Today, we’re going to revisit our old friend Catch-Up Cathy and meet her neighbor, Rachael Roth. Our ladies are 50 years old, earn the same salary, and have the same amount saved. Both have the same annual living expenses and want to retire at age 65.
Catch-Up Cathy decides that she’ll max out her traditional 401(k) savings, including the full catch-up amount, every year between now and retirement at age 65. She wants to grow her 401(k) as much as she possibly can.
Rachael Roth, however, doesn’t want to pay pesky income taxes on withdrawals from her accounts in retirement – after all, Roth accounts are better, right? Therefore, she decides that she’ll instead make all her ongoing savings into the Roth 401(k) option her employer offers.
So, who’ll be behind at retirement? Stick around, I think a lot of you might be surprised.
Traditional vs. Roth 401(k)
The original idea behind tax-deferred retirement accounts such as the 401(k) was that, after we stop working, we’ll be in a lower tax bracket. Deferring some of our income taxes until then can turn into a significant tax break over retirement. Uncle Sam gave up a little tax revenue today to encourage people to save for retirement.
Then, with the passing of the Taxpayer Relief Act of 1997, the Roth IRA was born. This allowed for the creation of an account that could grow tax-free – and not be taxed when money was distributed. Less than ten years later, the tax code was changed to allow employers to offer a Roth 401(k) option to employees.
Ever since, employees have asked the same question: “Regular or Roth?” That’s where we find our friends Cathy and Rachael today.
For simplicity and consistency, we’ll again use the same assumptions we’ve made in our prior videos for all calculations. Inflation will be 3% and our expected portfolio returns will be 7%. Again, these assumptions are round numbers close enough to historical data for the purposes of our comparison.
For income, we’ll assume they each make $120,000 per year. To estimate their Social Security, we’ll simply input Cathy’s and Rachael’s income into the Social Security online quick calculator to arrive at a monthly benefit. We’ll also assume they’re both single.
For retirement portfolio income, we’ll once again use the 4% Rule. As always, I want to acknowledge that there are some limits to the 4% rule, but it’s great for these kinds of back-of-the-envelope calculations.
For Cathy, we assume she fully maxes out her 401(k), including catch-up contributions. Given the current catch-up limit of $6,500, her total savings would be $27,000.
For Rachael, we assume she skips the regular 401(k) contributions altogether; instead, she’ll invest entirely in her Roth 401(k) going forward. Remember, she’ll need the exact amount for living expenses as Cathy. Adjusting for this and taxes puts her savings around $19,100 per year.
It’s interesting to see the magnitude of difference between the amounts they’re saving. Catch-Up Cathy is putting away $7,900 more per year than Rachael Roth. Of course, all those extra savings will have an associated tax liability whenever she makes a withdrawal from her retirement accounts.
To determine how much Cathy and Rachael can spend in retirement, let’s make some assumptions about what they have saved. Again, we’re going to assume they’re a little behind on their retirement savings; life can be hard sometimes, so let’s not fault them for that.
Let’s say they have:
- Cash Accounts: $ 25,000
- Stocks & Mutual Funds: $ 75,000
- Retirement Accounts: $ 250,000
- Total Investments: $ 350,000
Total Savings at Retirement
If Cathy and Rachael plan to retire in fifteen years, how much will they have saved at that point? Given their current investments, we can make a simple calculation based upon their savings and projected growth.
Let’s not forget to add an employer match for Rachael’s and Cathy’s 401(k) contributions, since that’s common in the real world. Let’s assume an employer match of 100% up to a contribution of 3%.
Given these assumptions, we expect Rachael Roth to have around $1.5 million saved at retirement, while Catch-Up Cathy will have around $1.7 million.
Retirement Income Available
Now that we know what Cathy and Rachael will have saved at retirement, let’s determine what kind of retirement income they can expect.
For Rachael Roth, we know she’ll have around $1.5 million saved. Using the 4% Rule, we can expect her investments to provide approximately $5,100 per month in retirement income. Adding her estimated Social Security brings her total income at retirement to around $9,000.
Of course, these numbers are inflated. To make a fair comparison, we’ll have to adjust them back to today’s dollars. Using our inflation rate of 3%, we find that equates to a retirement income figure of around $5,800 per month for Rachael Roth.
When we compare this figure to her pre-retirement expenses, we find that she’ll need to reduce her living expenses by about 7% when she steps away from work to have a sustainable retirement. That’s certainly not a stretch.
So, how about Catch-Up Cathy? Knowing that she’ll have approximately $1.7 million saved at age 65, we can expect her portfolio to provide around $5,800 per month at that time. However, we’ll need to make an adjustment for taxes for this to be a fair comparison. Let’s assume an effective tax rate of 12% for any retirement account withdrawals.
When we adjust for taxes and add Social Security, Catch-Up Cathy will have around $9,000 per month for her living expenses. Adjusting for inflation, we find that Cathy’s retirement income (in today’s dollars) comes out to approximately $5,800 per month – meaning that she’ll have to reduce her living expenses by 7% in retirement, nearly the same as Rachael.
By the way, if you want to run these types of calculations for yourself, I’ve created an inexpensive, downloadable spreadsheet you can find at pranawealth.com/resources.
Tax Rates Matter in Retirement
The effects of taxes make today’s comparison an interesting one. In our simplified example, we assume a flat 12% tax rate on Cathy’s retirement account withdrawals. But is that an accurate number? Using an online quick income tax calculator, Cathy’s Federal effective income tax rate alone is 12%. We haven’t accounted for state taxes at all. So, maybe this is what things look like if Cathy and Rachael live in an income tax-free state.
Here in the Peach State, her state income tax rate would be 5.75%. Adding that bumps her effective tax rate up to 17.6%. When we re-run these calculations at this new effective tax rate, she’ll now need to reduce her living expenses by 10% instead of 7%.
All of a sudden, tax rates become the defining variable in this comparison. In other words, your retirement marginal tax rate should be the driving factor in making the traditional versus Roth 401(k) decision.
Monte Carlo Analysis Results
Our example today exposes one of the limitations of the 4% rule: it doesn’t differentiate between different types of accounts for tax purposes. If we run a Monte Carlo analysis for Catch-Up Cathy and Rachael Roth using this same data, we find that they have very high probabilities of retirement success: 81% and 83%, respectively.
Of course, these numbers don’t factor in one-time expenses like home improvements, car purchases, nursing home costs, or changes in their retirement spending as they age.
Traditional vs. Roth 401(k): Which Is Better for You?
In our simplified comparison, we again find that our two retirees end up in a similar place using different means. The question becomes: will your taxes in retirement be sufficiently high to make the Roth 401(k) option best? Interestingly, it may be your state taxes that wind up being the determining factor.
Another consideration to factor into this decision would be other sources of taxable retirement income. If you’re expecting to have taxable pension income – or even taxable executive compensation such as defined benefit plan payments – this could be the determining factor.
Unfortunately, there’s no easy rule-of-thumb when it comes to deciding between traditional 401(k) contributions or Roth 401(k) contributions. It’s best to work with your financial planner and CPA to weigh the options.
If you need help figuring out how to best save for retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
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