The Ultimate Traditional vs. Roth 401(k) Strategy

Katie: Welcome back to The Money with Katie Show, Rich Girls and Boys, and oh boy, gird your loins, because today we are diving deep. This is the deep dive to end all deep dives. Okay, I'll stop saying deep dive. This is a topic that I've covered at least a dozen times on the Money with Katie blog, social media, YouTube channel. But I've never actually done an exhaustive deep dive on the podcast before. So drum roll, please: It is the Traditional versus Roth debate. Now this is a thicc boi, I'm gonna warn you. So in order for you to not have to listen to the droning sound of my voice for an hour straight, Henah's going to play our devil's advocate today, and she's gonna pop in to push back on our various theses. Every time I say theses, I feel like I'm sending my high school English teacher a telepathic bat signal. 

But anyway, without burying the lede, my overall perspective is that we sleep on Traditional pre-tax accounts because we generally misunderstand how we are going to be taxed on that money later. So I have a strategy that I like to use that I think provides the best of both worlds, as well as the most bang for your buck. You gotta love that. Now, any good financial professional—because, reminder, I am not a financial professional—will tell you the choice that makes more sense for you will be dependent on several different important factors, like your income, how you earn your spending, your retirement plan and more. That said, my main concern today will be providing you with a framework to think through this decision more accurately. So here's what we're gonna cover today. 

First, we're going to get into some definitions, some broader table setting. Then we're gonna get into the Traditional versus Roth debate points that we often hear. Then we're gonna think about why the Traditional is probably, usually, superior. And then we're gonna talk about the role that certain fringe factors play, like FICA tax and your filing status. 

Henah: Hi, Katie. 

Katie: Hi, Henah. Welcome. 

Henah: Thank you. So I would love to know, as the devil's advocate, why does this all matter? Because I've heard people reference this as not letting the tax tail wag the dog. Does how these accounts are taxed really matter? 

Katie: Yes. So I hear that, for sure, but despite the fact that the government taxes you coming, going, and getting the T-shirt, I still think this is worth the five minutes to learn, or I guess in our case today, the 55 minutes. Because the taxes that are gonna impact your retirement accounts either happen right now, or later, and taxes are among the largest expenses of your entire life, right? So I think some strategy is warranted. Spending an hour cost-comparing two different TVs, but then winging your tax planning, makes approximately no sense. But it is how most of us are gonna approach these things. 

So for our purposes today, the accounts that this decision will apply to, for most people, are probably the 401(k) and the IRA, but you may have a 403(k), a 457(b), or any number of other more obscure accounts as well, depending on your employer. And within those accounts, you're gonna have to decide if you wanna go for a Traditional or Roth approach to the 401(k) or IRA. And as of 2021, 88% of employers who offered a 401(k) plan allowed Roth contributions. So you're almost always going to have the choice. We'll be right back after a message from the sponsors of today's episode.

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Henah: Okay, baby, we are back. So let's say I'm using a 401(k). What does having a Traditional 401(k) really mean on the back end? 

Katie: Yes, if you have a Traditional 401(k), you are contributing pre-tax income to that account. So this means if you make $2,500 per paycheck and you contribute 10% to a Traditional plan, the IRS has not yet taken out its cut of that $250 contribution. Instead, it's gonna bide its time on the promise that at 59 and a half years old, when you are able to withdraw that, you're gonna pay taxes on your withdrawals that comprise your original contributions and the growth on those contributions in your older self's income tax bracket. Now, theoretically, you can think about this like the full $250 is going in; none of it is being used to pay a tax bill. And that's really all there is to it. 

Henah: Okay, that's easy enough. So then what's the deal with Roth? 

Katie: Yeah, so I have found this to be one of those things that people ask in hushed tones, like eyes darting around the room, “So okay, what does the Roth really mean?” Because much like references to the classic movies that I've never seen and you know I'm like, “Oh yeah, I love that one,” and the words that we should have all learned studying for the SAT, Roth is one of those financial terms that elicits the nods and smiles, but then you're Googling under the table on your phone. 

So the TL;DR is that if that earlier contribution that we talked about, that $250, had been to a Roth account, you would be contributing already-taxed paycheck dollars, which means you bite the bullet; you pay Uncle Sam now in your current income tax bracket, and you invest the money. So you can think about this in one of two ways. Either it's like you are putting in the full $250 and the taxes that you paid on it are coming out of the rest of your paycheck. Or you can think about it like you're putting in $250 minus the taxes. 

For example, you're in the 24% marginal tax bracket. You’d owe 60 bucks on the contribution, meaning the real contribution to the account is $190. Either way, you're paying more up front. That said, the contribution grows and grows and grows over the next 30 years, facing no taxes on the growth. And then boom, 59 and a half, you're gonna start withdrawing. It's just yours. You have no further taxes to speak of. Okay? 

Henah: So why would anyone use a Traditional account, given the absolute tax-free payday that a Roth retirement account provides later in life?

Katie: So the main advantage to a Traditional account is that it's gonna lower your tax burden now. So in other words, if you contribute the maximum limit of $22,500 to a Traditional 401(k) plan now in 2023, the government basically subtracts $22,500 from your salary and you only owe income tax on what's left. So if you're in the 24% marginal tax bracket and you contribute that full amount, that is a tax savings of around $5,400. Now this is what will ultimately be the key for the strategy that we're gonna talk about today. So go ahead and put that in your back pocket for later. 

