Many taxpayers ask the question: should I contribute to a Roth 401(k) or contribute to a Roth IRA? While there is no universal answer to this question, for many in the financial independence (FI/FIRE) community, I believe there is a clear answer.
Roth Accounts
What is not to love about Roths? If withdrawn properly, they promise tax free growth and tax free withdrawals. Further, Roths (be them 401(k)s or IRAs) give taxpayers tax insurance: income tax increases in the future are not a problem with respect to money invested in a Roth account. Roths even provide some ancillary benefits during retirement if the United States ever adopts a value added tax (a “VAT”).
Roth IRAs
Roth IRAs are an individual account and can be established at a plethora of financial institutions. Most working taxpayers qualify to make annual contributions to a Roth IRA. However, the ability to make an annual contribution to a Roth IRA phases out at certain income levels and is completely eliminated at $140,000 (single) or $208,000 (married filing joint) of modified adjusted gross income (2021 numbers).
The maximum annual contribution to a Roth IRA is $6,000 (if under age 50) or $7,000 (if age 50 or older) (2021 and 2022 numbers).
I have previously written about my fondness for Roth IRAs. One reason for my fondness is that annual contributions can be withdrawn from the Roth IRA at any time for any reason tax and penalty free. Thus, Roth IRAs can perform double duty as both a retirement savings vehicle and as an emergency fund. This is an advantage of Roth IRAs over Roth 401(k)s.
Of course, considering their tax free growth, it is usually best to keep amounts in a Roth IRA for as long as possible.
Roth 401(k)s
Roth 401(k)s are a workplace retirement plan. Contributions can be made through payroll withholding. Many employers offer a Roth 401(k), though they are far from universally adopted.
The Roth 401(k) does enjoy some advantages when compared to its Roth IRA cousin. First, there is no income limit to worry about. Regardless of income level, an employee can contribute to a Roth 401(k). Second, the contribution limits are much higher than the contribution limits for Roth IRAs. As of 2021, the annual Roth 401(k) contribution limit is $19,500 (under age 50) or $26,000 (age 50 and older).
The Roth 401(k) is not a good account for emergency withdrawals. Withdrawals occurring prior to both the account holder turning 59 ½ years old and the account turning 5 years old generally pull out a mixture of previous contributions and taxable earnings.
Roth 401(k) vs Roth IRA
So which one should members of the FI/FIRE community prioritize? Contributions to a Roth 401(k) or contributions to a Roth IRA?
To help us answer that question, let’s consider a young couple pursuing financial independence:
Stephen and Becky are both age 30, married (to each other), and pursuing financial independence. They both would like to retire at least somewhat early by conventional standards. They each have a W-2 salary of $90,000. They have approximately $2,000 of annual interest and dividend income. They claim the standard deduction. At this level of income, they have a 22 percent marginal federal income tax rate. Stephen and Becky each have access to a traditional 401(k) and a Roth 401(k) at work. They would like to maximize their retirement plan contributions.
How should Stephen and Becky allocate their retirement plan contributions? Should they contribute to a Roth 401(k) and/or to a Roth IRA?
To my mind, the best play here is to contribute to a Roth IRA ($6,000 each) and contribute to a traditional 401(k) ($19,500 each). Stephen and Becky should not contribute to a Roth 401(k).
There is a significant tax opportunity cost to making a Roth 401(k) contribution: the ability to deduct a traditional contribution to a 401(k). Remember, the Roth 401(k) shares the $19,500 annual contribution limit with the traditional 401(k). Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional 401(k).
For Stephen and Becky, the hope is that in early retirement tax laws either stay the same as they are today or at least keep today’s flavor. The idea is to take a deduction while working at a 22 percent marginal tax rate (by contributing to the traditional deductible 401(k)). Then, in early retirement, they convert amounts in the traditional 401(k) to a Roth. At that point, hopefully they have a marginal federal income tax rate of 10 percent or 12 percent. Many early retirees have an artificially low taxable income (and thus, a low marginal income tax rate) prior to collecting Social Security.
