This Loophole Makes Traditional 401(K) Better Than Roth [2023 Update]

we are back with the age-old question should you do a traditional or a Roth 401k the answer is if you follow this strategy traditional almost always wins out to the tune of hundreds of thousands of dollars down the line and today I'm going to show you how now the main advantage that everyone knows about for a traditional account is that it lowers your tax burden now but and this is the part many people don't realize depending on your tax bracket that could mean substantially more investable income that's why with rare exceptions I don't think I'd ever opt for a Roth 401k even if taxers in the future were to rise substantially it all comes down to this one very simple yet very powerful tweak when you invest in the traditional 401K you then have to invest the tax savings that you're generating somewhere else if you do that a traditional 401k and a Roth IRA or taxable brokerage account on the side will produce net more money in the future than just investing in a Roth 401k on a so if you're in the 24 marginal tax bracket and you contribute the full 22 500 that is an annual tax savings of about fifty four hundred dollars because here's the often overlooked Nuance that our strategy relies on Roth contributions are taxed top down starting at your highest marginal tax rate but traditional withdrawals and retirement are taxed at your effective tax rate they're taxed like earned income which means you pay taxes bottom up on your withdrawals the first 10 000 or so is going to be taxed at ten percent the next thirty thousand or so will be taxed at twelve percent and so on that also means you get the benefit of the standard deduction so even if tax rates go up we are still comparing today's marginal remember highest rates to the future is effective remember bottom up and lower tax rates it's also worth noting that there are ways to get your money out of a traditional 401K tax free too we have done episodes on tax-free retirements before that we'll Link in the description so to prove this out I did an experiment and remember if you decide to run the numbers for yourself your marginal tax bracket might be lower than you think after your standard deduction so be sure to subtract the standard deduction from your gross income before you assign yourself into one of these buckets so which path would get you further ahead investing in a Roth 401k and paying the taxes now or investing in a traditional 401k and investing your tax savings somewhere else preferably in a Roth IRA for tax diversification we're using a 25-year working timeline the maximum contributions every year three percent average inflation applied to both purchasing power and contribution limits a seven percent average rate of return and an earner and the 24 marginal tax bracket since that earner Falls somewhere in the middle and don't worry I also ran the numbers for the 12 group for whom the tax savings up front would be the smallest we're not going to worry about state taxes today but consider them personally if you work in a high state tax state like California and you plan to retire in a lower no state tax state like Florida prioritizing traditional tax savings now is even more of a no-brainer someone using the strategy in the 24 marginal tax bracket would have two million dollars in their 401K after 25 years had they invested their tax savings every year somewhere else assuming the same parameters they would also have 492 thousand dollars in another account whether a Roth IRA or a taxable brokerage account we'll link the spreadsheet in the description so you can see for yourself had you contributed to a Roth 401k you'd still have that two million dollar balance that you could draw down on tax free but you wouldn't have the other 492k that you generated in the traditional 401K example by investing the extra take-home pay your tax savings generated for you so now it's time to start drawing down right you've retired you've got your 2.5 million dollars between your two accounts and it's time to F around and find out what you're safe withdrawal rate on two and a half million dollars is at four percent it's one hundred and one thousand five hundred and forty eight dollars now this has the purchasing power of around forty eight thousand five hundred dollars in twenty twenty three so if you assume three percent inflation annually between now and twenty forty eight we will just adjust our tax brackets accordingly you'll withdraw your one hundred and one thousand five hundred assuming you withdraw all four percent of it from the 401K you'll pay taxes on the entire amount though note that you could take eighty two thousand from the 401K and the other nineteen thousand from the Roth IRA or taxable brokerage bonus account and your tax liability would be even lower but assuming you pull your entire four percent withdrawal from the 401K if you're single you'll set aside about eighty five hundred dollars to pay the taxes for a net income of ninety two thousand nine hundred and if you're married living on one set of retirement accounts you'll set aside about forty eight hundred dollars to pay the taxes for a net income of about 96k if you're