Henah: Okay, saved in the pocket. So which one is better? Why do so many people love Roth? 

Katie: Yeah, let's discuss, 'cause there are so many die-hard Roth fans out there that I feel like I have to duck and cover when I say this. But I'm gonna say it. With rare exceptions, I don't think I'd ever opt for a Roth 401(k), even if marginal tax rates in the future were to double. And it all comes down to one very simple yet powerful tweak: When you invest in the Traditional 401(k), you then have to turn around and invest the tax savings, aka the $5,400 that we spoke about a minute ago. So I'm gonna repeat that. You have to invest the tax savings somewhere else. 

Henah: Okay, so you're saying I'll get a tax break for contributing, and I need to invest the amount of that tax break in another account. Is there anything else that's nuanced that's going on here? 

Katie: Yes, because remember how we said when you contribute to a Traditional account, you get a tax break this year, but when you contribute to a Roth account, you get a tax break later? That's true, but there is an important nuance that's often overlooked, which is that Roth contributions are taxed at your highest marginal tax rate. Traditional withdrawals later in life are taxed at your effective tax rate. So we'll pause and explain. We have a progressive tax system. Your income is taxed in different brackets, and your marginal tax rate represents the highest rate that you pay based on how much you earn. But your effective tax rate basically looks at the total tax you're paying and divides it by your income to determine what percentage of your income overall was paid in taxes, which is significantly lower than the marginal tax rate. 

Henah: Yeah. So why is that important? 

Katie: So when you withdraw your money from your Traditional 401(k), you have to pay taxes on it, right? That's the deal you signed up for. But you don't pay the taxes in your highest marginal tax bracket. The money you withdraw is treated like earned income, which means you're taxed on it as if it's income from a job. You're taxed bottom-up in the brackets instead of top-down. So the first $10,000 of withdrawals is taxed at 10%, the next $30,000 or so is at 12%, so on and so forth. That also means you get the benefit of the standard deduction.  

Henah: Okay, I mean, that's all compelling, but all of that tax-free growth in a Roth account must dwarf the up-front tax savings from Traditional, right? Why would you tax the harvest instead of the seed? 

Katie: Yeah, the old harvest and seed. Well, it kind of boils down to the fact that a smaller seed nets a smaller harvest, to extend our metaphor. So even though people always say that tax rates are gonna go up, we are still comparing today's marginal, aka the highest rates today, to the future's effective. Remember, the bottom-up, the lower tax rates. So to prove this out, I decided to do a little experiment to determine which path would actually get you further ahead.

What's gonna generate more money based on your tax bracket? So we're gonna look at investing in a Roth 401(k), maxing out a Roth 401(k), paying the taxes now, or investing in a Traditional 401(k) and then investing our tax savings somewhere else. So before we launch in, my standard disclaimer stands: Anytime you're trying to project anything 50 years into the future, ultimately a fool's errand. We are just gonna use averages and the current tax code to try to make the best choices we can for the future based on what we know about today. So there are a few things that we should probably get on the same page about up front.

Henah: Yeah, so hit me with what the parameters are gonna be here. 

Katie: Yes. So I'm using averages. I would consider these pretty conservative. So nobody slide in my DMs with a pitchfork to tell me that I'm an optimistic dumb B with a public relations degree…though, guilty. But we have to make some assumptions in order to flesh out any sort of long-term scenario that's gonna serve as a basic framework for the comparison. So the important thing is these same averages apply across both the Traditional and Roth scenarios. Anything that's gonna hurt is gonna hurt both. Anything that's gonna help is gonna help both. 

So parameters are a 25-year working timeline, okay? It doesn't really matter when you start, but to make it feel more real, we're gonna assign some ages. We'll pretend we're starting to invest at age 30 and we're retiring at age 55. We'll assume that we contributed the maximum to the 401(k) for all 25 years of this timeline. Then we're gonna flesh out another 25 years to age 80 to demonstrate how this trend continues, though you could extrapolate this indefinitely if you wanted. We're just gonna assume that hey, in year 26, based on the 4% withdrawal rate, we're gonna begin withdrawing, adjusting upward for inflation every year. 

We're also gonna assume 3% average inflation. So this is also gonna apply to the contribution limits that are gonna go up by about 3% per year too. We're gonna assume that we'll get a 7% average rate of return. So that means the real rate of return in these scenarios is actually gonna be about 4%. Now that's quite conservative, and I chose to do it this way because I wanted to show that the stock market does not have to go on a wild bull run in order for Traditional to win. 

Then, to determine the tax rate that we would assume we'd be facing on our withdrawals in year 26 based on today's tax code, I basically extrapolated backward to figure out what the amount would be worth in today's dollars. So, assuming those tax brackets are gonna continue to shift upward with inflation like they have been. So for example, if you're married and withdrawing $44,000 today and have no other income, your effective tax rate as a married person is 4.3%. But in 26 years from now, the inflation adjusted amount is $92,000. You need $92k to produce $44,000 of today's purchasing power, right? But it's theoretically going to be taxed at the same effective tax rate, since the brackets would also be going up with inflation. And we're gonna analyze three different situations. We're gonna get a good spectrum here. So we'll look at earners in today's 12%, 24%, and 32% marginal tax brackets 'cause we wanna try to cover a wide range of common incomes.

