Here's the claim: Since there are contribution limits to tax-advantaged accounts, one way you can contribute "more" is by contributing completely to your Roth account. The argument goes -- since a percentage of the money in the traditional account is subject to tax, hypothetically let's say a 10% tax, then that means only 90% of the money in that account is "yours". However, because a Roth account is not subject to taxes, all of the money in the Roth account is "yours", and therefore you have technically "contributed more".
You're contributing more because you're spending more
This claim makes mathematical sense. It's easy, however, to forget that you spent more to contribute since you also paid taxes.
For example: maxing a traditional IRA costs $6,000 at the time of contribution because there are no taxes. Maxing a Roth IRA costs $6,000 + (your top tax rate on the $6,000). So if you're in the 22% bracket, it costs $7,320 to max the Roth IRA. You'll ultimately have more after-tax money in the Roth because you spent $1,320 more to fund it.
The more important question to ask here is: "Does fitting more in (by spending more) mean that it's the better choice?" I was a bit skeptical when I first came across this argument. Since the pre-tax contributor isn't paying taxes, they would necessarily then have more money in their paycheck. Would that skew the results over a lifetime of investment?
Does that mean it's a better choice?
The only way to know is to run some simulations. Let's see how it works out.
Hypothetical situation: Corey and Michelle are a married couple that is solidly in the 22% bracket after the standard deduction. For simplicity, let's assume they live in a state with no state income tax. They have one 401(k) with the option of traditional and Roth contributions. They want to max the 401(k) at $19,500 and are deciding whether to do it with completely traditional (pre-tax) contributions or completely Roth (post-tax) contributions. Let's run the numbers to see what they can do.
Some Assumptions:
The contributions will compound at an average rate of 8% annually for 30 years.
Tax rates will be the same at the time of distribution as they are now.
Corey and Michelle will be living on $80,000 in retirement.
The taxable account used in option 2 uses a buy-and-hold strategy with no dividend payouts. We will assume 8% averaged annual returns, just like the investments in the 401(k).
Models are only as good as their assumptions, so take from it what you will.
Option #1: 100% Roth
In order to max out the Roth 401(k) account at $19,500, Corey and Michelle will need $25,000. That's because their contributions will be coming from their top marginal bracket, which will be taxed at 22%.
Now, that money will grow at 8% for 30 years, giving Corey and Michelle a total of $196,221. That money is all theirs--tax free. This is if they made no other contributions.
Total investment: $25,000
$19,500 to Roth 401(k)
$5,500 to federal taxes
Total Account Balance after 30 years, after taxes: $196,221
Option #2: 100% Traditional
Since option #1 took $25,000 to invest, we will use the same investment here of $25,000. That means there is enough for a maximum pre-tax contribution of $19,500, and then an extra taxable $5,500 to save in a taxable brokerage account, for a total of $25,000 invested.
The extra $5,500 will be subject to their top marginal rate of 22%, so after the 22% tax, Corey and Michelle will be left with $4,290 to invest in their taxable brokerage account.
In the 401(k), the $19,500 will grow to the same $196,221, but it will be subject to income tax. Since we assumed Corey and Michelle will be living on $80,000 per year, we have to check what their tax rate would be.
Since we made an assumption that tax rates wouldn't change, their effective tax rate on $80,000 in retirement is 7.79%. The blue row is the standard deduction.
Extrapolating that to the entirety of their 401(k) savings, the $196,221 turns into $180,935 after 7.79% in taxes.
In the brokerage account, the $4,290 growing at 8% for 30 years has now turned into $43,168. There's two ways I can go with this simulation and we'll consider the worse of the two. One way to consider is that since Corey and Michelle are living off of $80,000 in retirement, they are within the 0% long term capital gains tax bracket and therefore would have to pay no capital gains on the growth from the past 30 years, meaning all of the $43,168 is theirs tax-free.
To be fair to the simulation, we'll consider what happens if they are actually in the 15% capital gains bracket. That means that $38,878 of the account is capital gains and would be taxed at 15%, leaving a grand total of $37,337 for Corey and Michelle in their brokerage account.