married in both people and the couple are doing this with their own retirement accounts you'd basically double everything not bad right compared to the highest marginal tax rate in your working years that you would have paid on Roth contributions if you have a ton of taxable income from another source like real estate investing income a business you still own and earn from or another massive qualified account your tax rate is different because your income is different but if you're only relying on your 401k and maybe a Roth IRA and taxable account for your retirement income this holds up so did this strategy produce more money than drawing down directly from the Roth 401k well it's relatively simple to answer that question because had we gone Roth only our 401K value would still be the same we just don't have that bonus account that was funded by the tax savings if we had a Roth 401k worth the same 2 million dollars based on the same contributions and returns or four percent withdrawal would be eighty two thousand dollars tax-free that is you have no taxes to pay but as you can see your net income is lower than the ninety three thousand dollars you would have gotten single or the 97 000 you would have gotten married filing jointly because your overall portfolio value is lower thereby lowering your saved withdrawal rate when we run the same scenario but at a 12 marginal tax rate it Nets a traditional plus invested tax savings outcome of 2.3 million dollars this generates a four percent safe withdrawal rate of 92k which has the purchasing power of about forty three thousand dollars in today's dollars if you're single you're effective federal tax rate would be 7.96 on that amount and if you're married it would be 4.05 percent thereby making your married filing jointly net income about 88 000 and your single net income at about eighty four thousand six hundred the Roth outcome is a tax-free withdrawal of eighty two thousand one hundred and forty two dollars this means even in the 12 bracket as someone who's filing single in retirement you still end up with about 2 000 more in the traditional plus tax savings example that said it's definitely close and the 12 percent marginal tax bracket is probably a case where the outcome is going to be such a toss-up that Roth might make more sense since other major factors changing could tip the scales in its favor My ultimate strategy is to go traditional 401k and then invest the tax savings in a Roth IRA but you could also use a taxable brokerage account because think about it you'll never pay taxes on that Roth IRA ever again thereby giving you both tax diversity and access to incrementally more investable income now and investment income later for our full traditional versus Roth Deep dive check out our podcast episode Linked In the description we'll go into all the other complexities and nuances that factor in and of course we are projecting things 25 years into the future and we are doing so in a vacuum there are other factors that play in people's lives that don't allow things to play out really neatly in real life but that said damn I am pretty confident in the fact that there is an excellent chance the traditional 401K is almost always going to be the preferable Choice as long as you invest your tax savings you you've probably heard me talk about M1 Finance on the show before because it is one of my go-to brokerages for my taxable investing but they just sweetened the pot with a new offering a high old savings account with a five percent annual percentage yield yes five percent this is the highest rate I have seen anywhere so far and accounts are FDIC insured up to five million dollars signing up for my account only took about 60 seconds and much like the rest of my taxable investing with M1 the process was super smooth if you're saving up for a big purchase like a home a car or even just want your emergency fund to maintain purchasing power over time the five percent high yield savings account from M1 Finance is a great option you got fifty thousand dollars for a down payment waiting you can earn twenty five hundred dollars per year in interest to access become an M1 plus member for ninety five dollars per year with the M1 plus apy of five percent if you kept a minimum of a Nineteen Hundred Dollar balance in your account the annual plus fee would be covered by the interest earned before we go comment below what you thought the most interesting part of our breakdown was and remember to like And subscribe to our Channel I will see you next week same time same place on the money with Katie show

Channel: Money with Katie

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Keywords: #MoneyWithKatie, #Traditional401K, #RothIRA, money with katie, money with katie retirement, money with katie investing, katie gatti, katie gatti tassin, traditional vs roth ira, traditional 401k, 401k, roth ira, roth 401k, traditional ira, retirement, retirement planning, investing account, investing account types, fire, financial literacy, tax strategies for high income individuals, tax strategies, tax strategies for high income earners, roth ira vs 401k

Id: qY3JY0Tj8xw

Length: 9min 17sec (557 seconds)

Published: Wed May 24 2023