Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA

by Kosmo on 2012-02-153

In recent years, Roth IRAs have become very popular with investors. The Roth IRA is named after Senator William Roth of Delaware, who sponsored the 1997 legislation that created them. The basic idea behind the Roth IRA is pretty simple — you invest after-tax money into your Roth IRA, and are not taxed on the money when you withdraw it. Conversely, with a 401(k) (or a traditional IRA), you invest pre-tax money, but pay taxes on everything when you withdraw. I’ll compare and contrast the Roth with a 401(k), since that’s what I’m most familiar with.

Investing in a Roth IRA means you will pay less in taxes.

As long as your investments yield a positive return, this will always be true because you’re only taxed on the principal with a Roth (since it’s after-tax money, you’ve already paid the tax before investing it) whereas you’re taxed on withdrawals of principal and earnings when you withdraw from a 401(k). Thus, many financial advisors tout this as a reason for the Roth account being superior to the 401(k).

However, I think that this is an example of asking the wrong question. What’s most important is not to minimize taxes, but rather, it’s to maximize the amount of money you keep.

Deciding Between Pre-Tax or After Tax Money For Your Retirement Accounts

How do we make a decision between these two funding options for your retirement needs IF you’re financially limited to one option? Let’s analyze a basic scenario to see what considerations to take when deciding how to invest for retirement. Let’s start with these assumptions:

  • One has $5,000 of pre-tax money to invest.
  • Investments will double between now and retirement.
  • The current tax rate and post-retirement tax rate are both 28%.

Given these assumptions, let’s work with some examples.

Amy decides to invest in a Roth IRA. The pre-tax amount of $5,000 is taxed during the normal course of events. She pays $1,400 in taxes (28% of $5,000), leaving her with $3,600 to invest. Her investment doubles by the time of retirement, leaving her with $7,200.

Beth opts for a 401(k) account. The entire $5,000 is invested into her account — she does not pay any taxes at the current time. Her $5,000 also doubles, leaving her with an account balance of $10,000. When she makes withdrawals, they are taxed at 28%. She pays $2,800 in taxes, leaving her with $7,200 in her pocket.

While Amy pays only $1,400 in taxes and Beth pays $2,800, it’s important to note that Amy is paying in current dollars and Beth is paying in future dollars (which are almost certain to be worth less than current dollars).

There’s no accounting trick needed to make the numbers come out this way. By taking the tax hit up front, you start with less money in the balance of your Roth than in an equivalent 401(k). As an aside, note that if you decide on a starting investment of $5,000 in a Roth IRA, then you’ll need a pre-tax income of $6,944.45.

Is there nothing certain but taxes? The key variable is the tax rate. If you pay a lower tax rate today than you will at retirement, then a Roth makes sense. If you expect to pay a lower rate after retirement, then a 401(k) is the right choice. Sounds very easy — but there’s no way to guarantee future tax rates.

The Vote For A Roth IRA

When you’re currently in a lower tax rate than you expect in the future, then your best choice is a Roth IRA. Here are some scenarios where a Roth makes sense.

  • Crystal just graduated college and landed her first real job. She’s on the lowest rung of the corporate ladder, and her income will be in the 10% bracket. Barring some unforeseen changes in the tax law, Crystal will never again pay such a low tax rate. It makes sense to invest in a Roth, as it means paying taxes at the 10% rate instead of a higher future rate.
  • Susan lost her job in March and has been on unemployment all year, dropping her income lower than it has been in decades. The silver lining is that she can invest in a Roth IRA and pay a low tax rate on those contributions.
  • Emily expects to have substantial post-retirement income. She split her career between two companies and will receive a generous pension from both. She also has 401(k) accounts through each of the employers, and the investments have performed very well. The net effect is that Emily’s post-retirement income will be substantially higher than her current income — putting her in a higher tax bracket. It makes sense to take advantage of her lower current rate and invest in a Roth IRA.

What are some issues that can impact your decision to go with a Roth? What about this question: will a balanced budget amendment affect tax rates?

Let’s consider the larger picture here as well, and bring up some potential events down the road. You may have heard that some politicians have been pushing a balanced budget amendment which would force congress to match spending to revenue. The two basic ways to balance the budget would be to cut spending and raise taxes. However, the proponents of the balanced budget amendment seem to be glossing over the difficulties in passing such an amendment. One of the requirements for this is ratification by the state legislatures of ¾ (three quarters) of the states. When you consider that one of the easiest ways to cut spending would be to push the cost of certain programs down to the states, then it seems likely that at least 13 states would opt to block ratification.

When Does A 401(k) Make Sense?

When you expect your current tax rate to exceed your post-retirement tax rate, then a 401(k) is a better option. Here are some scenarios that support the choice for a 401(k) account.

