Common mistake when deciding between Traditional versus Roth for retirement savings
A common retirement discussion I have with my clients at the beginning of the year is “Which retirement account should I save towards: Traditional or Roth?” Very often, I will see people recommend, either through articles or podcasts, something along the following:
- “If you’re in a higher tax bracket now than you think you’ll be in retirement – go Traditional”
- “If you’re in a lower tax bracket now than you think you’ll be in retirement – go Roth”
While that advice in theory sounds accurate, it’s not complete and it’s usually not that cut-and-dry. Aside from the fact that income tax thresholds change every year, and marginal rates can change at the stroke of a pen, the most common mistake I see people make when offering this sort of advice is ignoring the step to invest the current year tax savings you receive when contributing to a Traditional retirement account. If you fail to do this, the math behind the above quotes will not favor the Traditional account.
If you defer a % of your salary to your 401(k), whether you choose Traditional or Roth, you’re simply contributing the same amount of $’s towards that account. And assuming you invest in the same investments whether you choose Traditional or Roth, you’re going to end up with the same 401(k) balance, however, the Traditional will be all pre-tax dollars, while the Roth is completely tax-free. For the math to balance this out, it’s important to be investing your tax savings as well.
I’ll illustrate this below:
Let’s say you have an employee who is starting at a new company and getting set up with his new 401(k) plan. He is 30 years old and will be contributing the maximum allowable amount each year ($23,000; $30,500 when 50 or older). Let’s also assume his investments return 8% on average annually.
Regardless of whether this employee chooses Traditional or Roth, given the contributions and assumed investment returns, by the end age of 60 he will have a 401(k) balance of $3,198,740.
If you were offered the account on the left or the account on the right, you obviously are choosing the Roth every time, as that money is entirely tax-free. The after-tax value of the Traditional 401(k) in the above example would be significantly less compared to the Roth.
And of course, every individual’s tax situation is different, but even if we assume this individual would have an effective tax rate of say 15% in retirement, his Traditional 401(k) would have an after-tax value of $2,718,929. That’s an after-tax value of $475,811 less than the Roth 401(k), with the same amount of money contributed over the 30-year time period. All this while he’s paying a lower tax rate in retirement than when he was working. If he simply followed the above advice of “higher bracket while working than retirement -> choose Traditional” and took no further action, he could potentially have significantly less available funds for retirement.
This brings us back to the main point, which is the necessity to invest your current year tax savings should you be contributing to a Traditional retirement account. The benefit of choosing a Traditional 401(k) is the current year tax deduction you receive for doing so. With a Traditional 401(k), every $ you contribute is deducted from your income when calculating your Adjusted Gross Income (AGI). For simplicity purposes, let’s say the employee in our example grossed $150,000 in 2024. If he contributed $23,000 to a Traditional 401(k), that will reduce his AGI to $127,000. If he contributed that $23,000 to a Roth 401(k), his AGI would remain at $150,000. As a Single taxpayer, he’d save $5,520 in Federal income taxes this year ($23,000 x 24% marginal bracket) contributing to a Traditional 401(k).
Now let’s assume this 30-year-old chooses the Traditional 401(k), except this time, he also invests that $5,520 / year of tax savings in a Roth IRA. (If you make too much to contribute to a Roth IRA, a taxable account will be just fine as well.)
Assuming the same contribution limits and 8% investment return, by the end age of 60, this individual will have that same $3,198,740 Traditional 401(k). But he’ll also have a $767,698 Roth IRA to compliment his 401(k). If we again assume that the $3,198,740 will pay 15% in taxes on each distribution, that would bring this after-tax value $3,486,627.
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After-tax value of Traditional 401(k) = $3,198,740 x 85% = $2,718,929
Value of Roth IRA = $767,698
Total after-tax value of retirement portfolio = $2,718,929 + $767,698 = $3,486,627
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This is how you make the quotes at the beginning of the article accurate (i.e., higher tax bracket now = Traditional). In the scenario we reviewed, the client is in a lower bracket in retirement compared to his working years, so the math works in favor of the Traditional because he invested his tax savings.
Now, everything we reviewed here is to illustrate how to help maximize the after-tax value of your retirement portfolio. Every individual’s financial situation is unique, and you may find yourself in a position where Traditional is more favorable even if you cannot invest the tax savings. It may be a situation where those tax savings allow you to pay your child’s college expenses. Or the tax savings help with the current monthly bills. Or you invest the tax savings into your business to help your business grow instead of your portfolio. So, it certainly depends. But the main point to take away from this is: you don’t want the deciding factor of Traditional or Roth to simply be based on the speculation of “higher bracket/lower bracket now versus later”. And if you do choose Traditional, spending the tax savings you create on discretionary expenses or simply letting it sit in your cash savings will tilt the math in favor of Roth.
Additional benefits of Roth accounts for retirement:
- Could potentially reduce income enough in retirement that a lesser amount of your SS is taxable, or even taxable at all
- Could potentially reduce your income in retirement enough that your Long-Term Capital Gains are now in the 0% tax rate
- No RMDs to push you into higher marginal tax brackets later in retirement
Drew Schaffer, CFP®
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