In Defense of the Traditional 401(k)

August 14, 2014

Should you make pre-tax or Roth 401(k) contributions? I recently read this article by Penelope Wang called “The Great Retirement Account You’re Not Using” that argues for Roth contributions. However,  I still think pre-tax contributions make more sense for most people. Here is my response to each of her main arguments:

Higher Income

Penelope cites a T Rowe Price study that savers come out ahead with Roth contributions v making pre-tax contributions and investing the tax savings even if they retire in a lower tax bracket. However, that’s only true if you’re maxing out your pre-tax 401(k). If you pay a 25% tax rate today, save an additional 25% in pre-tax v Roth contributions, and retire in the 25% tax bracket, you’ll end up with the same amount of money after-taxes in retirement.  If you pay a lower tax rate in retirement as most probably will, you’re better off with the pre-tax contributions.  The only way you end up ahead with the Roth is if you have to invest your tax savings in a taxable account as the study assumes.

So yes, if you can contribute more than the maximum pre-tax, you may be better off making Roth contributions rather than investing the tax savings in a taxable account. But if not, you’ll probably be better off with pre-tax contributions. (Plus your reduced taxable income may make you eligible for additional tax breaks.)

Greater Flexibility

Penelope cites the fact that you can avoid RMDs with a Roth 401(k) by rolling it into a Roth IRA and that you can make large withdrawals for things like health care expenses without going into a higher tax bracket. However, she forgets one of the main advantages of pre-tax 401(k)s when it comes to flexibility and that is that you can convert pre-tax money into a Roth IRA in a year when your tax bracket is particularly low. Some examples of this might be going back to school, taking time off for maternity leave, unemployment, or retirement. As for RMDs, you’ll probably pay less taxes on those distributions in retirement than on your Roth contributions today.

Tax Diversification

I agree with Penelope that it’s advantageous to have tax-free money in retirement but I think a better place for that tax-free money is a Roth IRA. That’s because many people earn too much to contribute pre-tax to a traditional IRA if they have a retirement plan at work and the Roth IRA has the additional advantage of access to the contributions at any time and for any reason. By contributing to a Roth IRA, you can have the flexibility of being able to make tax-free withdrawals, both today and in retirement.

For some people who can contribute more than the max to a pre-tax account or expect to retire in a higher tax bracket, the Roth 401(k) contributions make sense. But I think most people will be better off making pre-tax contributions to their 401(k) and contributing to a Roth IRA for tax-free income. What do you think? Leave your thoughts in the comments section below.