Money Match-Up: What is the Best Way for High-Earners to Invest Retirement Funds?

Here's the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue. Today's issue features another interesting debate -- what is the best way for high-earners to invest retirement funds? The two options discussed today: funding a 401k via the traditional path versus through a Roth IRA. We'll begin with Jason from Winning Personal Finance who prefers traditional accounts...

Traditional Accounts Are Best for High Earners

Your “dream life” probably looks very different than mine. One thing most of us have in common though is that we all want to win. Getting the most value we can out of our hard earned money is one way to do so. The US government has given us an opportunity. They’ve created retirement accounts with tax advantages to incentivize saving for our retirement. With a traditional account, you get a tax break in the year you contribute and pay taxes when you withdraw from the account. A Roth account provides no up-front tax breaks and allows all earnings on that money to be tax free. Knowing it’s a good idea to contribute to a tax advantaged retirement plan is the easy part. The harder question is, which is better, Roth or traditional? On the surface, the answer is simple. The better account is the one that will lead you to pay less in taxes. Today’s matchup asks which account is better for a high income family. I’ll happily argue that in most cases, a traditional account is best for those with high incomes.

Predicting The Future

It’s fairly straightforward to predict your marginal tax rate today. This number is important because it represents the amount you’d save on taxes for contributions into a traditional plan. The harder part, is predicting your marginal tax rate on that same money in the year you withdraw it. If you will withdraw your money at a lower marginal tax rate than you pay today, a traditional plan is for you. If you will withdraw your money at a higher marginal tax rate than you pay today, a Roth is for you. Yes, I know I’m only supposed to take one side of this argument but this is not a one size fits all approach. Unfortunately, none of us can perfectly predict the future.

High Earners Pay High Taxes Today

Since we don’t know what the future holds, let’s use some logic. Chances are, high earners are paying high marginal tax rates today. During retirement, (the old definition of retirement when a person actually stops earning income) high earners are likely to withdraw their funds at a lower marginal tax rate than their high marginal tax rate today. Paying a lower tax rate in the future than you’d have to pay today favors a traditional account.

Lower Income In Retirement (Usually) Means Lower Taxes

The tax rates in the US tax code are tiered. The first chunk of income is tax free. The next tier has low tax rates and it goes up from there. If you have no other income in retirement, you can fill up these lower tax rates with your withdrawals or a Roth conversion from a traditional plan. This structure of the tax code is why it’s often best for a high earner to defer paying their taxes.

Let’s Try an Example

The Physician Philosopher and I agreed to use a set of variables to compare the two. They are:

Married couple with a single income of $200,000
They have two kids and take the standard ($24,000) deduction
The earner contributes $18,500 into a 401(k)
His or Her employer will contribute 4% of salary for a total of $26,500
Tax savings from choosing a traditional 401(k) for this contribution would be $4,290 and would be invested in a taxable account when comparing a traditional plan to a Roth option.

This couple would fall into the 24% tax bracket today (in 2018) assuming they contribute to a Roth and fall into the 22% tax bracket if they made a full contribution to a traditional 401(k). We don’t have any other information. Is this family better off with the Roth or traditional account? I believe the traditional account is the answer for this high earning family. A 22% or 24% federal marginal tax rate is pretty high. It’d be nice to pay taxes on that income at a lower rate. At some point, this family will retire and start living on their savings. That’s why they saved for retirement. Right? At that point, they can use traditional plan withdrawals to fill up the lower tax tiers. I’m going to add a couple of additional assumptions for the retirement phase.

Over time the invested contributions increased by 300%.
All of the contributions are withdrawn in the same year with no other income.
The family’s children are grown and no longer can be claimed for a child tax credit.
The tax rules remain the same as they are in 2018.
can determine which option is MOST LIKELY to be the better approach for you. If you get it right, you can save thousands in taxes.

What if You Guess Wrong

By choosing a traditional pre-tax account, our hypothetical family is betting that the taxes being saved today will outweigh the tax rate paid when the savings are withdrawn. Here’s my favorite part of this approach. Even if they guessed wrong, they win. If the traditional account was the wrong call, it will probably be because high income during retirement years caused them to continually pay high taxes. In that case, it will mean the family is very wealthy. How else would they end up paying high taxes during retirement? Think about it. Based on today’s (2018) tax rates, the first $101,399 (for a couple married filing jointly) has a marginal tax rate lower than 22%? In fact, with no other income, they’d have to withdraw more than $400K a year from retirement accounts for the effective tax rate in that year to be over 22%. If they’ve found a way to make significant income throughout life, that’s a win in my book. Even if the traditional vs. Roth decision made years earlier did not work out. By picking a traditional plan as a high earner, you’ve already won. Either by:

Having more after tax dollars than the Roth option or
Having fewer after tax dollars but still being very well off

That’s what I like to call a win/win!

