Return of the Roth 401k—But still I say, don’t go there!

I thought I’d plunged a stake into the heart of the Roth beast with my Journal of Financial Planning article in 2008.

But no. Even my favorite and most highly esteemed financial columnist, Jason Zweig of the Wall Street Journal, has succumbed to the siren song of Roth.

Once more into the breach.

Common sense:

1. Of course, you should contribute to a Roth if you forecast a higher tax rate in retirement than while working.
2. And if you forecast that you will bear about the same tax rate in retirement, you can also justify switching to Roth contributions under the heading of “tax diversification.”
3. But if your tax rate in retirement will be lower than your tax rate while working, how foolish to pay taxes now at, say, 32%, to save on taxes later at, say, 25%. Or even 15%. Dumb and dumber.

So what will your tax rate be in retirement, on your 401k distributions, many years hence?

Forecasting tax rates

This is where journalists invariably punt. I mean, who the heck knows what rate you, the concrete individual, one of millions of subscribers to the WSJ, will have to pay decades hence?

But there’s no need to punt. To narrow down your probable tax rate in retirement, let me suggest the following gut simple, universally applicable rule, in two parts:

1. Contributions to a traditional 401k are deducted at your marginal tax rate. They come off the top of your income stack.
2. Distributions from a traditional 401k are taxed at your average tax rate. They are your income stack!

Not quite, of course—as a middle class person, you’ll also receive Social Security, regardless of whether you contributed a dime to your 401k. So logically, we can assign the bottom of your retirement income stack—the first $19,400 to which the 10% tax bracket applies for married couples—to social security; and likewise, we can assign your standard deduction, now $24,400, to social security.  Because only 85% of social security is taxable, an allowance of $19,400 + $24,400 accounts for about $51,500 of social security income, in 2019—not unreasonable to expect, for a pair of married professionals. 

It follows that all your 401k (and other tax deferred) distributions will be taxed in the 12% bracket or higher (under Trump rules). Your retirement income stack begins at 12%.

Your tax stack for 401k distributions, then, is the weighted average of the proportion of your distributions that falls into the 12%, 22%, 24%, 32%, 35%, and 37% brackets—under Trump.  If the Obama tax brackets are restored before you retire—a reasonable fear—your tax stack is the income that falls into the 15%, 25%, 28%, 33%, 35%, and 39.6% brackets.

The rule: compare your marginal tax rate while working, to your average tax rate while retired.  Those are the two numbers that make the call for Roth-yes or Roth-no.

Now we can take a specific case and compare marginal tax rates while working and contributing to a 401k, to expected average tax rates when retired and taking 401k distributions. Once we determine whether the retirement tax rate will be higher or lower, the Roth decision is straightforward.

Example: Running the numbers

Jack and Jill are 50 years old, both professionals, pulling down $400,000 before retirement contributions or other deductions.  Under Trump, they are well into the 32% bracket (under Obama rules, they would have been near the ceiling of the 33% bracket). 

As earlier agreed, Jack and Jill should do the Roth, if their (average) tax rate in retirement will be higher than 32%; and they may consider the Roth as tax diversification, if their anticipated average tax rate on their 401k distributions will be anywhere close to 32%–say, any anticipated rate on the order of 30% +/-.

And here, the simple and devastating question can be asked:

Under Trump (Obama) rates, at what retirement income will Jack and Jill have an average tax rate equal to 32%?

It won’t be $400,000—that income is taxed at a mix of 12%, 22%, 24%, and 32% under Trump.  To average out at 32%, we will need to add income taxed at 35%, and maybe some income taxed at 37%.  How much exactly?

Here is the table.

Trump tax rates			Obama tax rates
Bracket	Bracket ceiling	Tax paid in bracket & in total	Bracket	Bracket ceiling	Tax paid in bracket & in total
12%	$78,950	$7,146	15%	$78,950	$8,932
22%	$168,400	$19,679	25%	$159,252	$20,075
24%	$321,450	$36,732	28%	$242,727	$23,372
32%	$408,200	$27,760	33%	$433,445	$62,936
35%	$612,350	$71,453	35%	$489,615	$19,659
37%	—	$245,551	39.60%	—	$113,012
Total income	$1,276,000	$408,320		$775,000	$247,990
Average tax rate		32%			32%

 

So if you retired today under Trump, and your first year 401k distributions were $1.276 million, your average tax rate would be 32%, and you should have been indifferent, twenty years ago, between contributing to a Roth versus a regular 401k. (Had tax rates been the same, then.)

Oh wait: if the age 70 Required Minimum Distribution (RMD) is 3.7%, at what 401k balance would you be required to withdraw, and incur tax on, a distribution of $1.276 million today?