Contrast the significant tax opportunity cost of making a Roth 401(k) contribution to the tax opportunity cost of making a Roth IRA contribution: practically nothing.
Stephen and Becky have no ability to deduct a traditional IRA contribution because of their income level and the fact that they are covered by a workplace retirement plan. Thus, they aren’t losing much, from a tax perspective, by each making a $6,000 annual Roth IRA contribution.
Situations Where the Roth 401(k) Contributions Make Sense
For those in the financial independence community, generally there are four situations where choosing to contribute to a Roth 401(k) makes sense. In three of these situations, the tax rate arbitrage play available to Stephen and Becky isn’t available. In the fourth situation (tax insurance), there is a separate consideration causing the taxpayer to forgo an initial tax deduction to get assurance as to the tax rate they will be subject to.
In the situations below, a Roth 401(k) contribution is likely preferable to a traditional 401(k) contribution. As compared to a Roth IRA contribution, (a) the first contributions should generally be to the Roth 401(k) to secure the employer match, and then after that, (b) generally both the Roth 401(k) and the Roth IRA work well. To my mind, the emergency-type fund feature of the Roth IRA, which I’ve previously discussed, is probably the tiebreaker in favor of making the next contributions to a Roth IRA.
Transition Years
Think about a year one graduates college, graduate school, law school, or medical school. Usually, the person works for only the last half or last quarter of the year. Thus, they have an artificially low taxable income (since they only work for a small portion of the year). Why take a tax deduction for a contribution to a traditional 401(k) in such a year, when one’s marginal federal income tax rate might only be 10 percent or 12 percent?
Transition years are a great time to make Roth 401(k) contributions instead of traditional 401(k) contributions.
Young Earners with Low Incomes
Many careers start with modest salaries early but have the potential to experience significant salary increases over time. My previous career in public accounting is one example. Medicine is another example. Young accountants and doctors, among others, making modest starting salaries should consider Roth 401(k) contributions at the beginning of their careers. As their salaries increase, they should consider shifting their contributions to a traditional 401(k).
As a *very general* rule of thumb, those in the 10 percent or 12 percent marginal federal income tax rate (particularly those not subject to a state income tax) should consider prioritizing Roth 401(k) contributions (regardless of occupation).
No Hope
Picture a charismatic franchise NFL quarterback. He’s got a $40M plus annual NFL contact, endorsement deals, business ventures, and likely a long TV career after his playing days are done. For him, there is no hope ( 😉 ). He will probably be in the top federal income tax bracket the rest of his life. He might be well advised to “lock-in” today’s low (by historical standards) 37% federal income tax marginal tax rate by choosing to contribute to a Roth 401(k) instead of to a traditional 401(k).
Tax Insurance
We really do not know what the future holds. That includes future federal and state income tax rates.
Thus, some workers may want to buy tax insurance. Roth 401(k) contributions are a way to do that. The extra tax paid (because the taxpayer did not deduct traditional 401(k) contributions) is an insurance premium. That insurance premium ensures that the taxpayer won’t be subject to future income tax (including potential tax rate increases) on amounts inside the Roth 401(k) and the growth thereon.
Remember, none of this is “all or nothing” planning. Some may want to allocate a piece of their workplace retirement plan contributions to the Roth 401(k) to get some insurance coverage against future tax rate increases.
Conclusion
In the FI community, a maxed out traditional 401(k) and a maxed out Roth IRA (whether through a regular annual contribution or through a Backdoor Roth IRA) can be the dynamic duo of retirement savings. This combination can provide tax flexibility while maximizing current tax deductions. Roth 401(k) contributions often have a significantly greater tax opportunity cost as compared to the tax opportunity cost of Roth IRA contributions. In such situations, the Roth IRA is preferable to my mind.
Of course, each individual is unique and has different financial and tax goals and priorities. The above isn’t advice for any particular individual, but hopefully provides some educational insight regarding the issues to consider when allocating employee retirement account contributions.
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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.