And for the purposes of today's exercise, we are not going to worry about state taxes. Now I think that might feel like a sloppy oversight, but since it's such a wide variable, I'm not gonna include it, though I do wanna say, if you are working today in a high income tax state like California or New York and you are retiring in a low income tax state like Tennessee or Texas or Florida, your preference should almost definitely skew toward Traditional. And if you're working in a low income tax state and retiring in a high income tax state, you would adjust a few points on the board for Roth. 

Now remember, if you decide to run these numbers for yourself, your marginal tax bracket might be lower than you think after the standard deduction. So be sure to subtract the standard deduction from your gross income before you assign yourself into one of the buckets. It's also worth noting that before we explore these scenarios, there are creative ways to get your money out of a Traditional 401(k) tax-free, too. And we've done episodes on tax-free retirements that we will link in the show notes. But let's pretend you're not being strategic at all in retirement. You're not optimizing a tax strategy at all. You are just pulling the full amount that you need to live on each year in retirement from a 401(k) for the sake of this analysis, and because this is where everyone hollers again and again about tax rates going up, the other round of projections that we're gonna dive into doubles the effective tax rate to reflect possible higher taxes in the future. Okay, you got all that? We're gonna be right back to show the results after a message from the sponsors of today's episode. 

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Henah: Okay, so we're back and I am scared. So let's chat through the results. 

Katie: Okay, so if you invest in a Traditional 401(k) and you capture the tax savings represented by your marginal tax bracket, by investing that amount of money saved somewhere else, you fare better than if you had just contributed the amount to a Roth 401(k) and paid the taxes in your working years. So my ultimate recommendation to totally bone the system, leave the IRS in the dust, is to invest the tax savings in a Roth IRA. You got me? So you can also use a taxable brokerage account, but think about it: You're never gonna pay taxes on that Roth IRA ever again, thereby giving you both tax diversity and access to the entire amount in the account. Remember, withdrawals in retirement are taxed like ordinary income, except you no longer pay a payroll tax. Yay. We'll talk about that in a little bit. And when fleshed out for 25 years, this strategy for the 24% marginal tax bracket leaves you with $2 million in your 401(k). Hey. 

And crucially, if you had invested the tax savings that you had generated every year somewhere else, assuming all the same parameters, you would also have another $492,000 in another account, whether Roth IRA or taxable account. So I think it's safe to say, time to retire, hit the club, ladies. We will link the spreadsheet in the show notes so that you can see the math and take a look for yourself. But had you contributed to a Roth 401(k), you would still have that same $2 million balance tax-free, but you wouldn't have the other $492,000 that you generated in the Traditional 401(k) example, because you wouldn't have had any tax savings to invest somewhere else.

Henah: Okay, so I think I'm following, but then the question becomes, is the $492,000 bonus account valuable enough to offset the fact that you have to now pay taxes on your $2 million drawdown? 

Katie: Yeah, so we'll keep going to figure this out. So it's time to start drawing down. You've retired; we're 26 years into the future now. You've got two and a half million between your two accounts, and it's time to F around and find out what you got here, what your safe withdrawal rate is on two and a half million dollars at 4%. It's $101,548, which before you get too excited, has the purchasing power of around $48,500 in 2023, if you assume 3% inflation annually between now and 2048. So you'll withdraw your $101,500 and you'll pay your taxes on the portion that is coming out of the 401(k). 

Henah: All right, so the moment of truth: How much is that tax bill? 

Katie: Yes, the moment of truth. So if you are single, you would set aside about $8,525 to pay the taxes. You've got an 8.37% effective tax rate based on inflation adjusting today's brackets. And if you're married living on one set of retirement accounts, you'll set aside about $4,827 to pay the taxes, so a 4.74% effective tax rate based on inflation adjusting today's rates. Now if you're married and both people and the couple did this, you'd basically double everything. 

Henah: Okay. Wow. So those effective tax rates seem really low. Why is that? 

Katie: Yeah, well, for starters, you're not gonna pay FICA payroll taxes, which are 7.65% on these withdrawals. And like we mentioned, your federal income tax is calculated bottom-up. So the effective tax rate in retirement on withdrawals is much lower than your marginal tax rate on contributions while working. So if you're married filing jointly in retirement and you're living on one person’s set of accounts, your net income after taxes on the portfolio value is $97,028 in year one, which is the equivalent to about $46,500 in today's dollars. So your effective tax bill ate up about $2,000 of your $48,500, if we're talking about today's dollars. And if you're single, your post-tax net income is about $93,331, or about $44,500 in today's dollars. So your effective tax bill ate up about $4,000 worth in today's dollars. 

Henah: Okay, so if two people in a married couple both did this individually, then it's kind of like you're paying $4,000 per person. 

Katie: Yes. And so whether we're talking about 4% or 8% effective tax rates here, it's still a lot lower than paying a 24% marginal tax rate on a Roth contribution. And of course, we are basing your drawdown on the 4% safe withdrawal rate. And if you have a ton of taxable income from another source, like real estate investing income, a business that you still own and earn money from, another massive qualified account that you're pulling money from, your tax rate is different because your income is different. But if you are only relying on the 401(k) and maybe this bonus account for your retirement income, this holds up. 

Henah: Okay, so we know what our net income was after paying federal income taxes on our withdrawals, right? How does that compare to our Roth 401(k) 4% withdrawal? 