Answer: a 401k balance of about $35 million will trigger a taxable distribution of $1.276 million in 2019 at age 70.  If, looking forward, you expect that to be your portfolio balance at age 70, please do consider making a Roth 401k contribution this year.

Ooops, detail: that’s $35 million in constant 2019 dollars.  If you are fifty years old today, then in nominal 2039 dollars, call the bogey $47.5 million in your 401k at age 70 (assuming twenty years of inflation at 2% and change). If that’s your retirement portfolio’s destiny, then you must switch to Roth contributions, now!

That’s not you?  You aren’t planning on a 2039 balance in your 401k of $47.5 million? Okay, let’s see what the average tax rate might be, for a more typical professional managerial couple upon retirement. 

**Note that the amounts required if the Obama brackets are restored are of course lower; but still, in my opinion, unrealistic. It would take an AOC-level tax rate, driven deep down into the upper-middle class income range, rather than applied to the super-rich, before an average rate of 32% could be reached on the typical income of a professional / managerial couple.**

Please recognize: there are lots of folks who may earn in the vicinity of $400,000 in 2019, if both are age 50 and both work. Yahh, people like this are somewhere above the 90^th percentile in American income, but that’s still hundreds of thousands of fortunate baby boomers.  These people really do exist, in quantity (and many of them read the Wall Street Journal).  But almost none of them will have saved $47.5 million nominal, in their 401k accounts, circa 2039.

Rather, a thrifty couple in their early 50s, who has and will always make the maximum contribution, might very well accumulate $4.5 million, nominal, in their 401k accounts by 2039; or $3 million real, in constant 2019 dollars—to which we can apply 2019 tax brackets. (Tax brackets adjust with inflation each year).

Their RMD on $3 million, were they retiring today, would be $109,500, and their average tax rate would be about 15.4%.

So, they can forego a government subsidy of 32%, today, for contributing to a classic 401k, and instead contribute to a Roth 401k, in order to save tax, when retired, at … 15.4%??

To make that bargain, you must really, really hate the idea of paying taxes in the distant future.  Your hate must be at least 32/15 as great as your love for getting a tax break right now, from a traditional 401k contribution.

Makes no sense to me.

To summarize:

1. President Reagan, as one of his first achievements, got tax brackets to adjust with inflation. Today the ceiling of the 12% tax bracket is $78,950 for a married couple; in 2039, it will be about $120,000.  If your 401k accumulation is forecast to be any less than $3.3 million in 2039, then 12% is going to be your tax rate in retirement, for purposes of evaluating a Roth.
   1. Or 15%, if all the Obama brackets snap back … including the lowest bracket, occupied by tens of millions of registered voters.
2. Planning on a $47.5 million dollar 401k balance, nominal, in 2039? Your average tax bracket will be about 32%.  You should consider a Roth, if your married income today is on the order of $400,000 or more.
3. There are a few people who will accumulate huge sums in tax-deferred accounts, some of them WSJ readers. Executive salaries cluster in the $5 million to $10 million range, and deferred compensation plans are common.  Defer one or two million of salary per year, and an accumulation of $47.5 million in tax-deferred plans becomes very possible.  These people definitely can benefit from Roth 401ks … except that the $25,000 annual limit makes the benefit de minimus for them.

Coda

I’m not anti-Roth in any way. This year, in our 60s, my wife and I made our first ever Roth 401K contributions.  Due to complicated Alternative Minimum Tax calculations, with which I will not bore you, our tax rate in 2019 will equal our tax rate in 2029 and probably, our tax rate again in 2039—independent of whether the Obama tax rates are re-instated. 

Since our tax rate won’t change after retirement, and since we’ve been fortunate in the investments made over many years in our traditional 401k accounts, the tax diversification rule applies. Better for us to switch to Roth 401k contribution, since our tax rate now will be the same as our tax rate at all future planning horizons.

What I will not do, is incur a current tax liability for converting traditional 401k balances to Roth balances.

Why not?

Well, what if Steve Forbes is elected President, and institutes a flat tax in the 20s?  How dumb to have paid conversion tax now in the 30s.

What if the large number of affluent retirees, who vote every time in every election, encourages Congress to someday establish a lower tax rate for RMD distributions?  How dumb to have paid in the 30s now, when RMD tax rates might be reduced to the capital gains rate, or an approximation thereof.

Bottom line

If you pay tax now, as required under all Roth arrangements, you are never, ever, going to get a refund of that tax paid. And Congress can always vote to shaft you again, later. See my Barron’s piece for the creative ways in which a future Congress could walk back Roth benefits.

Conversely, if you take a tax deduction now, as under all traditional 401k arrangements, then of course, you should plan on disgorging that tax benefit later; but who knows, life is long, anything can happen.  You took the money and ran.

You know the saying about the value of a bird in the hand, versus two in the bush. Please start applying that life wisdom to the question of Roth versus deductible 401k contributions.