The 401k Race: How We Placed Our Bet

A 401k is a powerful tool for reaching financial independence.  But there is a decision to make.  Should we invest our 401ks using pre-tax dollars or using a Roth 401k?  It’s kinda like betting on horses.

Choosing between a Traditional IRA and Roth IRA is common question and one that has been covered quite a bit.  While there are a number of good resources out there (I am partial to the Mad Fientist’s Traditional IRA vs. Roth IRA – The Best Choice for Early Retirement). I haven’t seen many that lay out considerations for specific circumstances within the 401k framework…. like ours.  The purpose of this post is you walk you through how the we in Heartland on FIRE household approach this question and our current strategy.

First some basics on the 401k options.

What’s the difference between a Pre-Tax and Roth 401k?

In a pre-tax 401k your contributions reduce your current taxable income.  The gains are not taxed; however, taxes are due when the money is withdrawn.

In a Roth 401k your taxable income is not reduced.  The gains are not taxed and no tax is due upon withdrawal.

So, how do we figure out which option is the best for us?

Let’s start with a base understanding of how taxes work while you are working and in retirement.

Simply put: During your working years, you are taxed on your earnings, while in retirement you are taxed on the amount you withdraw from your taxable retirement accounts or other income sources.

The 2018 Tax Brackets are as follows.  I pulled this handy table from Forbes.  If you want to see the actual IRS document, or have trouble sleeping you can find it HERE.

Rate	Individuals	Married Filing Jointly
10%	Up to $9,525	Up to $19,050
12%	$9,526 to $38,700	$19,051 to $77,400
22%	38,701 to $82,500	$77,401 to $165,000
24%	$82,501 to $157,500	$165,001 to $315,000
32%	$157,501 to $200,000	$315,001 to $400,000
35%	$200,001 to $500,000	$400,001 to $600,000
37%	over $500,000	over $600,000

As an example, if you are an individual and your taxable income was $50,000.  It would be taxed as follows:

Income	Rate	Tax Owed
The first $9,525	10%	$952.50
$9,526-$37,000	12%	$3,501.00
$37,001-$50,000	22%	$2,486.00

Summing the tax for each bracket and you get a total of $6,939.50.  This is an effective tax rate of 13.9% ($6,939.50/$50,000).

The Big Gamble

The goal is to choose the path that will result in less taxes paid.  If we think will be paying higher taxes in retirement, then the Roth is a slam dunk.  However, if we think we will have higher taxes during our working career then it’s best to go the Traditional route.

If we knew what our lifetime earnings and our spending in retirement would be, then this would be a black and white decision.  However, not even Ms. Cleo could tell tell us how that is going to shake out., RIP.

The FIRE Angle

Since this is Heartland on FIRE (Financial Independence/Retire Early), early retirement is our goal.  A key strategy for achieving FIRE is to have a high savings rate.  As such, our actual annual spending needs are much lower than our income.  If this trend continues into retirement, then it stands to reason that the Pre-Tax 401k would be the best path for us.

Namely, that we would be in a lower tax bracket in retirement and each year the pre-tax account would potentially see extra growth from the reinvested tax savings and investment gains on those addition contributions.  This really adds up over time.

Let’s Do Some Math!

Starting with a ton of assumptions (full disclosure: these are not our actual numbers)

• 30 year old couple, Married, Filing Jointly
• Current Income =$180,000
• No current 401k Balance
• Maxing out 401k = $37,000 annual contributions
• Uniform inflation of income and tax brackets = 2%
• Uniform investment growth = 6
• Length of Retirement =30 years
• Current Annual Spending of $75,000 (Savings Rate of 42%! wow… real go getters)
• Tax savings from using pre-tax dollars are also invested (assuming a similar growth rate)
• Retirement occurs when the annual spending equals 4% of the 401k value (the infamous Safe Withdrawal Rate).

I know what you’re thinking…

via GIPHY

Running this calculation requires some math… like a lot of math.  Rather than explain the convoluted process behind the calculations, I am making the spreadsheet available for you to explore at your own pace.

Pre-Tax vs Roth 401k Analysis

Skipping past the math, here are the results:

First, here is a snapshot of the chart showing the difference in 401k Value at retirement:

The difference in 401k value at 55 years old is calculated at $585,259.  Assuming a 30 year retirement, the total taxes paid during retirement (for the pre-tax withdrawals) equals $568,828… yielding a $16,431 advantage to the Pre-Tax option. 

That’s closer than I thought.  However, using a Pre-Tax 401k, this couple would be able to retire at 55 years old.  This is when the expected annual spending is 4% of the 401k value.  The Roth option allows retirement at 58!  That’s 3 whole years!

So, when we are at the 401k race track, we will continue placing out bets on the pre-tax horse!

Remember, we are not providing financial advice here, just pointing out how we think this issue through in our household.  Do your own research.

Thanks for checking in!