Katie: Yeah. So in the other scenario it's relatively simple, because our 401(k) value is still the same. We still know that it grows to $2 million, right? We just don't have that bonus account that was funded by the tax savings. So if we had a Roth 401(k) worth the same $2 million based on the same contributions and returns, our 4% withdrawal would only be $82,142, but tax-free. That is, you have no taxes to pay, but as you can see, your overall net income is lower than the $93,000 you would've gotten single or the $97,000 you would've gotten married filing jointly, because your overall portfolio value was lower, thereby lowering your safe withdrawal rate. So you end up with more money generated overall by contributing to the Traditional and then investing the tax savings, too.

This is the simplest way to flesh out these two scenarios to show how contributing to a Traditional 401(k) and investing the tax savings is a superior strategy for the 24% marginal tax rate, if you don't have excess earned income in retirement from other sources. 

Henah: What about the 12% and 32% tax bracket examples? I'm assuming it's more dramatic for the 32% bracket because the savings are larger, but 12% seems like it could go either way. 

Katie: Yes, absolutely, regarding the 32%, and yeah, that's where things get interesting is the 12% marginal tax bracket, because when we run the same scenario, but at a 12% marginal rate, it nets a Traditional plus invested tax savings outcome of $2.3 million, which generates a 4% safe withdrawal in retirement of $92,000, which is about $43,500 in today's dollars. So if you're single, your effective federal tax rate would be 7.96% on that amount, and if you're married, it'd be 4.05% on that amount, thereby making your married filing jointly net income about $88k and your single net income around $84.6k. So the Roth outcome, like we said, tax-free withdrawal of around $82k. This means even in the 12% bracket as someone who's filing single in retirement, you still end up with about $2,000 more in the Traditional plus tax savings example. That said, it's definitely close, and the 12% marginal tax bracket is probably a case where the outcome is going to be such a tossup that Roth, all Roth across the board, might make more sense since other major factors changing could tip the scales in its favor.

Henah: What do you mean by that? 

Katie: Basically that a 12% marginal tax rate is a very low price to pay for Roth contributions. You're probably not gonna do much better than that. So if you want Roth contributions, that would be the time to make them. 

Henah: So all of this is great if tax rates stay the same, but what if they go up? 

Katie: Yeah, I think the short answer is that the whole effective tax rate plus no FICA taxes for Traditional withdrawals thing tends to do quite a bit of heavy lifting for lessening our tax burden in retirement. But let's say the tax rates do go up; let's say your effective tax rate doesn't just rise, but it doubles—because remember, in order for your effective tax rate to be twice as high, the marginal tax brackets would have to skyrocket. So in our 24% example, that means our single Rich Girl’s tax rate jumps from an effective rate of about 8% to 16%. So she ends up paying about $17,000 in taxes and nets about $84,800 from her original $101,000, which is kind of a woof. But the married couple does fare a little bit better, assuming they're living on one person's retirement accounts. Their effective tax rate doubles from today's rate of around 4% to a hypothetical 9.48%, and they end up paying about $9,600 in taxes and netting $92k of the $101k. So even still, both fare better than the completely tax-free Roth withdrawal of about $82,000. And the same is true for the 12% bracket for married filing jointly. Even if effective tax rates are double in 25 years, their net income would be about $84k as opposed to the Roth withdrawal of about $82k, but the single 12% filer would've come out ahead in that instance using Roth, if effective tax rates are doubled in the future. So that's again a caveat to keep in mind, and it's partially why I will concede that a 12% marginal rate probably could safely choose Roth across the board and be fine. 

Henah: Yeah, I mean it feels like the 12% bracket is where a lot of people really start, but incomes can fluctuate wildly over time, right?

Katie: Absolutely. I am 28 years old; I've been in four different marginal tax brackets so far in my career, but the fact that the outcome was the same for all three major brackets, Traditional being preferable, should assure you that it probably doesn't really matter beyond 12%. It all comes down to effective tax rates and investing the tax savings you generate from Traditional contributions, assuming of course that the progressive tax system doesn't totally disappear, which it could, right? And if you don't invest your tax savings, well, yeah, you probably should have picked Roth. 

Henah: Okay, cool. So you've mentioned FICA taxes a few times. Can we dig a little deeper there? 

Katie: Yes. Also known as the payroll taxes, and in your working years, you are paying into Social Security and Medicare, and then when you are retired, after ages 62 and 65, respectively, you're being paid by these systems, assuming they're still around. 

Henah: So how does FICA impact this outcome? 

Katie: So I've already made one primary argument in favor of Traditional, and it aimed to address this “tax the seed versus tax the harvest” argument by pointing out that if you chop off enough of the seed before you plant it, your harvest is gonna be smaller. But the additional piece here is, who eats their entire harvest all at once? Why not grow the bigger harvest and then pay as you go? That's really the crux of what we've discussed so far. But there's an interesting consideration with the FICA taxes here, too, because these pesky little buggers take an extra 7.65% from every paycheck if you are employed by someone else, and you're gonna pay 15.3% if you're self-employed. And do you know what FICA taxes also apply to? Your employee elective salary deferrals, also known as your contributions to your retirement accounts, with the notable exception of your HSA. You do not pay FICA tax on those contributions. So you'll pay 7.65% on your Traditional and your Roth contributions to your 401(k), even if your Traditional contributions are exempt from federal and state taxes, which is a bit of a bummer, but it does mean that your effective tax rate on your Traditional contributions is 7.65%, but your effective tax rate on your Roth contributions is your marginal tax rate plus 7.65%.

