout most of my 20s, I can’t currently afford the sizable down payment required to buy a place in Manhattan. I’m not even sure if I want to buy anytime soon, but if I did, it would take me a few extra years to get there because of my excessive 401(k) contributions. This is partially my fault for not planning ahead, but it’s also because I was seduced by the “max out your 401(k)” advice when I was younger.
This is why it’s hard for me to support maxing out your 401(k) for an extra half a percent a year (or sometimes less). That illiquidity premium is just too small to be worth it, even if you don’t need the money for something like a down payment on a house.
Of course, if you change any of the assumptions I’ve made so far, the decision around whether to max out your 401(k) would change as well. For example, if the long-term capital gains tax rate were to increase from 15% to 30%, the annual benefit of a 401(k) over a brokerage account would increase from 0.73% to 1.5% per year. That’s a big difference that could tip the scales in favor of maxing out your 401(k).
In addition, there are strong behavioral reasons for why you might want to max out. For example, if you are someone who finds it difficult to manage their own money, then the automation and illiquidity provided by a 401(k) could be exactly what you need to stay the course. You won’t find these benefits in a spreadsheet, but they definitely matter.
Ultimately, the decision to max out your 401(k) will be dependent on your individual circumstances. Factors such as your temperament, financial goals, and the cost of your employer’s 401(k) plan will all play a role in this decision. Make sure you have considered these factors carefully before moving forward.
Now that we have discussed the pros and cons of maxing out your 401(k), we can conclude our discussion of taxes by addressing the best way to organize your assets.
The Best Way to Organize Your Assets
It’s not about what you own, but where you own it. What I’m talking about is asset location, or how you distribute your assets across different account types. For example, do you have your bonds in your taxable accounts (e.g., brokerage), your nontaxable accounts (e.g., 401k, IRA, etc.), or both? What about your stocks?
The conventional wisdom suggests that you should put your bonds (and other assets that pay frequent distributions) into your nontaxable accounts and your stocks (and other high-return assets) into your taxable accounts. The logic is that, if you have more bond income (i.e., interest) than stock income (i.e., dividends), you should shelter that income from taxes.
More importantly though, since the tax rate on bond income is higher than the tax rate on stock income (ordinary income vs. capital gains), having your bonds in your nontaxable accounts would avoid these higher rates.
Historically, this strategy would have made sense when bond yields were much higher than dividend yields on equities. However, when bonds have lower yield/growth, shielding them from taxes may not be the best choice.
In fact, if you want to maximize your after-tax wealth, then you should put your highest-growth assets in tax-sheltered accounts (e.g., 401k, IRA, etc.) and your lowest-growth assets in taxable accounts.
This is true even though tax rates on ordinary income (and interest) exceeded those on capital gains in 2020. If you want to understand why high-growth assets are better off in nontaxable accounts, let’s use an example.
Imagine you put $10,000 into two different assets (Asset A and Asset B). Asset A earns 7% a year and pays no dividends/interest while Asset B pays 2% each year in interest. After one year, the account for Asset A will have $10,700 (before taxes) and the account for Asset B will have $10,200 (before taxes).
Assuming a 15% long-term capital gains rate and a 30% tax rate on interest income, the taxes owed from Asset A would be $105 [$700 gain × 15%] while the taxes owed from Asset B would be $60 [$200 interest × 30%]. Since we want to minimize our taxes paid, it would be better to have Asset A in a nontaxable account, even though it doesn’t pay any interest/dividends.
This example illustrates why you need to consider the expected growth rate of your assets in addition to the tax rates on income/capital gains before making an asset location decision.
Additionally, by placing your high-growth (and likely higher-risk) assets into a nontaxable account, you may be less tempted to sell them during a market crash because they are harder to access.
The other added benefit of this strategy is that your low-growth assets (bonds) are likely to maintain their value and provide you with extra liquidity when you need it most. Having your low-growth (and lower-risk) assets in your taxable accounts means that they are more easily accessible than if they were in a nontaxable account. So, when the market crashes, the assets that are most likely to maintain their value are the ones that are also most accessible.
However, separating high-growth and low-growth assets between taxable and nontaxable accounts could make it harder to rebalance across accounts. For example, if you have all your stocks in your 401(k)/IRAs and then they get cut in half, you can’t add money from your brokerage account to these accounts to rebalance. Though it might be mathematically optimal to put your higher-growth assets into your nontaxable accounts, I don’t like it because of the difficulty this creates for rebalancing.
This is why I prefer having the same allocation across all my accounts. This means that my brokerage account, IRAs, and 401(k) all hold similar assets in similar proportions. They are carbon copies of each other.
I prefer this method because it’s easier for me to manage them than having stocks in one account, REITs in another, and bonds somewhere else. It’s not the most tax-efficient solution, but it’s the solution that I prefer.
In full, if you are someone who needs to get a bit more return, then sheltering your higher-growth assets in nontaxable accounts is the way to go. However, if this isn’t as important to you, then having similar allocations across account types may allow for easier management of your investments.
Now that we have examined how to optimize where you store your wealth, let’s discuss why that wealth will never make you feel rich anyways.
96 Brownlee, W. Elliot, Federal Taxation in America (Cambridge: Cambridge University Press, 2016).
97 Leonhardt, Megan, “Here’s What the Average American Typically Pays in 401(k) Fees,” CNBC (July 22, 2019).