Total investment: $25,000
$19,500 to 401(k)
$1,210 to federal taxes
$4,290 to taxable brokerage account
Total Account Balance after 30 years, after taxes: $218,272
$180,935 in 401(k)
$37,337 in brokerage account (if 15% capital gains tax applies)
So in example one, the savings that come from paying less to income tax actually puts deferring taxes and investing the tax savings in a brokerage account ahead of paying a high income tax rate at the time of contribution with the Roth account: $218,272 versus $196,221 for a difference of $22,051 (11.2% more).
Where's the break-even?
I think it's interesting to consider where both options would have the same amount of after-tax money in 30 years. The break-even point is important because it represents the point at which one strategy is best on one side, and the other strategy is best on the other side.
Using the same calculation strategy as above, the break-even point is if they paid a 19% effective tax rate on their 401(k) distributions in retirement. This is lower than the 22% paid in the Roth account because of the capital gains tax on the money they have in the brokerage account.
In order to pay a 19% effective rate, Corey and Michelle would have to have a retirement income of about $353,000--according to our assumption that the tax rates didn't change. That means a retirement income less than $353,000 benefits from the 100% traditional strategy, and a retirement income above $353,000 benefits from the 100% Roth strategy.
With such as large retirement income needed to reach the break-even point, you can see that there is space for taxes to go up and the results to stay the same.
What about changing the assumptions?
A model is only as good as its assumptions, so we can adjust some of the assumptions to see how it affects the results in different scenarios.
What if they kept contributing instead of just this one-time contribution?
The results from changing this are more dramatic. The Roth account has an after tax total of $2,007,835 while the traditional and brokerage accounts have an after-tax total of $2,725,786--a difference of $717,951 (35.7% more).
What if taxes go up in the future?
Let's look at the tax rates from the two years I considered in my post about the potential of taxes going up, 1981 and 2001.
1981 was the highest tax rate for the middle class in US history, so let's assume we had a worst-case scenario and it went to those rates again. You can see from the table that you would need a retirement income of about $113,500 to reach the break-even point of a 19% effective tax rate on the traditional 401(k). So any retirement income less than $113,500 would benefit from deferring taxes in Corey and Michelle's case.
A more reasonable middle-class tax increase, in my opinion, could look like 2001 rates, so let's see how Corey and Michelle would pan out if taxes went up to 2001 levels.
You can see that Corey and Michelle would need a retirement income of about $162,000 to reach the break-even point of a 19% effective income tax rate. A retirement income over $162,000 would favor the 100% Roth strategy, and anything under that would favor the 100% traditional and brokerage account strategy.
What if their retirement needs change and they need more than $80,000?
As discussed in the above sections where we discussed the break-even point and the risk of taxes rising, there is more space above $80,000 where 100% traditional still makes sense. However, if you think your retirement income may go above those break-even points, then the Roth scenario would be better.
I'll also ask you: "What if their needs change and they need LESS than $80,000?" There's only so much we can know about the future. You just have to make the best decision you can with the information you have.
What if RMDs kick in?
The RMD situation can be complicated. I analyzed the RMD complication more in-depth in my post on deciding between Roth or Traditional accounts. The rules around RMDs are changing next year to be more favorable to the retiree. I will re-run the numbers when those rules are finalized and released.
Conclusion
Simply "fitting more" into the account doesn't necessarily result in a benefit. This thinking disregards that you are paying more to fund an after-tax account due to the tax bill. Avoiding the top marginal tax rate often outweighs the benefits of having "more" funds in the Roth account.
It ultimately depends how you deal with the extra money in your paycheck. If you plan to spend everything in your paycheck and only do one account, then filling a Roth account might be best -- that's because you're technically saving more. However, if you plan to use the extra money in your paycheck to invest elsewhere, the income tax savings that come from deferring taxes will probably sway the math in favor of a traditional account.
Disclaimer: The information provided here is for general knowledge only. I have not considered your specific situation. For information regarding your unique investment needs, contact a licensed financial advisor.