Whoa. This is awesome. My employer announced recently that they’ll be adding a Roth 401(k) as an option for employees to save for retirement starting next year. The current options are pre-tax (what we do now) and after-tax contributions, so this will be a third option.
Of the three, I automatically write off the after-tax option, with the Roth now on the table. It really only seems like a good option if the 401(k) is already getting maxed out. But even then at that point I’d much rather contribute to an IRA because of the immediate control of the account and much wider investment choices.
Like I said, the standard pre-tax 401(k) account is what we do now. It’s a nice way to decrease our immediate tax-burden and shelter some of that money for a couple of decades. It has always irked me a little though, ever since I found out Roth 401(k)s existed (last year, I think) that there were other people out there that would not have to pay taxes when they reached 60 years old on the growth of their investments but I would, simply for checking a box at their HR department and taking a little bit of a tax hit now. Retirement planning completely changes when you account, or forget to account for, the impact of taxes on your investments.
As much as contributing to the Roth sounded like a no-brainer for Mrs. Mase and I, it seemed wise to run the numbers beforehand to see how much of an impact on our finances it could actually make. The basic opportunity cost question is, would we rather pay taxes every year until we’re in our sixties, or shelter that income now and take the tax hit as we withdraw from those accounts decades from now.
Using the future value of an annuity formula to calculate the compound growth, I found that, given our current tax bracket and assuming a static wage each year, we are on track to save over $80,000 in taxes over the course of our working lifetime. Not bad. However, looking at the taxes on the back end, things aren’t as pretty.
I assume that at age 65, we start to draw down on the 401(k) balance at 4% per year (the famous safe withdrawal rate) over a 30-year period. I also assumed a higher tax bracket, because since in this future scenario we were so diligent and saved for decades, the government must punish us by taking a bigger bite out of our paycheck than if we had simply decided to save less and withdraw less. I assumed an 8% return, which I think is reasonable over such a long period of time, and I assumed that the 401(k) gets maxed out to the full $17,500 each year (not accounting for if the IRS raises the limit).
The results? We’d end up paying over a million dollars in taxes on the back-end. Of course, this assumes that the government’s income tax policies aren’t too different than what they are today. We can’t plan properly trying to account for variables out of our control though, so this assumption will have to do. Backing out the initial tax savings from when we were working, we see that the initial tax savings, while nice, don’t nearly offset the amount paid on investment gains and contributions later down the line. We’re talking about seven figures in taxes here.
What about the scenario where we contribute to the Roth instead? Here, the numbers just flip. Instead of saving $80,000 throughout our working lifetime, we end up paying those taxes up front. Less immediate gratification, but hey the end result is just so sweet. Those millions in taxes paid now turn into millions of taxes saved. With that additional money added into our retirement nest egg, Mrs. Mase and I will now have additional tens of thousands of dollars per year flowing in from investment gains (withdrawing 4% of a few million is certainly less than withdrawing 4% from an additional million).
This is really exciting. I’ve definitely become a nerd with this personal finance stuff because I started dancing around the house when I heard the news. I mean, it’s amazing that something so simple such as putting your money in the right account can drastically improve your results. It makes me think about the co-workers I have that are retiring right now or about to in the next few years. I know some of them have several hundred of thousands in their accounts, and I speculate a few of them have got to be 401(k) millionaires (aka the Millionaire Next Door types). This is in addition to pension benefits that they are going to receive. Can you imagine the type of wealth they would have been able to build if they had Roth 401k(s) as an option back in the 1970’s or 80’s?
This is incredible. If you have a Roth 401(k) at work, I suggest you run the numbers for yourself and see how much it benefits your particular situation. If you’re about to retire and plan on living on less income than you are now anyway, the Roth might not make as much sense because you’ll be in a lower tax bracket. If you’re 30 or younger than it should be a no brainer. Even if you retire super early like Mr. Money Mustache and stop contributing to the plan in your 30s or 40s, you will still save a ton of money on income taxes because the money you’ve saved up to that point still has 20 or 30 years to sit and compound. You can take the gains without having to worry about whether you can comfortably write the check for the Toyota for your grandson or write a check for the Tesla.