Rebuttal Against The Roth Argument

Tax Rate Changes Some argue that tax rates can change and therefore we should favor the Roth. It’s true that they can change. Still, I don’t find this argument favors a Roth (or a traditional) account. Your decision should be based on your best guess on what your tax rate will be in the future. As we’ve seen in the most recent tax legislation, the rules can change and can do so quickly. Considering most of us have no clue if they are going to go up, down, left or right, I use the status quo for my estimates. Behavioral Finance Not all $18,500 contributions are created equal. Maxing out a Roth account allows you to save more “after tax dollars” than contributing the same amount to a traditional account. In order to make up the difference, one would have to invest the tax savings in a taxable account. Since you’re reading this on Rockstar Finance, I know you’re already a superstar at this stuff and have the discipline to invest the tax savings. Many high income professionals who have the resources to max out their 401(k) are already saving more in other places making the behavioral finance argument largely moot. Stretch Roth There’s an argument for the Roth as a tool for generational wealth. It’s a nice to think about your Roth accounts still growing tax free after being passed down to your great grandkids. Here’s the catch, inheritance is inheritance. If you want your heirs to have the most spending power with their dollars, the key to doing so is for you or them to pay the lowest possible taxes on the resources. Assuming no estate tax considerations, if you spend your life in the highest tax brackets and your heirs do not, they are better off inheriting pre-tax dollars and paying a lower tax rate than you would have. Changing the generation of the person withdrawing this money, does not change the math on which account is better.

Final Point

Winning the traditional vs. Roth Game is about paying the lowest possible taxes. If you can predict the future (income, tax rates, future spending, other after tax assets) it would be easy to make the right call every time. We can’t predict the future. Today’s debate is for a high income family in a high tax rate. In this case, I’d bet on a traditional account and expect them to pay a lower tax rate when withdrawing that money at retirement age. Worst case scenario is that they chose wrong because their income is too high in retirement years. That’s still a pretty good outcome in my eyes. ------------------------------------------------------------------ Now let's hear from The Physician Philosopher who prefers to use a Roth IRA...

Why Roth contributions are better than Pre-tax contributions for high income earners

Discussing whether you should put your money into your 401K/403B via a Roth or Pre-tax method is an important topic to consider. After all, you have to click one of the boxes if your employer offers both! The question is: which one should you choose? I am going to outline four arguments below that highlight why it might be beneficial for the high-income earner to put their money in via a Roth mechanism. Here are the assumptions for the argument:

Married couple with a single income of $200,000
They have two kids
They are taking the standard ($24,000) deduction
Their employer will match 4% of their contribution for a total of $26,500
One other implicit assumption is that in order to place $18,500 in via a Roth mechanism this requires about $24,342 pre-tax dollars.

Roth Argument 1. The "I ain't Nostradamus" argument (Mixture of contribution types)

Employer contributions are made as pre-tax contributions. Therefore, if your employer provides a match and/or contributions above the match, this will be placed as pre-tax dollars. Given the pre-tax contributions placed by your employer, placing your employee contribution via a Roth mechanism allows for diversification of your dollars such that a portion of your 401K is Roth and a portion is pre-tax. No one knows what will happen with future tax laws (see the image below for proof). Well, maybe Nostradamus did, but "I ain't Nostradamus." A big part of the pre-tax argument is that you are likely going to be taxed at a higher marginal tax rate right now in your peak earning years than when you retire. But anyone who is being honest doesn't know that is going to happen. That's their best guess. [caption id="attachment_40817" align="aligncenter" width="625"] is more than double the pre-tax. I still think that is probably worthwhile.

Roth Argument 2. The Behavioral Finance Argument

So, I taught you that you aren't Nostradamus. You probably knew that, though, didn't ya? You want to know something else that you already know? Humans like to spend money. Placing your money in via a pre-tax method in the scenario set up above will result in $4,290 additional dollars coming home to your pay-check. Proponents of the pre-tax method will say, hey that's $4,290 you can put into a taxable account! While I agree with this in theory, the reality is that most people just spend this money. That's why there are entire books written about paying yourself first. If you see the money in your bank account, you are more likely to spend it than to put it into another investment. That's why paying yourself first is such a big deal, and why putting money in pre-tax may not help you invest more. For this reason, I think that a Roth contribution has an advantage, a behavioral finance advantage. It forces you to put more dollars into your investments before you ever see it in your paycheck.

