The number of words we devote to something can be a proxy for how much we care about it.
Based on that, money expert Clark Howard may be one of the nation’s biggest fans of Roth 401(k) and IRA plans.
Contributing to Roth retirement accounts is a de facto way to have more money in retirement. In a Roth, the $100,000 you put in now is a true $100,000. You can withdraw it tax-free in retirement.
But in a traditional 401(k), $100,000 in isn’t $100,000 out. (You have to pay federal income tax on that $100,000 when you take it out.)
Add Clark’s belief that our effective tax rate will go up in the future. Let’s assume you agree with Clark. All things being equal, paying taxes now — and then letting that money grow tax-free for years — is better than paying taxes later.
Even so, Clark gives blanket advice on his podcast. In other words, he’s giving advice that’s best for the most possible listeners. But he can’t account for every listener’s income, tax rate and circumstances.
For some high earners, deferring the tax bill to the future via a traditional 401(k) account is better. But what does that look like in the real world?
Is a Traditional or Roth 401(k) Better for Me Based on My Income?
Based on my age and income, how do I know if I should contribute to a traditional or Roth 401(k)?
That’s what a Clark listener recently asked.
Asked Kathryn in Oregon: “I participate in my employer’s 401(k). I put in 13% every paycheck.
“The financial planner that runs the plan has always told me to max out my 401(k) with pre-tax dollars and not participate in a Roth because based on my projected tax bracket at retirement I get more advantages with a traditional 401(k) versus a Roth.
“I’m wondering if I’ve made the wrong choice all these years. For reference, I’m 55 and make approximately $80,000 per year. Should I start a Roth on my own at this point?”
Traditional vs. Roth 401(k): It’s About Taxes
Let’s look at the 2024 federal tax brackets.
For married individuals filing jointly, your tax rate is 12% on $23,200 to $94,300 of income. For single filers, you pay 12% on $11,600 to $47,150 and you pay 22% on $47,150 to $100,525.
Remember, Kathryn can pay taxes on her 401(k) contributions now (with a Roth) or she can reduce her taxable income and avoid taxes on her contributions until later (with a traditional).
It’s really, really hard to imagine a future in 10+ years in which Kathryn pays a lower effective tax rate.
Kathryn could have millions and millions of dollars outside her 401(k) account for all we know. Perhaps she’ll avoid taking out a single penny from her 401(k) account outside of her RMDs.
Even still, will she avoid an effective tax rate that’s probably below 20%, and perhaps significantly below 20%, as she has right now?
“If you’re married, you absolutely without question want to be doing the Roth version of the 401(k). Because your tax rate now is 12%. And in your case, even as a single individual, most of what you earn is taxed at 12%. A small amount is taxed at 22%.
“I would say that tax rate is so favorable to you, because tax rates are so much lower than they historically have been and are likely going to be in the future. Because of these very large budget deficits we’re running just on Medicare and Social Security alone.”
Why Clark Thinks Taxes Will Increase
Let’s expound upon Clark’s last point. The federal budget always has been a political point of contention.
Ever practical, Clark has spoken about it in terms of food. He hopes our lawmakers put aside chasing popularity and find a way to feed us the economic version of vegetables. The longer they wait to do that, Clark says, the more painful it will become.
One of four things will (eventually) happen as we resolve the unsustainable and rising costs of Medicare and Social Security, Clark says:
- The United States goes broke as a country.
- We reduce the benefits that Medicare and Social Security provide.
- Lawmakers raise taxes.
- A combination of reducing benefits and increasing taxes.
Clark feels that increasing taxes is unavoidable at some point.
“So that’s why I would say it would make a lot of sense for you to have some Roth 401(k) money,” Clark says.
“Plus, you already have all the traditional 401(k) money you’ve built up over the years. Having both of those would be very advantageous to you long-term.
“So I respectfully disagree with the financial planner who’s encouraging you to do traditional 401(k). I believe that Roth would be a really good answer at your income and your tax rate.”
Final Thoughts
If you’re deep into the 32%, 35% or 37% federal tax brackets, it may make sense for you to defer taxes on your retirement contributions by choosing a traditional 401(k).
However, if you’re in one of the lowest tax brackets, and you’re a decade-plus from retirement, Clark strongly recommends a Roth 401(k) or IRA as the superior choice.
