The decision of whether to contribute to a Roth 401(k) or a Traditional 401(k) all comes down to whether you are likely to be in a higher tax bracket than you are now when you retire.
The only determining factor in whether you should contribute to a Roth 401(k) is what you think your tax rate will be when you retire.
David takes an example of two twin brothers and compares the difference between a Traditional 401(k) and a Roth 401(k) over the course of 30 years. The takeaway is that if tax rates remain the same, both plans are identical, but if tax rates are even just 1% higher than they are today then the Roth 401(k) will always win.
If tax rates go up, the Roth 401(k) wins hands down. If tax rates stay the same, then both plans will get the same results. The only scenario where the Traditional 401(k) wins is in the unlikely event tax rates are lower in the future.
Some economists have suggested that tax rates will have to double by 2030 just to keep our country solvent.
In his book Comeback America, former Comptroller General David Walker predicted that average effective tax rates in the US would have to rise to 45% by 2030 to pay for unfunded obligations, Social Security, MediCare, Medicaid, and interest on the national debt.
The farther out your investment horizon the more likely your tax rate in retirement will be substantially higher than it is today.
With the passage of the Secure 2.0 Act, you now have the ability to direct your employer’s match to the Roth portion of your 401(k).
When you retire, it is important to have some tax-deferred income in order to maximize your standard deduction.
If you have all your money in your Roth 401(k) then your standard deduction will stand idle and you will have paid taxes on your contributions unnecessarily.
The goal should be to allocate the lion’s share of your retirement money to your Roth 401(k) to protect you against future tax rate increases, and have the match put into the tax-deferred portion of your 401(k) so it can be offset by the standard deduction in retirement.
Mentioned in this episode:
David’s books: Power of Zero, Look Before You LIRP, The Volatility Shield, Tax-Free Income for Life and The Infinity Code
PowerOfZero.com (free 3-part video series)
@mcknightandco on Twitter
@davidcmcknight on Instagram
David McKnight on YouTube
Get David’s Tax-free Tool Kit at taxfreetoolkit.com
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