So it's a little bit like, oh, you thought you were paying 24% on those Roth contributions? Think again; you're paying 31.65%. That's almost a third of the contribution value that is being eaten up in taxes in that bracket. So take your seed, slice off a third, but you don't pay FICA taxes on your withdrawals from either type of account. None of your retirement income from your retirement accounts is subject to payroll taxes anymore. And here's why that matters. A T Rowe Price analysis found the income needed in retirement is typically about 75% of your income in your working years. And it casually noted, “Oh, a reduction in taxes is why,” which I just think is hilarious that we will probably gloss over that. The white paper is just tossing that out as a given, but in any case, you require less income in retirement to create the same spending power, basically. 

Henah: I see. So technically it's not the FICA tax itself that makes the difference, but our perception of our post-tax income when we're working. 

Katie: Exactly, because we pay FICA taxes on our contributions on both the pre-tax and Roth options, but we don't pay it on the distributions. So its net effect truly is zero, but it's still impactful because you feel like your income is about 8% lower than it actually is, which skews how much income you're assuming you're gonna need later to sustain the same lifestyle. Your entire paycheck gets taxed with these payroll taxes, up to $160,200 in 2023, where your Social Security liability tops out. So for example, if you make $100k per year and you are filing single, your take-home pay, omitting state taxes, is $77,341. That's after you pay $15 grand in federal taxes and $7,600 in FICA taxes. Your total tax liability is around $22,000. So it is natural to look at your experience, a take-home pay of $77,000 per year or $6,400 per month, and say, “Man, I feel like I might wanna spend more than this in retirement,” and assume that it means that you're gonna need to withdraw more than a hundred thousand dollars per year in order to do so, since that's the income during your working years that produced that $6,400 a month number for you.

But you would need to withdraw an inflation-adjusted $6,400 per month from your investments to have the exact same amount of total income that you had in your working years. 

Henah: And in order to have $6,400 per month in your working years, you had to earn $100,000 because taxes ate up the rest and you paid $22,000 in taxes. 

Katie: Yes, exactly. But in order to have $6,400 per month in retirement, you just have to withdraw that amount per month from your 401(k) and declare it as income. And in today's dollars, that does require a nest egg of about $2 million bucks, but you're not gonna pay FICA taxes on that income, which means you won't need to withdraw a hundred thousand dollars to end up with $6,400. You'll only need to withdraw about $89,996 to pay yourself $6,400 per month, and still have enough left over to pay your federal tax liability of about $12,600. So that'll leave you with about $77,000 to spend in 2023 dollars, or $6,400 a month, which is the same as your take-home pay during your earning years. 

But wait, it gets better! Infomercial voice…because how did we accrue that 401(k) balance of $2 million in the first place? Well, we had to save a portion of that $6,400 each month. We have to account for the fact that you weren't spending your full $6,400 per month in your earning years. You would've needed to save substantial chunks of it to end up with $2 million in the 401(k). So in this example, we are controlling for inflation by just ignoring it entirely, but the apples to apples comparison is $100,000 of working income produces $6,400 per month of take-home pay, some of which had to be set aside and invested, and generates a $22,000 tax bill or an $18,128 tax bill if you're contributing to a Traditional 401(k), holla, which this example is gonna presume you were. But $89,900 of annual distributions produces $6,400 of take-home pay each month while you're retired. None of which has to be set aside and saved for later, and generates a $12,000 tax bill. 

Henah: Okay, so I see where you're going with this. So even if a person was earning a hundred thousand dollars and taking home $6,400 after taxes, they didn't have to spend the entire amount because they had to save some of it, but the retiree doesn't. 

Katie: That's right. Thanks to payroll taxes, it requires less income in retirement to produce more take-home pay and therefore generates a smaller overall tax bill. And remember how we said you're gonna be benefiting from payouts from the system in retirement? That is the other piece of this. You and your spouse, if you've got one and you both worked, will also receive Social Security payouts in retirement, if the system still exists as it currently does. So to me, though, this doesn't invalidate the strategy, it just lowers the amount of taxable income you're gonna have to withdraw from your 401(k). If you would ordinarily withdraw $5,000 per month and you get $2k per month from Social Security, you only have to withdraw $3,000 to make up the difference, and your earned income stays the same. 

Henah: But what if I am in a higher tax bracket in retirement? What if my tax bracket is so high that even my effective tax rate on my withdrawals is higher than my marginal tax rate right now? What would have to happen for that to be true? 

Katie: Yeah, I mean, I think this is the predominant argument in favor of going all-in on Roth, that somehow we are all going to be spending more in our golden years than we are earning now in our careers. And I think with rare exceptions, it is almost impossible for that to be the case. Usually this question is the result of three very different belief systems and circumstances. So it's either likely misunderstanding how your tax bracket is determined in retirement, or thinking that your last working salary determines your retirement tax rate, or it's, you know, maybe you're unreasonably optimistic about future returns. You haven't actually sat down to project the numbers of what you're likely to have. 

And then the last case is the one that I would say is really the only mathematically sound scenario. People that are in a very low marginal tax bracket today, like 10% or 12%, but have a reasonable belief that they will spend more in retirement because their income is going to rise substantially, or they're married while they're working and they're single in retirement. But it's worth restating explicitly: Your income in retirement isn't based on what you earn, this factor that you really have less control over, because you're theoretically not earning anything. And this is where the folks who own 412 rental properties and mega pensions are gonna “but” the shit out of this. 

