Should Higher Earners Choose a Roth or Traditional 401(k)?

Why Income Level is Important

Your total income isn’t as important as your effective tax rate. However, more income usually results in a higher effective tax rate, so income is one of the first factors you should evaluate when deciding between a Roth or Traditional 401(k). The higher the income, the more likely it is that a Traditional 401(k) is better.

Here’s another way to look at this scenario. Try and estimate if your effective tax rate will be higher today or in retirement? If you think it will be higher today (while you’re working and earning a salary), you’d probably want to avoid paying taxes today. Assuming your tax rate will be lower in the future, it would be reasonable to want to defer those taxes to the future. This would suggest using a Traditional 401(k).

If you expect your effective tax rate to be lower today than in retirement, then a Roth option could allow you to pay taxes today, at a lower rate, and avoid taxes in the future, when you expect your effective tax rate to be higher.

The major kicker in trying to evaluate this question is that nobody knows what tax rates could look like in 10, 20, or 30 years from now. Therefore, you won’t know if you made the perfect decision until you reach the point that you are making withdrawals from these accounts.

What is an Effective Tax Rate and Why Does it Matter?

Your effective tax rate is different than your marginal tax rate or bracket. However, many people confuse the two. Your marginal tax rate usually refers to the tax paid on the last dollar of income. However, since our tax system uses a tiered calculation method, someone in a 22% tax bracket is still paying 10% on a portion of income, 12% on a portion, and 22% on the rest.

So, the average tax paid is referred to as your effective tax rate. For example, if your taxable income was $100,000 and you paid $16,000 in taxes, your effective tax rate would be 16%.

Effective tax rate is important because it captures the actual result of your tax situation. Whereas, two couples making $169,000 and $320,000, respectively, are both in the 24% marginal tax rate, but the ladder couple will have a higher effective tax rate (approximately 20%) because more of their income is taxed at that 24% rate. The couple making $169,000 would have pay approximately 17% effective tax.¹ (see The New 2019 Federal Income Tax Brackets and Rates, Forbes)

Other Guidelines

To help determine when your effective tax rate will likely be higher, try keeping it simple. Most people will not earn as much income when they retire as they did in their last 2-3 years of working. In fact, people require more earnings while working because they are typically making retirement account contributions, perhaps paying down a mortgage, helping kids with college, etc.

In retirement, assuming these things are no longer present, it doesn’t take as much income to live a similar lifestyle. So again, for those high earners approaching retirement, this would suggest sticking with a Traditional 401(k) in those later working years.

However, for younger workers, there is much more uncertainty about future income, future taxes, etc. As expected, due to inflation and promotions, it is common to expect that younger workers will continue to make more money the longer they work. In that case, taking advantage of a Roth 401(k) could make sense early in your career, but be cautious if you’re already paying a high effective tax today.

For many young medical and dental professionals, starting salaries could trigger high effective tax early in your career. And, at a time when younger workers like these are working hard to pay down student loans, the tax savings from using a pre-tax account could be a tremendous help to cash flow concerns.

Bottom Line

In a perfect world, we’d all know what our future tax rate would be, and it would make our Roth vs. Traditional decision very easy. Or, we’d all retire with our retirement accounts split 50% to traditional and 50% to Roth to give us options when we’re in the withdrawal phase. However, that’s not realistic.

For the higher earners out there, especially the younger ones, it may be too difficult to pass up significant tax savings today. Therefore, a high-earning younger worker may end up with retirement accounts that are 100% pre-tax in retirement. My opinion on that; I’ve seen worse things.

¹https://www.forbes.com/sites/jrose/2018/12/05/tax-brackets-and-rates-2019/#d176a0c3ec50. The New 2019 Federal Income Tax Brackets and Rates.

CarsonAllaria Wealth Management does not provide tax or legal advice. All articles and posts are provided by CarsonAllaria Wealth Management (CAWM or firm) for informational purposes only. By accessing or otherwise using this Article, you agree to be bound by the terms and conditions set forth below. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the Article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the Article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment strategy. In addition, this Article shall not constitute the provision of personalized investment, tax or legal advice, and investors shall not assume this Article serves as a substitute for personalized individual advice. Information contained in this Article may have been derived from third-party sources that CAWM believes to be reliable; however CAWM does not control such information and does not guarantee the accuracy or timeliness of such information and disclaims all liability for damages resulting from such sources. Links or references to third-party websites are provided as a convenience and do not constitute an endorsement by CAWM, and the Firm is not responsible for the content of any such websites. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.