Now that the new tax law is in effect, we've updated several aspects of our free Bonus Report titled "IRAs, 401(k)s, and Social Security: A Retirement Planning Primer." The updated report is available in the "Resources" section of this site (click "Resources" on the toolbar above, or simply go here).
Here's an excerpt, with current tax-rate and tax-bracket data:
The trickiest part of figuring out whether to use the traditional 401(k) or the Roth 401(k) has to do with tax rates — specifically your current rate vs. what you expect to pay in retirement. Most people today expect that, given the government’s financial condition and debt load, tax rates will generally be higher in the future.
This would seem to make a strong case for using the Roth, which allows you to pay taxes on contributions now at the lower rates, and take your distributions later tax-free when rates are likely to be higher across the board. But this overlooks an important point regarding retirement-account taxation: your marginal (highest) rate isn’t the only rate that matters....
[W]ith a traditional 401(k), you receive a tax deduction based on your level of contribution. That deduction reduces your final income, saving you tax at your highest tax rate now. But when you retire and start withdrawing money from your account, unless you have significant other income sources (which most retirees don’t), your withdrawals won’t immediately be taxed at the highest tax rates. Rather, they will start filling in the tax brackets from the bottom up because of the progressive nature of the tax code.
Consider the nearby table, which shows the tax rate applied to retiree income. (Read this table from the bottom up.) It shows that a retired married-filing-jointly couple would pay 10% tax on their first $19,050 of income, then would pay 12% on their next $58,350, and so on.
What the table demonstrates is that while someone may end up, for example, with a marginal tax rate of 22% in retirement, their first $77,400 of taxable retirement income will be taxed at significantly lower rates.
This is a strong argument for many workers in favor of using the traditional 401(k) rather than the Roth. The traditional 401(k) allows you to take your tax deduction today at your highest tax rate, then likely pay tax at lower average rates in retirement. The Roth 401(k), in contrast, turns this on its head, causing you to pay tax now in the higher brackets while saving you tax later in the lower brackets.
So should everyone use the traditional 401(k) instead of the Roth? No. Some people are likely to benefit from the Roth. Super savers are the first group that should use the Roth 401(k). If you contribute the maximum to your 401(k) and also fully fund IRAs each year, you’ll likely come out ahead using the Roth. Also, anyone who is likely to see significantly higher pay in the future than they earn now should consider the Roth.
If you can pay tax today at relatively low rates, it probably makes sense to do it, especially if you expect to hit the higher tax brackets in retirement. This is why many financial advisers encourage young people to use Roth IRAs and Roth 401(k)s.
The full Bonus Report, "IRAs, 401(k)s, and Social Security," is available free to all — SMI members and non-members alike. Again, you can download it here.