But stick with me, because for most of us, retirement income is taxed based on something else. It's taxed based on what you spend. So in practice, that means you'll only be taxed more in retirement if you're spending more than you are earning now. Some of these accounts that you're gonna pull from, like the Traditional 401(k), are taxed like income; others are taxed in more favorable capital gains tax brackets like the taxable brokerage account, and it's likely that you're gonna pay 0% in tax on your long-term capital gains on some or all of your withdrawals from your taxable account, since the current top of the 0% long-term cap gains bracket for married filing jointly is like $90,000. Some will argue that even that might be hacked away. And to that, I say it's probably a futile effort to speculate on the tax code 40 years from now. But if you're like, “Hey, you know what? No, I only make $80,000 today, but I plan to live a large, lavish life in retirement, baby,” we should pump the brakes, because that's kind of unlikely. 

Henah: Wait, why is that unlikely? 

Katie: Well, it all comes down to this very simple truth that in order to have enough money in retirement to live large, you have to invest a shit ton of money. And the only way to grow a humongous nest egg, one that is capable of spinning off very large sums of cash and returns, is to fill it with a ton of cash, and preferably early in life so it has time to compound parabolically, which again, isn't impossible, but certainly on the unlikely side of average, if you think that most people hit their peak earning years between 35 and 44, and in order to invest a shit ton of money, you have to make a ton of money. Either that or work for a very long time, like 50, 55, 60 years, right? And what's true about people who make a ton of money? They are in a high tax bracket. So it's a bit of a paradox. It's that if you're in a lower tax bracket now, the only way for you to be in a higher tax bracket in retirement is by spending a ton of money after you retire. But you won't have a ton of money to spend unless you are earning and investing a lot now. And if you're earning and investing a lot now, you are likely already in a tax bracket that you're gonna have a hard time eclipsing with spending later. 

So it's a little complicated, but I think the other aspect is, it's either that or you're living on very, very little and investing the healthy majority of an average salary. And at that rate, I would say, behaviorally speaking, it's unlikely that you would want to live that way for your most of your life and then immediately flip a switch in your golden years and suddenly change your entire lifestyle. 

Henah: Okay, but Katie, as a Rich Girl, what if I inherit $10 million? Then what? 

Katie: Yeah. Hey, good question. Assuming that $10 million bucks is coming in the form of a brokerage account, thanks to the step-up and cost basis that happens when someone dies per the current estate laws, your $10 million inheritance will be the new cost basis. So you could be taking rather large withdrawals from that. You're not gonna be paying taxes on them unless it grows a lot more after you accept it.

Henah: Okay, so I'm gonna hope that that's what happens. But what happens to the average earner who works for 25 years, or 40? Can we test how their tax rate would change in retirement? 

Katie: Yes. Let's look at our average earner first, who works for 25 years and then calls it. Someone making $60,000 per year, which is in line with the median salary in the United States. We will say that they start saving for retirement at 25 when they're earning $60k and they receive a 4% raise every single year after tax. Their monthly income would be about $4,000. So we'll also pretend that their lifestyle costs $40,000 per year, which is about $3,300 per month, and that that also is going to go up by 3% per year due to inflation.

Now if they save the rest for retirement, they end up with approximately $1 million in retirement after working for 25 years, from age 25 to age 50. In the first 14 years of their career, they got nowhere close to contributing the maximum to their 401(k) because their income minus expenses didn't allow them to. So this individual probably thought, at least in the beginning of their career, that they would definitely be in a higher tax bracket in retirement. But remember, we're taxed based on how much we withdraw, aka how much we spend, because we no longer have an income. So our withdrawals from our 401(k) become our income. And at $1,075,000-ish, the safe withdrawal rate is about $43,000 per year.

That's a problem, because you'll note that by 2045, this person's annual spend is $81,000, hashtag #thanksinflation. In reality, this individual would not be able to afford to retire yet at 50 years old, because they would only be able to cover roughly 53% of their annual expenses, assuming no other sources of income like a pension. That means that at no point in this person's career, even in year one, were they in a lower tax bracket than they would be in retirement if they retired. At this point, though, as we've noted, they wouldn't be able to yet. So with a relatively short timeline of 25 years and an average income, it's almost impossible, even if your final salary is $153,000, as it was in this trajectory case that we ran.

Henah: Okay, that's good, even if it's a bit depressing to know. So given those parameters, they actually couldn't retire, but let's be more realistic and assume they work for 40 years. What happens then? 

Katie: Yes. So we'll extend our data table out by 15 more years. If this person works until age 65, they would retire with $3.7 million. Of course, our living expenses have to keep up with inflation too, which means our $40,000 per year life will cost $122,979 at 65 years old. $3.7 million safe withdrawal rate is $148k. So this individual could cover their expenses and then some. They are ready for retirement, hell yes. But the tax brackets also shift upward with inflation, as we've noted, right? It stands to reason that the government in 40 years will more or less tax a $122,000 withdrawal the way it taxes a $40,000 withdrawal today, because this is just $40,000 adjusted for 39 years of inflation. So the purchasing power, theoretically, the same. Anyway, this individual may be withdrawing somewhere between $122k and $148k per year from their account, but the tax brackets will have had 40 years to shift upward with inflation. And if the purchasing power of that money is still equivalent to somewhere between $40k and $60k today, this individual was still never in a lower tax bracket in their working life than they would be in retirement.

Put another way, it's almost impossible to invest enough money over your working life to be able to withdraw your way into a super high tax bracket in retirement without making a lot of money and being in a high tax bracket in your working life. 

