Followups Personal Finance

Roth versus non-Roth: If you make a lot Roth probably makes sense

This is a followup to a recent post, where I attempted to dispel some myths around 401k investing and discuss when and when not to invest in a 401k.

I received the following question: “One question though – we are now in the 37% bracket but let’s say I don’t expect to need income above the 24% bracket in retirement. Assuming taxes don’t go up (which they very well might), that makes Roth conversion less favorable no? It depends I guess on how much is base contribution vs how much is capital gain when you withdraw?”

It’s a great question, and in this post, I’m going to lay out some scenarios where Roth is preferred and where it is not preferred. Reminder, with a Roth retirement account you pay the income taxes now and do not pay them when you retire. In a non-Roth, you don’t pay income taxes now, but pay them later. In a qualified retirement account (Roth or non-Roth), you avoid capital gains taxes.

So the question is basically wondering if there is a “tax arbitrage” in that you expect your income tax rate to decline in the future, so you might as well wait and pay that lower rate rather than paying the taxes right now (via a Roth).

Punchline is if you are in this high of an income bracket, you will probably have more savings than can go into a 401k. And while you may be in a lower tax bracket in the future, the capital gains benefit offsets this and suggests utilizing a backdoor Roth.

Ok, let’s get to it.

This specific scenario:

If you are in the 37% marginal tax bracket right now and expect to drop to the 24% marginal tax bracket in the future, then that’s a 13 percentage point gap (you are paying the marginal rate on these investments). However, given this high starting income tax bracket, traditional IRA’s are likely closed off to you, so your choices are 401k’s and Roth-IRA’s (via the backdoor discussed in this post). Now, as discussed previously, unless utilizing a brokerage-linked 401k, you may be paying average 401k fees of 0.82% compared to 0.09% if you just invested in a market-tracking ETF. So that’s about a 0.75% headwind every year from choosing to invest in a 401k rather than a Roth IRA. It’d take about 18 years to eat away at the 13 percentage point tax savings. So if you plan on retiring earlier than 18 years from now, then the Roth is likely not for you if you only looked at this this way. If it’s more than that, then you should consider a Roth IRA. But that’s not the only consideration.

However, you should take two other considerations: (1) tax rates may rise over time, especially if government spending rises (there is a government budget constraint that dictates taxes must rise if spending continues to rise without an offset) and I’m benchmarking this to the current paradigm; Exhibit 5 shows US Federal budget deficit over time; (2) If you are retiring in the next 18 years, you may want to max out your 401k, but at this income level, you likely have excess savings beyond what you’re putting into your 401k. And the question is what to do with those – option A is put it any old account and invest and pay capital gains taxes, which would be about 15% when you retire (under the current regime). For your specific inputs, you’d need to earn about 87% by the time you withdrew the funds from the retirement account to justify the capital gains shield. That may seem high, but that’s about a 3.5% annual return with compounding – quite low. So if you believe that, you should consider a Roth.

General scenarios

I’ve put together the below matrices that try to answer the question depending on different current and future income tax brackets posed in the question. For simplicity, these are presented for married filing joint couples. If you want to see them for another category, please post a comment, and I’ll make them. The main conclusion is you have 20 years to retirement, it basically makes sense to use a Roth if you have filled up your 401k in basically every scenario.

Exhibit 1 shows the gap between your current and future tax rates based on your current income and future income.

Exhibit 2 shows the number of years until retirement to justify a Roth versus a 401k if you pay 0.82% annual fees to a 401k and 0.09% in a Roth.

Exhibit 3 is designed for if you have already maxed out your 401k and need to decide between a Roth and a non-capital gains protected account. It shows the return required on the invested amount to justify Roth’s capital gains tax advantage versus a non-capital gains protected account.

Exhibit 4 takes Exhibit’s 3 output and shows the implied annual return required over a 20year window to justify a Roth over a non-capital gains protected account.

Note: For simplicity and to be conservative, I simply took the 0.82% fee from a 401k manager and applied it to the opening balance; reality is as the investment grows, they will take more of it since the 0.82% is on the entire balance, which makes this conservative.

Exhibit 5: US Federal Budget seems to have been growing steadily absent the 1990’s when briefly returned to surplus