Yesterday I posted Time to Stop 401(k) Contributions?, arguing that as applied to many in the FI community, traditional deductible 401(k) contributions are fine.
Today two very interesting pieces of content hit my radar. First, one of my favorite personal finance content creators, Clark Howard, is advocating for Roth contributions instead of traditional contributions for most Americans.
Second, UBS and Credit Suisse issued their Global Wealth Report for 2023. Allow me to call your attention to page 16. The median American adult has personal wealth just a bit under $108,000. This means almost half of American adults have less than $100K of wealth, and the majority of American adults do not have $200K of wealth. For most Americans, deferred taxation is not the problem! Sufficiency is the problem!
For me this report cracks the case. If the median American adult does not have close to sufficient wealth to comfortably retire, why are they worried about taxes in retirement?
Assuming this report is anywhere near close to a correct measure of adult American wealth, I believe I am correct and personal finance legends Ed Slott and Clark Howard are wrong when it comes to the traditional 401(k) versus Roth 401(k) debate.
The best way for working Americans to address sufficiency problems is by contributing to traditional, deductible retirement accounts. As demonstrated below, one employing this sort of deduct, deduct, deduct strategy would need to be successful well beyond what most Americans accomplish in order to create a tax problem.
When one has insufficient resources for retirement, the traditional, deductible 401(k) makes the most sense. He or she needs to build up assets, not worry about future taxes! With relatively little in the way of resources, future taxes are not likely to be a problem (especially in retirement when compared to one’s working years). Further, by contributing to a traditional, deductible 401(k) instead of a Roth 401(k), one behind in retirement saving takes home more money to invest in additional saving mechanisms such as Roth IRAs and taxable brokerage accounts.
Let’s Break Down Some Retirement Numbers
I believe we need some numbers to figure out who’s right.
Example 1: I start with Single Sally, who is 75 years old. Since she is somewhat like the median American, but older, let’s assume she has $250,000 of wealth and receives $30,000 a year in Social Security. Assume further that all $250K is in a traditional IRA and Sally, age 75, wants to live for today: she isn’t constrained by the 4% rule but rather decides to withdraw 10 percent per year ($25,000). On that $55,000 annual gross income, Single Sally pays just over $2,000 in federal income taxes (an effective rate less than 4%).
Why would Sally pass on a 10%, 12%, or 22% deduction from a traditional 401(k) contribution during her working years? Why would Single Sally put the money in a Roth 401(k) so as to avoid a less than 4% federal income tax in retirement? And how different is Sally’s situation from that of many Americans?
Update 8/17/2023: Single Sally is in the Tax Torpedo, an interesting tax phenomenon with a modest impact on her total tax liability. I added a spreadsheet to look at this in more detail.
Example 2: But Sean, I’m reading your blog. I’m not shooting for just $250K in retirement wealth! Okay, let’s start testing it by considering wealth significantly above the mean and median adult Americans. Single Sarah is 75 years old. She receives $30,000 a year in Social Security. But now she also has a $1M traditional IRA and takes an RMD ($40,650) based on her age. Single Sarah also has some taxable accounts and thus has $4,000 of qualified dividend income and $1,000 of interest income. On that approximate $76,000 annual gross income, Single Sarah pays just over $7,200 in federal income taxes (an effective rate of a bit more than 9.5%).
In order to grow a $1M traditional IRA (likely rolled over from workplace 401(k)s), she almost certainly was in the 22% or greater federal marginal tax bracket while working. Why would Single Sarah switch from taking a 22% tax deduction (the traditional 401(k) contribution) to a Roth 401(k) contribution to avoid a 9.5% effective federal tax rate in retirement?
Example 3: Example 3 is Single Sarah at age 80. Her investments are doing so well her traditional IRA is still worth $1M, causing her to be required to take a $49,505 RMD. This causes her federal income tax to increase to $9,175, for an effective federal income tax rate of almost 11%.
How many Americans will get to age 80 with $1M or more in tax deferred accounts? Even if they do, how bad is the tax problem? If Single Sarah’s effective tax rate is 11%, a 50% tax hike gets her to about 16.5%. Will she enjoy paying that tax? No. Is it crippling? Hardly!
Conclusion
The next time you hear “30 or 40% of your 401(k) belongs to the government” you should consider my examples. For many Americans, “10%” will be much closer to the mark than 30% or 40%.
It’s time to step back and ask whether prioritizing Roth 401(k) contributions during one’s working career is the best advice for the majority of Americans. As demonstrated above, a tax increase of 50 percent (highly unlikely) would result in most Americans having an effective tax rate below 20% in retirement.
I believe for many Americans, the optimal retirement savings path combines deductible workplace 401(k) contributions with Roth IRA contributions at home.
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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, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Loved your reference to the “Man from Roth” Clark Howard! It’s surprising that his name does not get mentioned more in the FI community. He did retire in his early 30’s after all.
I don’t always agree with Clark’s Roth recommendations either, inclusive of the Roth 401k. However, I believe he has gone on the record saying that one reason he is so Roth-focused with his listeners is to “trick” them into funding more for retirement spending later, i.e. with the Roth, a $6,500 contribution today will not require netting out for taxes later. So his well-intended Roth deception is directed at the insufficiency problem you noted above and may not necessarily result in the lowest lifetime taxation.
Thanks for the back-to-back posts.
FI Designer’s point is good. Both with 401(k) and Roth, a person can use Roth accounts to increase total tax-protected savings, relative to tax deferred 401(k) and IRA accounts. For people who expect a similar marginal tax bracket in retirement and who are at the maximum annual deposit amounts, switching from tax deferred to Roth is a winning move. As you clearly describe in this blog post, however, the vast majority of people will end up with retirement tax brackets that are below those of their working years.