The conventional wisdom says to accumulators “Save through a Roth 401(k)! Don’t you dare contribute to traditional 401(k)s. Those things are infested with taxes!!!”
Doubt that prioritizing Roth 401(k) contributions over traditional deductible 401(k) contributions is the conventional wisdom? Let’s hear from some very prominent personal finance commentators:
- Suze Orman has come out for Roth 401(k) contributions over traditional 401(k) contributions.
- Dave Ramsey’s Ramsey Solutions recommends the Roth 401(k).
- In July 2023, Ed Slott wrote this article strongly encouraging Roth 401(k) contributions instead of traditional 401(k) contributions. He doubled down in March 2024, colloquially stating that the IRS might own 60% or 70% of a traditional retirement account.
- Clark Howard strongly recommended Roth 401(k) contributions on his podcast.
- Jill Schlessinger advocates for prioritizing Roth 401(k) contributions over traditional deductible 401(k) contributions.
These commentators have much bigger platforms than I have, and they are to be commended for their many solid contributions to the personal finance discourse. On this particular issue, however, I believe their conventional wisdom misses the mark. I believe most of those saving for retirement during their working years should prioritize traditional deductible 401(k) contributions.
Here are the eight reasons why I believe the conventional wisdom on the traditional 401(k) versus Roth 401(k) debate is wrong.
Traditional Retirement Account Distributions are Very Lightly Taxed
Those 401(k)s and traditional IRAs are infested with taxes, right!
I have run the numbers in several blog posts and YouTube videos. Long story short, while working contributions into traditional 401(k)s generally enjoy a tax benefit at the taxpayer’s highest marginal tax rate while traditional retirement account distributions are taxed going up the progressive tax brackets in retirement (including the 10% and 12% brackets). This results in surprisingly low effective tax rates on traditional 401(k) and traditional IRA withdrawals in retirement.
The Tax Hikes Aren’t Coming
If “experts” keep predicting A and the exact opposite of A, B, keeps occurring and A never occurs, then the experts constantly predicting A aren’t good at predicting the future!
That’s where we are when it comes to predicting future tax hikes on retirees. Experts keep predicting that taxes are going through the roof on retirees. Experts use those predictions to justify the Roth 401(k) contribution push.
There’s a problem with those predictions: they have been dead wrong!
I did a video on this. Not only does Congress avoid tax hikes on retirees, recent history indicates Washington is addicted to tax cuts on retirees. To wit:
- December 2017: TCJA increases the standard deduction and reduces the 15% bracket to 12%. There are few better ways to cut retiree taxes!
- December 2019: The SECURE Act delays required minimum distributions (“RMDs”) from age 70 ½ to age 72.
- March 2020: The CARES Act cancels 2020 RMDs and allows those already taken to be rolled back into retirement accounts in a very liberal fashion.
- November 2020: The Treasury gets into the act by publishing new RMD tables that reduce annual RMDs.
- December 2022: SECURE 2.0 purports to delay RMDs from age 72 to ages 73 or 75 (for those born in 1960 or later). Congress was in such a rush to cut taxes on retirees the House didn’t dot the Is and cross the Ts from a Constitutional perspective!
Sure, the federal government has too much debt. Does that mean that taxes must necessarily rise on retirees? Absolutely not!
There are many solutions that can leave retirees unscathed, including:
- Raising tariffs.
- Raising taxes on college endowments, private foundations, high income investors’ dividends and capital gains, and hedge fund managers.
- Eliminating electric vehicle tax credits.
- Spending cuts, particularly to military spending and foreign spending. These are becoming more likely as American politics continue to change.
Conventional Wisdom Misses the Sufficiency Problem
How much tax do you pay on an empty 401(k)? How much tax do you pay on a nearly empty 401(k)?
Those crying wolf over taxes in retirement miss the real issue: sufficiency! According to this report, the median American adult wealth is about $108,000 as of 2022 (see page 16).
Let’s imagine all that $108K is in a traditional retirement account. Few will take it all out at once. The rather annual modest withdrawals will hardly be taxed at all due to the standard deduction and/or the 10% tax bracket.
If people are behind in their retirement savings, what’s the best way to catch up? Deduct, deduct, deduct! Those deductions save taxes now, opening the door for more savings. For those behind in retirement savings, sacrificing the valuable tax deduction to make Roth contributions makes little sense in my opinion. Why? Because those behind in retirement savings will face very low taxes in retirement.
Sadly, the median American adult has a sufficiency problem and would be fortunate to one day have an (overblown) tax problem instead!
Missing Out on the Hidden Roth IRA
Q: What’s it called when I take money out of a retirement account and don’t pay tax on it?
