401(k), Roth 401(k), and Tax Rates

Retirement planning services are a common benefit offered by employers. A typical benefit is the 401(k). A new option being offered by employers is the Roth 401(k). How do the two options differ and why might you choose one over the other? There are differences and here I’ll choose to focus on one, tax rates.

In theĀ The Power of Zero by David McKnight he explains the differences with a particular focus on taxes, when you pay them, and how much. He uses a farming analogy to explain this difference. A farmer plants his seed and a few months later has a harvest. He is required to pay taxes and depending on the tax option he chooses he either pays taxes on the seed or on the harvest. This is a big difference between a 401(k) and a Roth 401(k).

  • 401(k) pays tax on the harvest
  • Roth 401(k) pays tax on the seed

Why might you choose one option over the other? It all depends on the marginal tax rate that is applied to the seed or the harvest. If you believe taxes will be lower in the future then pay taxes on the harvest; if you believe taxes will be higher in the future then pay taxes on the seed. Do the math. Two investments that grow with the same principle, time period, growth rate, and the same marginal tax rate (at seed for one, harvest for the other) will have the same return. However, if you modify the future marginal tax rate (higher or lower) on the harvest then you will see a deviation in the returns.

What do you think marginal tax rates will be in the future? Higher or lower? That’s the million dollar question (literally)!

Here are some factors to consider about future marginal tax rates in the United States WHEN you retire. How might these factors affect marginal tax rates?

  • What will be the ratio of workers to retirees? (i.e. tax payers vs benefit receivers)
  • What will be the financial status of entitlements? (i.e. Social Security, Medicare and Medicaid)
  • What percentage of tax dollars will go towards those entitlements & national debt?

In his book Mr. McKnight provides data showing that we live in a period of historically low marginal tax rates and of financially strained social entitlements and eventually something has to give. If you connect the dots and do the math then you’ll understand why.

Back to the 401(k) vs Roth 401(k), which is preferable for your retirement when you consider future tax rates? For me it’s clear. I believe taxes will go up to support entitlements. Therefore I’ll pay on the seedĀ and my choice is the Roth 401(k).

What are your thoughts on future tax rates and how might they affect your 401(k) and Roth 401(k) withdrawals in retirement?