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.

On page 37 of this month’s Money Magazine, Penelope Wang makes a strong suggestion that everyone should stop passing up on Roth 401Ks because they are better than traditional 401Ks. This was shocking news to me. I figured that if this is true, it should be “Front Page” material, not a buried in a one-page article with an extremely vague title: “Stop Passing Up This Great Deal.”

When I was writing this article originally, it wasn’t available online. Thus my research was limited to a spirited debate of it in the Boglehead forums. However, in the spirit of doing a little true journalism and receiving a lot of serendipity, I delayed the article a couple weeks. The delay means that a version of this article is now online (not the exact article, but very much the gist of it), sporting a more descriptive title of: “The Great Retirement Account You’re Not Using.”

Before I get into the article itself, I want to kick things off with my view of 401(k)s and Roth 401ks and explain why I believe one would choose one vs. the other. Spoiler: The biggest difference between the two is when you pay your taxes. The traditional 401(k) uses pretax money and is taxed when withdrawn. The Roth 401k uses post-tax money, but is not taxed when withdrawn.

Let me give you an example. Let’s say that I make $100,000 and I want to save 10% of that ($10,000) in some kind of 401(k) vehicle. Let’s say that I’m in a 25% tax bracket (I’m trying to keep the numbers simple.) If I pick the Roth 401(k), that $10,000 gets taxed, leaving me $7,500 in the account. If it grows 10% a year for 20 years, I’ll have $50,456 to withdraw tax-free. If I pick the traditional 401(k), that $10,000 goes in the account. If it grows 10% a year for 20 years, I’ll have $67,275 which will be taxed at withdrawal. After paying the same 25% in taxes, I have… $50,456 in spendable money.

So in this example, it doesn’t matter which one you do. They come out the same. The reason why someone would choose one over the other is the tax rate. If you are in low tax bracket and expect to be a higher one in the future, you want to pay those taxes now and get them out of the way. If you are in a high tax bracket now and expect to be in a lower on in the future, you want to pay those later at the lower tax rate.

Imagine my confusion when reading an article that seems to claim that the Roth 401k is almost always better. Penelope Wang says:

“Every dollar you save in a Roth 401(k) is worth more than a dollar you put in a pretax account. That’s because you’ll eventually pay income taxes on those pretax dollars while you get to keep every penny in a Roth. Granted, you get an upfront tax break by saving in a traditional 401(k), and you can invest that savings.”

Essentially she’s comparing a post-tax Roth 401(k) dollar with a pretax 401(k) dollar. It simply doesn’t make sense to do that kind of comparison. If you look at a Roth dollar without understanding that you’ve already paid tax on it, it is going to appear that you escaped the tax system altogether, which is simply untrue. If you downplay the upfront tax break by the traditional 401(k), you are missing the whole benefit of that 401(k).

In the aforementioned Bogleheads discussion on the topic, readers have found what appears to be the T. Rowe Price’s research.

Much of the Money Magazine article seems to say that the Roth 401(k) is better than the traditional 401(k) because of that T. Rowe Price research. I find that a less than satisfying explanation. I’d rather read exactly what the benefits are in terms of the applicable tax law.

It was at this point where the serendipity kicked in. I got an email about with all the people going to Fincon this year and spotted T. Rowe Price‘s Stuart Ritter, the person credited for the research. After some phone tag, we connected and I got a much more satisfying explanation. I hate to create a cliff-hanger (just kidding, I love it!), but that explanation is worthy of its own article, so tune in tomorrow.

I want to leave by saying that I’ve probably been too harsh on Ms. Wang. Often, editors create the titles in magazines, so the lack of descriptive was not likely her doing. In addition, writing words online is cheap and easy. I don’t have specific space requirements like print magazine writers do. I can afford to give a much more detailed explanation in an entirely separate article. I don’t think anyone could have done the topic justice in the space provided. It’s a shame it wasn’t a two or three page feature.