Henah: Interesting. Okay, but what if you're a high earner who lives way beneath their means over 25 years? 

Katie: Yeah. Let's say we have an individual who makes $150k per year, but still spends like our friend who makes $60k. So if they're spending about $3,300 a month, the intent here is to show what would happen if someone who made a ton of money still lived modestly and invested the majority of their income. Now their picture looks a lot different.

If this individual works for the same 25 years and only increases spending by 3% per year the same way, they will retire after 25 years with $7.7 million. Maybe the point of this episode should be “increase your income,” because damn, the safe withdrawal rate on $7.7 million is $308,000. Now, the gap between this person's annual expenses adjusted for inflation at $81k and the amount they can withdraw, $308, yeah, quite wide. Moreover, $308k has, when adjusted for 25 years of inflation, the equivalent purchasing power of about $156k today.

Now, you could argue that there are a few things about the scenario that may not stand up to the practicality test of how most people behave in the real world. Aka, most people making $150k don't live on $40k per year, and those who do are likely doing so because they intend to retire early, which means they're probably not gonna work for a full 25 years. This individual would technically reach FI at $1.3 million in year 10, after which point they could safely pull the ripcord well before accumulating $7.7 million. But hey, let's pretend they didn't. Let's stay true to our mathematical roots here and pretend that we do have someone making $150k living on $40k and working for a full 25 years, finishing their career with a salary nearing $400,000. 

Henah: From my lips to god's ears, because then they can withdraw $300,000 per year. So they didn't make $300,000 per year until year 19, which means, though, that they were in a lower tax bracket for the first 19 years of their career, right? 

Katie: Close. But I think the important thing is the inflation-adjusted value of that $300,000 per year withdrawal, because remember, it's equivalent to $156k today, which means it stands to reason that $308k in the future is gonna be taxed similarly to the way $156 k is taxed today. And how long did it take this person to be in a higher tax bracket than $156k in the trajectory that we ran? Year two.

It took them one year of work to eclipse the seemingly insane retirement tax bracket triggered by an outrageous $300,000 per year drawdown, made possible by the fact that they made $150,000 per year and lived on $40k. Even an extremely high earner who lives on very little and works for 25 years and amasses $7.7 million of wealth would still have a hard time getting into a higher tax bracket in retirement. So it comes down to this, as far as I can tell. Someone whose lifestyle is conducive to spending more than they earn is not going to amass the type of wealth necessary to spend that much in retirement.

Henah: Okay, I hear you. Are there any instances, aside from pensions and real estate income, that you think could put someone safely in a higher bracket in retirement? 

Katie: Yes, there are two that I can think of where someone would potentially find themselves in a higher tax bracket in retirement scenario. And it's a perfect segue to our third and final piece of pushback, which is that you're in a really low tax bracket right now, 10% or 12%, but believe you will be in a much higher one for the majority of your career. Going from an average income to a high income isn't enough, though, because remember, the amount we can spend in retirement is based fully and completely on how much we saved and for how long. So if you spend 90% of your income on $60k per year and you also spend 90% of your income on $150k per year, you're no better off. But let's take a look at this scenario. 

So let's assume this person is a median earner for the first five years of their career, and then takes a rocket ship to the 24% plus marginal tax bracket. So in this instance, where someone more than doubles their income in year five from $70k to $150k, but sustains their same lifestyle indefinitely, they will skid into year 25 with $4.5 million dollars, giving them a safe withdrawal rate of $180,000, which is much higher, still, than the $81k that they need. Now, that $180k is equivalent to about $75k of purchasing power in today's dollars, which means, using our same logic, if they were to withdraw that full amount in their first year of retirement, they would theoretically be in a higher tax bracket than they were in their first five years of working. If you believe that your early salary is going to double or triple relatively early in your career, which can and does happen, but you plan to continue to live a similar lifestyle, the math would indicate there is a good chance you will be in a higher tax bracket in retirement. 

But if you inflate your lifestyle—say you start spending $6,000 per month instead of $3,300 per month when you get your big fat raise—we're gonna run that scenario separately. Now you hit your 25 with $3.2 million, not $4.5m, and you need $126,000, not $80,000, to support your lifestyle. Now, lucky for you, the safe withdrawal rate on $3.2 million is $128k, which means you've got just enough to cover your expenses. But remember, $128k in 25 years from now is the equivalent of about $70k today, and by year five, they were already in that $70,000 range. So this makes the concern around being in a higher tax bracket in retirement pretty unlikely, barring an environment where there are sustained super, super high returns and abnormally low inflation for decades, which…that would be a fantastic problem for all of us. I hope we all have that problem. 

The other scenario I can think of is someone who just works for an incredibly long time, because giving your portfolio a really long time to compound, adding to it a lot over time. I didn't run any tests for that scenario, but if you work for 50 years, you invest devotedly the entire time, yeah, you're probably gonna find yourself in a position to pay yourself more than your job did in your early years, if you want to. 

Henah: So how do required minimum distributions factor into this? If you have a giant 401(k) in your seventies, you may have to take big distributions, right? 

Katie: Yeah. And frankly, the most compelling argument I've ever heard in favor of Roth is that of RMDs, because once you turn 73, the government looks at the size of your pre-tax bucket and they say, all right, you gotta start withdrawing more and paying taxes on it. That event, in which the government may wrest back control and force you to use your own money, means you no longer have total control over your tax rate. And it is a very valid criticism, though still, I'd say it's one of those problems you're gonna have to admit you'd be happy to have like, “Oh darn, I have so much money the government's making me spend it.” There are ways around it, though. One way to avoid RMDs is by converting your pre-tax funds to Roth once you retire, or in other low-income years. 

