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 The traditional 401(k) uses pretax money and is taxed when withdrawn. The Roth 401k uses post-tax money, but is not taxed when withdrawn.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.