Roth Argument 3. The Stretch Roth IRA Argument

This is the strongest argument for Roth contributions. A Stretch Roth IRA is awesome. Plain and simple. Our assumptions at the beginning of this post show that this couple has two kids. These two kids can get paid a substantial amount of post-tax dollars every year without raising their taxable income, and let the rest continue to grow (you guessed it) tax-free. Or maybe they give it to their kid's kids. The way to do this is to convert your 401K into an IRA when you leave your employer. You can convert any some remaining pre-tax dollars into Roth dollars via a Roth Ladder Conversion in early retirement when your income is low. Want to see the power of a Stretch Roth IRA? Here's an example: Grandma on FIRE Assume you're a grandma (or grandpa). And you achieve FIRE (Financial Independence and Retire Early) at the age of 55. Your 28 year old daughter just had a baby girl who is age 0. Five years later, you and your spouse face an unexpected early demise in a car accident. (Morbid, but a Stretch Roth IRA’s are about inheritance money). You decided to convert your 401k to an IRA when you left your employer and designated your granddaughter (now 5 years old) as the beneficiary, because she is the youngest grandchild in the family (results in lowest RMD). You had $2 million dollars in this account, all of it Roth because of making Roth contributions to your 401K and performing a Roth Ladder Conversion in early retirement. Under this assumption, the money will grow at 6%. This is how it works out for the granddaughter. She would be required to start taking an RMD based on age 6, which would be a little more than $27,000 that year. Remember, that’s tax-free because grandma already paid the tax. If she doesn’t take out any more than the RMD each year, it will grow to a max of $16,500,000 (16.5 million dollars, you read that right) by age 66. At that peak, her RMD will be approximately $1,000,000…still tax-free. Hopefully, she will be investing the majority of that money when she starts running her own business (because you set a good example) and it’ll continue on for the next grand-kid in the family. Oh, and since she will have so much. She can give that Stretch Roth IRA to her kids, or your great grand kids. It's the gift that keeps on giving.

Roth Argument 4. The "Mo' money, Mo' Problems" Argument

The last argument out lay out there is that the more money you have tucked away into your 401K/403B in a pre-tax contribution, the more money you will have on the pre-tax side in your IRA when you leave your employer. This all sounds well and good until you turn 70.5 and have to start taking out your Required Minimum Distributions (RMD's). With a Roth IRA, you do not have to take RMD's. And neither will your spouse if you die. Only your heirs are required to take out RMD's on a Roth. With pre-tax money, the RMD starts with the owner at age 70.5... this can be brutal, and I'll show you why:

The "Mo' Money, Mo' Problems" Experiment

Let's add one assumption to the argument above to make the point. Let's say that this high-income couple saves 20% of their income, like they should. That's $40,000 plus the $8,000 they get from their employer each year. So, they are saving and investing a total of $48,000 each year. They will likely get some raises and bonuses, but we will keep those out to make the math simple. If someone invests $48,000 over 30 years (say from age 30 to 60 when they early retire) and it grows at 8% interest, they will have a little more than $4.2 million. For the next 11 years until 70.5 years old, they take out 3% of their total sum because they don't have a mortgage, car payments, or college tuition for the kids anymore. This leaves them around $120,000 just to live on...not too shabby! The nest egg grows to about $4.9 million (assuming 5% growth in retirement) with those assumptions. At the age of 70.5 if this is all pre-tax money, the RMD on that money will be around $150,000. By age 80, it will have ballooned to almost $300,000. So much for the idea of saving taxes by going pre-tax instead of Roth. All of those pre-tax RMD's will be taxed just like your income is now. So, this couple is actually going to be taxed MORE in retirement, and not less. You can convert some of your 401K from a traditional IRA to a Roth IRA through a Roth Ladder Conversion to avoid some of this, but you certainly won't be able to convert all of it (or even most)! So, again, the more Roth money the better. This simple argument shows that for a person with a large anticipated nest egg for retirement (which a high-income earner should have), Roth money is superior. You can choose to take out how much you want and leave the rest in without getting hit with the RMD. Same for your spouse.

Take Home

I think the Roth argument really starts to shine in three particular situations: the higher the income, the higher the employer match/contribution (via pre-tax method), and if you are a super-saver. I also think that the inherent advantages of the Stretch Roth IRA in addition to the RMD implications, behavioral finance impact, and lack of clairvoyance we can have about the future tax code...all make the Roth contribution a good option for the high-income earner. Regardless, chances are that since you are reading this on Rockstar Finance you are going to be fine! Just do the math and make an intentional decision that is the best fit for you and your family. Of course, the better you do the better the Roth decision will be! ------------------------------------------------------------------ So, those are the two sides of the issue. What do you think?