Rick Roth or Terri Trad?
In my debut blog post, I wrote about the two sides of compounding. Our investments compound (sweet!) but so does our debt (yuck!)
Decisions, like our investment returns and our debt, compound if we don’t check in on them every now and then.
[INSERT DIET AND EXERCISE ANALOGY]
I’m often asked about the Roth 401(k) vs. Traditional 401(k) retirement savings strategy.
The decision to use one or the other is not necessarily an either/or question. Moreover, the decision can and will change throughout your life.
Let’s dive deeper into when we should use one, the other or both. And since I like to humanize and use weird analogies to build resonance, let’s spend some time with Rick Roth and Terri Trad.
Terri Trad 401(k)
Terri Trad, formally known as Theresa Traditional, is your pre-tax “Traditional” 401(k) buddy. You want to save more in the Terri Trad bucket when your income is high because those contributions LOWER your taxable income in the year of the contribution.
Let’s say your adjusted gross income before retirement plan contributions is $300,000. You are a single filer. This is a high-income year for you and you don’t love the idea of paying state and federal taxes on all $300,000 so you contribute the employee maximum of $23,500 for 2025.
Only $276,500 of your income is taxable in 2025. The $23,500 is invested in the Terri Trad 401(k) bucket until it’s eventually withdrawn in retirement at which time it is taxed at your ordinary income tax rate.
Reasons to save into your Traditional 401(k)
1. Your income pushes you into a higher tax bracket.
There’s no hard and fast rule on what a higher tax bracket is but generally, if you find yourself on the edge of the 24% and 32% marginal tax bracket or higher, you may want to consider contributing to the Terri Trad pre-tax bucket.
At $200,000 of income as a single filer and $250,000 as married filing jointly, you may also be subject to an additional 3.8% net investment income tax which makes the Terri Trad contribution even that much more appealing.
A high tax bracket today can also be viewed in comparison to what your projected tax rate will be in retirement. If your income needs and lifestyle imply lower income than what you need today, this can also be a reason to consider Traditional 401(k) contributions.
2. Tax rates are historically higher than average.
Today, the opposite is true and I’ll share more details on historical tax rates when we hang out with Rick Roth. Tax rates can and will change so it’s important to think about where we are relative to historical rates and of course what tax law changes may be on the horizon.
3. You don’t mind the hassle of planning Roth conversions later on
Many retirees find themselves taking required minimum distributions, RMDs for short, that are well above their income needs for the year.
Excess income can of course lead to obvious consequences like a higher income tax bill and some not-so-obvious issues like the additional 3.8% net investment income tax or a bump up into a higher IRMAA bracket leading to higher Medicare premiums.
The antidote to this is to strategically convert assets from Terri Trad to Rick Roth ahead of your RMD years (beginning at age 72, 73 or 75 depending on the year you were born).
By capitalizing on low-income years with Roth conversions, you can shave a bundle off your lifetime tax bill and avoid unnecessarily high RMDs.
Rick Roth 401(k)
Alright we’ve had our fun with Terri Trad. Terri is a good hang but we’re now looking for a different vibe. Not better or worse just different.
In comes Rick Roth.
Roth 401(k) accounts offer a different set of opportunities than pre-tax, Traditional 401(k) contributions.
With your friend Rick Roth, you bite the tax bullet upfront to reap the long-term rewards of tax-free growth in the Roth account. Your Roth 401(k) distributions are completely tax-free in retirement
With the Roth contribution, you pay taxes on your income and THEN make the Roth contribution.
No reduction in your adjusted gross income but no taxes to be paid on distributions in retirement either.
Reasons to save into your Rick Roth 401(k) account
1. You are a young professional
Most of us are building skills and experience early in our career with our highest earning years ahead of us.
Lower income? Lower tax bracket.
A perfect time to hang with Rick Roth.
2. Your income is abnormally low
If you are a business owner and are either just starting your business or have seen a meaningful drop in income in a given year, look for the silver lining. In these instances, Roth 401(k) contributions make perfect sense.
3. Tax Rates are low by historical standards
Where tax rates are relative to historical standards can provide insight into the Roth vs Traditional decision. This is a far from perfect signal as to what tax rates will be in your retirement years but historical context matters.
4. You prefer certainty
One key advantage of Roth contributions is that you eliminate one unknown variable: future tax rates. Pay the taxes now and you have no need to consider what rates will be in the future.
Sure, rates could be LOWER later on and that’s the reality of making decisions based on future circumstances. We don’t know! But at the very least, you know the taxes you paid today and don’t have to worry about that in the future.
One less thorn in your side.
5. You prefer less restriction
You are NOT required to take RMDs from Rick Roth accounts. Take as much or as little as you need from these in retirement.
Why is this so? The government has already received their cut from your tax payment at the time of the contribution. They have no more taxes to collect so they don’t need to require you to distribute anything from Roth accounts.
A bit of both
You may ultimately want to open both a Traditional and Roth 401(k) account and contribute to them based on yearly circumstances.
Rarely are decisions binary and the Rick Roth vs. Terri Trad is another example of how one is not better or worse than the other.
Ultimately, flexibility rather than setting and forgetting can prove to be a more optimal approach when deciding between a Roth or Traditional contribution.
