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)
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.
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.
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