Reconsider Your Roth While on the Path to FIRE

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation.

This will be my third post in this series on Traditional vs. Roth accounts, but hopefully it will be the most enlightening on the superiority of Traditional accounts over Roth accounts for those seeking FIRE. If you haven’t read my two prior posts on this subject, then go back and check them out for some background. In this post, I highlighted the differences between the accounts as well as the reason why today’s marginal tax savings must be compared to effective tax burden in retirement. In this post, I concocted a real world example comparing two individuals with exactly the same income and expenses to show how a traditional account will come out ahead.

Let’s layout, what I would consider to be, a fairly typical financial situation for someone seeking FIRE. Like earlier posts, I will use a single individual with no kids for simplicity sake, but the same ideas and similar calculations would apply for those married with kids. I also am going to assume that inflation, raises, and expenses all rise in a proportionally equal manner to make the calculations more simple. This individual, Steve, has a salary earning $36,000/year, putting him in the 15% marginal tax bracket. His total expenses are $18,000/year, which he intends to keep the same throughout his retirement, tax adjusted of course. At his workplace he has the option of contributing to a Roth 401k or a Traditional 401k, and he is trying to decide which will be the best option for him and will allow him to reach FIRE as soon as possible while investing the $18,000 difference between his income and expenses. A 50% savings rate may seem high, but for those seeking FIRE this is fairly common. Steve is starting his FIRE journey at the age of 39 after recently paying off all of his credit card debt, and he now has a total net worth of exactly $0. He knows that with a 50% savings rate he will be able to reach financial independence in about 16 years, at which time he will be 55 years old and able to withdraw money from his 401k (whether traditional or Roth) without a 10% penalty. Let’s start by looking at what his current tax burden will be with each type of account to try to gain some clarity on the situation. Here are the current tax brackets from reference.

Traditional 401k

If he chooses the traditional 401k and invests the full $18,000 each year, here is what his tax burden will look like:

• $36,000 – $18,000 (Traditional 401k contribution) = $18,000
• $18,000 – $10,400 (Standard deduction and personal exemption) = $7,600
• $7,600 * 10% (Marginal tax bracket) = $760

His total tax burden will be $760/year for an effective tax rate of $760/$18,000 = 4.22%.

His total tax savings each year from contributing to a traditional 401k in this example is:

• (($9,325 – $7,600) * 10%) + ((($18,000 – ($9,325 – $7,600)) * 15%) = $2,613.75

This calculation may seem difficult, but really all I’m doing is adding that $18,000 back in as taxable income, which would fill up the rest of the 10% marginal bracket and spill over into the 15% marginal bracket.

• $1,725 in the 10% bracket = $172.50
• $16,275 in the 15% bracket = $2,441.25

To see what his effective savings on his taxes would be, all we have to do is take the amount invested and divide by the tax savings.

• $2,613 / $18,000 = 14.52%

This is the important number to consider. If Steve can manage to pay less than this percentage in taxes in retirement, then he will come out ahead with all other things being even.

Roth 401k

If he chooses the Roth 401k and invests the full $18,000 each year, here is what his tax burden will look like using the formula from the marginal tax brackets above:

• $36,000 – $10,400 (Standard deduction and personal exemption) = $25,600
• $932.50 + 15% of the amount over $9,325
• $932.50 + (($25,600 – $9,325) * 15%) = $3,373.75

This number should make sense because if we add Steve’s tax burden from the traditional 401k example to his tax savings, we should reach the same answer, which we do. To find his effective tax rate in this example, we divide his tax burden by his total income, just as before.

• $3,373.75 / $36,000 = 9.37%

Calculations in Retirement

Finding what Steve’s effective tax rate is while working and what his tax savings is with a Traditional vs. a Roth account is well and good, but it means nothing without seeing the other side of the equation. In this case, that means looking at what his tax burden will be after FIRE in each situation.

Roth after Retirement

We’ll start with the Roth scenario since he won’t be paying any taxes at all, so there is basically no math to do. Steve will withdraw 4% of his portfolio to live on each year, which now equates to $18,000. Since he invested in the Roth 401k, his withdrawals are tax free for the rest of his life!

Traditional after Retirement

Now, obviously in the future tax brackets won’t be the same which I mentioned in both of the previous posts on this subject. Since we have no idea whether they will increase or decrease in the future for someone withdrawing the inflation adjusted equivalent of $18,000/year, we will assume that they stay the same. His $18,000 withdrawals will no longer truly be $18,000 because of inflation, but since we agreed to assume that raises and expenses will keep pace with inflation, effectively cancelling each other out, we can still use the same numbers. Keep in mind that if Steve is able to pay less than the 14.52% that he saved on his taxes by contributing to his traditional 401k while working, he comes out ahead by choosing this route. Let’s calculate what Steve’s tax burden would be when withdrawing money from his traditional 401k using the tax table from above.

• $18,000 – $10,400 (Standard deduction and personal exemption) = $7,600
• $7,600 * 10% (Marginal tax bracket) = $760

Since his taxable income remained the same both before and after retirement in this scenario, the tax burden is exactly the same. This also means that his effective tax rate will also be the exact same.

• $760 / $18,000 = 4.22%

Conclusion

If Steve contributes to a Traditional 401k while working, he will save at his marginal rate, which for him, is partially in the 10% bracket and partially in the 15% bracket, leading to a blended rate of 14.52%. In retirement, due to the progressive tax code as well as the standard deduction and personal exemption, he will only be paying an effective tax rate of 4.22% on his traditional 401k withdrawals. That 10% difference will end up being well over $100,000 throughout a 30 year retirement when left to compound in low cost index funds.

As illustrated in this example, it is vital to remember to not compare your marginal tax rate before retirement to your marginal tax rate after retirement. The true comparison is marginal tax bracket before (or blended marginal rate if split between two brackets) to the effective tax rate after retirement. This gives a HUGE edge to Traditional accounts over Roth accounts, especially for those with low expenses meaning low withdrawal amounts in retirement. I hope that this helps to clear things up. Please feel free to ask questions below and go through the math yourself to make sure what I’m saying is correct.

Caveats 

This post would not be complete without me mentioning factors that would alter this scenario. If Steve has any income in retirement, that will change the effective rate at which his withdrawals will be taxed. Income sources could include: social security, pensions, income from part time jobs, and for those above the 15% tax bracket, qualified dividends. I don’t foresee a situation that any of these would completely cancel out the benefit of a Traditional account over a Roth account, but it would certainly reduce the overall benefit. It is important to run these calculations for your own individual situation to determine what is best for you.