Yesterday, I wrote about Money magazine article which is slightly different than the version that is now online. The article made a case that Roth 401(s) are better. I found the explanation of pointing to T. Rowe Price’s research lacking.
I broke down my thinking that (for the most part) the biggest difference between Roth and Traditional 401(k)s is when you pay your taxes. I even gave a detailed example showing that the math came out to be exactly the same. (I did, however, gloss over a major advantage for Roth 401(k) in that it helps tax diversification. It can be valuable tax-management to be able to withdraw money tax-free. So there are ancillary benefits that I don’t debate.)
I ended the article on a cliff-hanger. I was fortunate enough to have a conversation with Stuart Ritter of T. Rowe Price who was able to help me understand the explanation better. I quickly learned that the devil was in the details.
Here’s what I missed: Behavioral Finance.
The research showed that most people put a percentage of their salary in their retirement accounts. For example, if you make $50,000 and put 10% of your salary into a 401(k) you’ll be putting away $5,000. If you then choose a traditional 401(k) your money comes out pre-tax and you’ll have to pay taxes on that sometime in the future. If instead you choose a Roth 401(k) you’ll be taxed first, but never have to pay taxes on the money again. Would you rather $5,000 grow and have to pay taxes on it or not?
This glosses over the fact that in this scenario traditional 401(k)s will leave you with more money in your paycheck. While some people will use that money productively others may spend it frivolously. In this sense, I see the Roth option as a way to force savings and curb a little lifestyle inflation.
However, Ritter pointed out that T. Rowe Price didn’t want to assume this would be wasted. He pointed out that if someone bought an iPad it could be seen as good thing or a bad thing depending on how it was used. Thus a comparison to such a material object isn’t very useful. They took the extra step of figuring out how it would work if people took that extra money in their paycheck and invested it. This makes it closer to being an apples-to-apples comparison. The result? Investing in the Roth 401(k) still proved better.
At the end of the day, personal finance is well, personal. We can study behavioral finance until the cows come home and create some generalizations that might be best for most people. However, your individual case may very well be the exception. Many experts say it is best not to use credit cards. However, there’s a minority percentage of people who pay them off in full each month and collect significant rewards in the process. I’ve saved thousands of dollars doing just that.
Breaking Down the Best Option for Us
So to make it personal, I figured I’d offer some analysis of how switching to a Roth 401(k), or, more accurately, a similar vehicle, will be useful for us.
You may had noticed that over the last two days I included Roth TSPs in the title. A TSP short for Thrift Savings Plan and is a version of a 401(k) for government workers that seems to work exactly the same. For the most part, Roth TSPs can be thought of as Roth 401ks. My wife has a Roth TSP option, but until now we’ve avoided it. Why? It was hard to know if we’ll be in a better tax bracket in “retirement.” We earn a nice income now, and most people earn less in retirement. It wasn’t until recently that I realized it could be much higher. We plan to have my business income, wife’s pension, rental property income, Social Security, and a nest egg of retirement account savings. All these income sources could add up to be extremely significant. It would be nice to be able to withdraw from that nest egg of retirement account savings tax-free.
I had a causal chat email chat with Mike Piper of Oblivious Investor who was mentioned in the Money magazine article. He brought up the point that government workers with a taxable pension could find that the Roth TSP is a better choice. It makes sense… they are less likely to drop to a lower tax bracket in retirement, because they have this significant income source (a pension) propping it up.
In general, I still don’t know if I’d say that a Roth 401(k) is better than a traditional 401(k). I would say that it is different and could be better based on your circumstances. It’s best to do research to understand the pros and cons of each and do what’s right for you. For our circumstances it looks like it (specifically its twin sister, the Roth TSP) is better. We’ll start putting money there immediately. At a minimum, this gives us some tax diversification which was one great point the article made.
In my paranoid, government conspiracy brain, I would say that the Roth option is always better EXCEPT I don’t trust the government not to tax it someday. Oh, they won’t call it a tax. They’ll call it a withdrawal fee, or service charge or something, but I can’t believe the government won’t look to these accounts, see the trillions of dollars sitting there and not want a share of it. It is simply in too bad fiscal condition to let all those dollars go untouched. So while I love the concept of the Roth (and have one) there is something about the traditional that I like since the dollars are out of the government’s hands for as long as possible.
Seems that we should strive to change the behavior, then. Educate people to do the simple division that allows them to determine the equivalents amounts to put into Traditional or Roth.
My concern is that using the T. Rowe Price table is going to convince people to make the wrong choices.
You basically have three options to invest in this scenario
1) $1000 into Roth
2) $1000 in Traditional and $250 into the “tax-magnet” account that generates ordinary income. (I refer to this as the “WTF Hybrid”)
3) $1333.33 in traditional
All of these options cost the same amount of money out of pocket.
Let’s look at the T. Rowe Price table for 25 years old and a 10 percent lower (-10) tax rate at retirement.
Wow – the Roth does better. We should definitely do that, right?
This table is comparing option 1 and 2 and is completely ignoring option 3. Option 3 is the much better option in this case. “Behavioral finance” could cost potentially cost a person hundreds of thousands of dollars in this case.
Isn’t that a good reason to change a behavior?
I wrote on article on Roth vs. Traditional a while back. This is from 2012, so there may be a few things that are dated. I walk through a bunch of different lfe scenarios.
Well put Kosmo. If “they” (i.e. main stream financial media) are going to make sweeping generalizations why not just tell people to diversify their options in retirement?
LM, in your case why not have half your contributions go to a Roth and have go to a traditional? This way you can pick and choose what to take out of when the time comes. Maybe one year you are in a lower tax bracket than another?
Also, another factor that is probably not be taken into account is what losing the deduction might do to you today. What if it pushes you into a place where you start to lose other tax deductions? I haven’t been elbow deep in income tax law in a bit, but for example, lets say without pushing your income is now above the limit where you can deduct student loan interest?
It isn’t the concept I get annoyed with, but rather, the idea that there is just a simple answer that can be paraphrased on the 39th page of a money magazine.
Lazy Man says
The original Money Magazine article did point out the tax diversification. I kind of glossed over it because it seemed obvious and not “interesting.”
Well, my wife has contributed the maximum to a traditional 401K for around 10+ years now. She’s eligible to retire in about 6 years. If we do 100% Roth now at her higher earnings, perhaps it has a chance to catch up to be 50% traditional and 50% Roth. If we were to do half and half, it might end up being 75% traditional and 25% Roth.
I’ve thought about what we’d lose in tax deductions today. We don’t have student loans, so that isn’t something that comes up. I’ll have to consult with my tax person, but I think we can take the hit today.