And you might be thinking, okay, but wait, shouldn't we have just started with Roth, then? No, not while you're making a hundred thousand dollars per year, Henny, like why not start converting to Roth and paying your effective tax rate on those conversions as soon as you retire, when you have no other earned income?

For example, if you are married, filing jointly, your standard deduction in 2023 is $27,700. If you retire at age 55, you now have 18 years to perform Roth conversions worth an inflation-adjusted $27,700 at a low or 0% tax rate. Thanks to that standard deduction, assuming you have no other earned income, that will allow you to convert nearly $500,000 of your 401(k) or 401(k)s, if each spouse has one, to Roth before your RMDs begin. Like we said, we’ll link the episode in the show notes about tax-free retirement. 

Henah: Yeah, let's talk about spouses for a second, though, because tax rates really change based on your marital status.

Katie: Totally. Yeah. When I set up my 401(k) at 22, I was making $52,000 per year, and my taxable income capped out at the 12% bracket, $52k minus the standard deduction. So I originally opted for the Roth 401(k); I was contributing to my 401(k) as a single person, but now as a married filing jointly superstar with favorable rates, I realize we'll be drawing down on that money based on married filing jointly tax rates, not single tax rates, at least if all goes according to plan. Which again, big caveat. And if you're like, “Yeah, so?” Think about the general advice that we give young people when we instruct them how to decide between Roth and Traditional 401(k) contributions. We say, “Do you think you'll make more now, or do you think you'll make more later?” In other words, do you think your tax rate is higher right now or do you think it'll be higher later? And I think most of us are optimists and we say, well, of course my tax rate's gonna be higher later. I'm on one strong upward trajectory, baby—all gas, no brakes. So why does being single or married matter? Well, the equation I would always do in my head was, I'm making $60k now. Do I think we're gonna wanna spend more than $60k later? Yeah, there's two of us. Maybe I should just pay the taxes now so we can use more than $60,000 later and pay less. 

Now, the flaw in this logic might be obvious now; it's not apples to apples. Your tax rate that determines how much you pay in taxes on your salary now, as a single person, is in a less forgiving bracket system than the tax rate that'll determine what you and your spouse pay to use it later. So pretend I'm single and I make $60k per year. My marginal tax rate is 22%, which means if I max out my 401(k) and opt for Roth, I'll pay about $4,900 in taxes on that income, assuming the tax brackets will stay more or less the same when adjusted for inflation over the next few years. Let's say I plan to withdraw $80,000 of my 401(k) per year in retirement. Now I might look at that and think, well, $80k…bigger than $60k…I am better off paying the taxes now on 60 K, so I don't have to pay the 22% on $80,000 of income later.

And it sounds like it makes sense, but the logic underlying the sentiment is wrong, for the reason that we just discussed. What happens if you add a spouse to that picture? So at some unspecified future retirement date, it's time to start drawing down on the 401(k). If I opted for that Roth 401(k), I paid $4,900 in tax on each annual $22,000 contribution in my 22% single bracket. So let's say I'm drawing down $80k of income in wedded bliss. A married couple filing jointly only pays a marginal tax rate of 12% on $80,000 of income, not 22% after standard deductions. That means you paid, as a single person contributing to the 401(k) 22% on your contributions, you paid 22 cents per dollar. But if you had used the Traditional 401(k), contributed $22k tax-deferred to withdraw later as a married couple, you'd only pay a 12% marginal tax rate on that income, and an effective tax rate of about 7.6%, or 7 cents per dollar used. 

Henah: Okay, so that seems like something to be conscious of during your single working years, or if you don't foresee yourself married in retirement. 

Katie: Right. If you're making single contributions now and you anticipate being married in the future, the pendulum might swing even more favorably in the direction of Traditional, since the tax rates that would be applied to Roth contributions are higher for singles than married filing jointly. For unmarried women, especially the high earners, I would say the Traditional 401(k) is likely to be more advantageous if you intend to get married later. The bottom line is that you're using the married filing jointly tax rates to your advantage during your drawdown, while also skirting those pesky single taxes by using a pre-tax account in your single earning years. Opposite is also true. If you're married while working, but single while drawing down, your tax rates in your drawdown phase might actually be less favorable than the tax rates you were subjected to as a married person. And since women typically outlive men, it's possible this will be the case, even if you never divorce at some point in your retirement, it's just you might outlive your spouse.

This is another feather in the cap of Roth contributions, but we are getting into the murkiness of waters that are honestly really hard to plan for. So as stated before, I am a public relations graduate with access to a Google sheet and the tax code. I'm not an economist or a financier, so it is possible there are holes in this reasoning. And if you think there is something that I'm not considering, shoot us an email. We'd love to hear from you. Like I said, the spreadsheet that fueled the methodology we discussed today is in the show notes, so you can make a copy; check it out for yourself. And of course, as we are projecting 25 years into the future, we are doing so in a vacuum, and there are other factors at play in people's lives that don't allow things to play out as neatly in real life.

That said, damn, I am pretty confident in the fact that we have proven there is an excellent chance that the Traditional 401(k) is almost always going to be the preferable choice for those in the 22%, we’ll say, bracket and above, as long as you do what? Invest your tax savings. 

All right, that is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.