  • As a result of winning $100,000 in the lottery this year, Jane has a modified adjusted gross income (MAGI) of $175,000. Since Roth IRA contributions are not allowed for individuals with an MAGI over $110,000 or married couples with an MAGI over $160,000, Jane is not allowed to contribute to a Roth IRA, but is allowed to contribute to a 401(k).
  • Gina is in the last year of an exemplary career and she’s in line to make a lot of money this year. A promotion five years ago resulted in a big raise. She’s also receiving a substantial performance bonus for landing several key customers during the year. While her income is still below the limits for a Roth IRA contribution, it will still be twice what her projected post-retirement income will be. This means that Gina should opt to contribute to a 401(k), since a Roth IRA contribution would be taxed at a higher rate.
  • Heidi has been investing in a Roth IRA since her first job. She doesn’t have substantial assets outside of her account. Since withdrawals from her Roth IRA won’t count as income, her post-retirement income is projected to be just a few thousand dollars. It makes sense for her to reduce her current income and push more income into her post-retirement years so that it is taxed at the lowest rate. Thus, she decides to fund a 401(k) in lieu of investing in her existing Roth. Note though, that she shouldn’t completely minimize her post-retirement income; she may want to earn enough income to reach the top of at least the second tax bracket (possibly higher, depending on what her current bracket is).

General Thoughts & Basic Assumptions

Here are additional tips to support your retirement investing decisions.

  • The above scenarios all assume that the investor only has enough money to contribute to either a 401(k) or Roth IRA, but not both. If you’re able to do it, it may make sense to max out both. As of the year 2012, you are limited to contributing $5,000 to a Roth, with a $1,000 “catch-up” provision that allows people 50 or older to contribute a total of $6,000. You are limited to contributing $17,000 to a 401(k), with a catch-up provision of $5,500 that allows people 50 or older to contribute a total of $22,500 per year. Thus, even if a Roth is the best option for you, it may make sense to contribute to a 401(k) after you’ve maxed out your Roth IRA. Some employers offer a Roth 401(k), which, at a high level, is a Roth IRA with the higher limits of a 401(k).
  • In general, a Roth makes the most sense early in your career, since your income in these early years will likely be less than your post-retirement income. With every raise or increase in your income, the scale will tip a bit more in favor of the 401(k), until the point where your current tax rate exceeds your projected post-retirement rate. Don’t feel that you must pick one plan and stick to it. It might make sense to invest in a Roth at age 25 but a 401(k) at age 50. This doesn’t mean that your original decision was wrong — it was actually the best investment choice for that particular time period or circumstance.
  • Don’t ignore the yield of the actual investment when making your choice. If a 401(k) is your optimal strategy, but your specific 401(k) plan offers weak investments compared to your choices in a Roth IRA, then a Roth might be the preferred option. Earning 10% and paying slightly higher taxes is still better than earning 1% and paying lower taxes.
  • While it’s impossible to predict future tax rates, it’s important to realize that the brackets are periodically adjusted for inflation. For example, while the lowest tax bracket currently cuts off at $8,500 for single people, thirty years from now, the bracket might cut off at $20,000. So if you’re earning $100,000 now and expect to earn $100,000 when you retire, don’t assume that you’ll always be in the same bracket.
  • Take advantage of employer matching. My employer matches 401(k) contributions dollar for dollar up to a certain amount. This means that I double my money right away. Even if a Roth account is generally a better option for me, it makes sense to take advantage of the matched funds.
  • While the focus of this article has been on maximizing your nest egg, there are other reasons why you may opt for either a Roth IRA or a 401(k) plan. For example, you can withdraw the principal from a Roth account at any time without penalty (remember, you’ve already paid taxes on this money). These factors may play a part in your decision.
  • Everyone’s situation is unique. If you have post-retirement income from other sources (such as a pension or non-retirement investment accounts), then this will affect your post-retirement tax rate. As with any financial decision, the more information you use, the better the decision will be.

Copyright © 2012 The Digerati Life. All Rights Reserved.

{ 3 comments… read them below or add one }

krantcents February 15, 2012 at 6:35 pm

I am fortunate enough to do all of them and even use brokerage accounts. I am hedging my bets by contributing to all of them. Although I do no think I will be in a higher tax bracket in retirement, I like the Roth IRA for leaving it to my heirs.

Daniel February 16, 2012 at 11:02 am

What about Roth 401K vs Roth IRA? What would be better in this situation?

Kosmo @ The Soap Boxers February 17, 2012 at 7:16 am

@ Daniel – If a normal Roth IRA is better for you than a normal 401(k), then a Roth 401(k) is an even better option because of higher contribution limits.

If a normal 401(k) is better for you than a normal Roth, then it will also be better than a Roth 401(k).

While I’m oversimplifying a bit, a Roth 401(k) is essentially a Roth with high contribution limits. Employers can also contribute to an employee’s Roth 401(k), although the employer’s contribution doesn’t get the Roth tax treatment (yeah, that doesn’t make sense to me, either).

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