A: A Roth IRA!!!
Well, many Americans have a Roth IRA that lives inside their traditional 401(k). I call this the Hidden Roth IRA.
Prior to collecting Social Security, many Americans will have the opportunity to take tax free distributions from their traditional IRA or 401(k) because they will be offset by the standard deduction.
If all your 401(k) contributions (and possible employer contributions) are Roth, you miss out on the Hidden Roth IRA.
I break down the phenomenon of the Hidden Roth IRA in this video.
Missing Out on Incredible Roth Conversions
Did you know that you might be able to do Roth conversions in retirement and pay federal income tax at a 6% or lower federal tax rate? It’s true! I break that opportunity down in this video.
If you’re telling a 22 year old college graduate that all of their 401(k) contributions should be Roth you’re foreclosing many or all future Roth conversions! Why? Shouldn’t younger workers be setting up low tax Roth conversions in retirement while they are working?
“Roth, Roth, Roth!!!” sounds great and makes for a fun slogan. But it precludes incredibly valuable future tax planning!
The Widow’s Tax Trap and IRMAA are Overblown
The Widow’s Tax Trap is a phenomenon in American income taxation where surviving spouses pay more tax on less income. It’s real. But just how bad is it?
In one example, I found that an incredibly affluent 75 year-old married couple would be subject to a combined effective federal income tax/IRMAA rate of 15.44%. The surviving spouse would then be subject to a combined 19.87% effective rate after the first spouse’s death.
That’s the Widow’s Tax Trap. Real? Yes. Terrifying? No.
Few things are as overblown in American personal finance as IRMAA. IRMAA, income-related monthly adjustment amounts, are technically increases in Medicare premiums as one’s income exceeds certain thresholds. In practice, it is a nuisance tax on showing high income in retirement.
In one extreme example, I discussed a 90 year old widow with $304,000 of RMDs and Social Security income. Her IRMAA was about $5,500, a nuisance tax of about 1.8% on that income. Annoying? Sure. Something to factor into planning during the accumulation phase? Absolutely not.
Missing Out on Premium Tax Credits
Mark, age 22, graduates from college and buys into “Roth, Roth, Roth!!!” Every dollar he contributes to his 401(k) is in the Roth 401(k), and he elects to have all his employer 401(k) contributions put into the Roth 401(k) as well. At age 55, Mark decides to retire. He has a paid off house, $200,000 in a savings account, and $2.5 million in his Roth 401(k).
Mark will be on an ACA medical insurance plan from retirement (or the end of COBRA 18 months later) until the month he turns 65. There’s just one big snag: he has no income! Because of that he will not qualify for the combination of an ACA plan and a Premium Tax Credit, since, based on income, he’s eligible for Medicaid. Ouch!
Mark falls into this trap because he has no ability to create taxable income in retirement. Had he simply put some of his 401(k) into the traditional 401(k), he could have “turned on” taxable income by doing Roth conversions (mostly against the standard deduction!). Doing so would qualify Mark for hundreds of dollars in monthly Premium Tax Credits, greatly offsetting the significant cost of ACA medical insurance. Note Mark could turn on income by claiming Social Security at age 62, permanently reducing his annual Social Security income.
Retirement Isn’t the Only Priority
The tax savings from a traditional 401(k) contribution can go to tremendously important things before retirement. Perhaps a Mom wants to step back from the workforce to spend valuable time with her infant son or daughter. Maybe Mom & Dad want to pay for a weeklong vacation with their children. Maybe a single Mom wants to qualify her son for scholarship money.
There are pressing priorities for retirement savers prior to retirement. You know what can help pay for them? The tax deduction offered by a traditional 401(k) contribution.
Conclusion
The Conventional Wisdom is wrong!
Traditional deductible contributions to 401(k)s and other workplace retirement plans are a great way to save and invest for the future. Future taxes are a drawback to that tactic. But they have to be assessed keeping in mind the eight reasons I raise above. To my mind, it’s more important to build up wealth than to be tax efficient. As discussed above, those aren’t mutually exclusive, including for those using traditional deductible 401(k) contributions for the majority of their retirement savings.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Sean, this all makes sense and causes me to rethink going back to more traditional 401k contributions. Although its secondary to your point in this article I am curious if you a recommend and approximate percentage of Roth, Traditional, and Brokerage goal to consider when still in accumulation phase but nearing early retirement in a year or two (assuming relatively low tax bracket before and after retirement) to capture the needed income for ACA and other breaks but ultimately not end up with too much money down the line for RMD that were not converted for one reason or another if one solely used traditional 401k’s
Thanks for keeping the articles coming.