Conventional wisdom touts Roth 401(k) plans as the better choice for most taxpayers over regular 401(k) plans. But a paper in the July 2008 issue of the Journal of Financial Planning, published monthly by the Financial Planning Assn. (FPA), argues that not only are regular 401(k) accounts superior to Roth 401(k)s for all but the wealthiest of taxpayers, but they’ll also remain superior even if future tax rates rise.
The conventional wisdom is that, if a retiree’s tax rate is the same as the tax rate when they were contributing to a 401(k), it shouldn’t make any difference whether that person puts money into a regular 401(k), whose contributions are tax-deferred or a Roth 401(k), whose contributions are made with after-tax dollars. The retiree will end up with the same amount of after-tax money way.However, side fund analyses argue that it isn’t an apples-to-apples comparison. For example, an affluent taxpayer putting the maximum $41,000 into a 401(k) would actually need $56,944 in order to fund the Roth. That’s because the taxpayer would need to pay $15,944 in taxes on the $56,944 (at a 28% tax rate) in order to have $41,000 left to fund the Roth. A taxpayer using a traditional 401(k) would need only $41,000, as it’s not taxed upfront.
To make the comparison fair, side fund analyses create a taxable side account for the regular 401(k) contributor and fund it with an amount equal to the extra amount needed to fund the Roth 401(k)—in McQuarrie’s example, $15,944. They then compare the after-tax results, and the Roth version wins. McQuarrie illustrates that the supposed superiority of these analyses is flawed because so much depends on analysis assumptions such as the taxpayer’s age and asset allocation.But the more important argument McQuarrie makes for the superiority of the regular 401(k) is the difference between marginal and effective tax rates. Let’s say a taxpayer is in the 28% marginal tax bracket. That is, all or most of that taxpayer’s deferred contributions to a regular 401(k) account would probably have been taxed at that 28% rate if not contributed to the 401(k). That saves the taxpayer money upfront, but of course they have to pay taxes on the contributions and their earnings, when withdrawing funds during retirement. But that person doesn’t pay the 28% tax rate on every withdrawal dollar.
Under our progressive tax system, the first dollars of taxable income are assessed at the lowest tax rate (10%), then the next chunk of income is taxed at the next higher rate, and so on until the last chunk of dollars is taxed at the taxpayer’s highest rate. The result is an effective or average rate for the taxable income that’s lower than the top marginal rate. In McQuarrie’s example, the effective rate is 19.4%, not 28%. Workers using regular 401(k)s are deferring taxes at their marginal rate, but paying taxes at their lower effective rate when they withdraw the money during their retirement years, making them a superior choice for most taxpayers. McQuarrie also demonstrates that, the effective tax rates are likely to remain lower than the marginal rates for most taxpayers even if Congress increases future tax rates, leaving the regular 401(k) still the better choice.
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Check the difference of: Taxable vs. tax-advantaged saving comparison
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