Author Topic: Roth 401k or Trad 401k?  (Read 1323 times)

HankWilliams

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Roth 401k or Trad 401k?
« on: February 01, 2019, 10:30:44 AM »
Hi, Sorry if this has been discussed over and over.

Now that I've maxed out my HSA account (for HSA hacking), I'm ready to get back to trying to max out my 401k.
For years (before I learned about the FIRE strategies), I was maxing out the Roth 401k.

But now, I'm thinking I'm missing out on compound interest and thinking it would be better to pay the tax later. (I'm pretty sure I'll have more money later on to pay for the standard 401k taxes).

Hoping I'm asking this correctly, but should I switch to a standard 401k and stop contributing to the Roth 401k... that has about $130k.

Thanks folks!

DadJokes

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EvenSteven

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Re: Roth 401k or Trad 401k?
« Reply #2 on: February 01, 2019, 01:25:29 PM »
Choosing between Roth and traditional depends on what your tax rate is now vs what your tax rate will be when you withdraw. If it's higher now, then use traditional. If it will be higher when you withdraw use Roth.

You can't know for sure what your tax rate will be when you withdraw, so there will be some guesswork there, and some people like to have both to provide for some tax diversity.


https://www.bogleheads.org/wiki/Traditional_versus_Roth

Laserjet3051

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Re: Roth 401k or Trad 401k?
« Reply #3 on: February 01, 2019, 02:07:51 PM »
Just want to add, that the calculus for Roth vs traditional is different for every person. What is best for one is not best for another. AS others have already stated it boils down to what your future tax rate will be vs. current. For some people/situations, this may be easier to guess than others. But having tax diversity (trad AND Roth) will almost always be a plus.

Cornel_Westside

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Re: Roth 401k or Trad 401k?
« Reply #4 on: February 01, 2019, 02:15:06 PM »
As people have said, if you expect your taxes to be higher now, you want to defer them now (with a Traditional 401k). If you expect them to be higher in retirement, you want to defer them later (with a Roth 401k). Since you're on this forum, you are likely to be attempting to retire early, which means withdrawing expenses that are much less than your current income. That means your taxes are likely much higher now than they are in retirement.

So you should probably be in a Traditional 401k.

Greystache

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Re: Roth 401k or Trad 401k?
« Reply #5 on: February 02, 2019, 07:17:45 AM »
I recently had this discussion with my daughter who is just starting out in her career. For her, the answer is both. Her salary is in the $50K region and is in a relatively low tax bracket. Her strategy is to contribute just enough to the trad. 401k to get the company match and then put the rest of her investments into the Roth 401K.  Contribute as much as you can to your Roth when your taxes are low. I waited too long and I was only able to contribute for a few years before my income was too high to use a Roth.

Kroaler

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Re: Roth 401k or Trad 401k?
« Reply #6 on: February 02, 2019, 07:27:27 AM »
I did traditional, almost like a bet against future me.

If my future income is lower, I'll gladly pay the taxes on my huge , deferred taxes saving.

If it's higher than it is now, well that means I'm making more money than I planned.  I certainly wouldn't be mad at younger me for not doing a Roth.  I'd gladly pay the higher taxes that are associated with having more income than expected.

Arbitrage

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Re: Roth 401k or Trad 401k?
« Reply #7 on: February 05, 2019, 07:53:41 AM »
For most people, Traditional is the right choice. 

This is especially true for FIRE devotees, who will almost certainly be living far below their means - their marginal tax rate now should far exceed their effective tax rate when withdrawing. 

Some high-income people will tout the benefits of sheltering more in a Roth 401k (i.e. you can contribute an after-tax $19k in Roth vs. a pretax $19k in a Traditional).  The argument isn't without merit, but that's a lot of scratch to be voluntarily giving to the government, when there may be many opportunities down the road to pay a lower tax rate.

My current marginal tax rate is 33.3%, not counting payroll taxes.  I'm expecting an effective tax rate in retirement between 0-5%.  Traditional is a slam dunk. 

Abe Froman

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Re: Roth 401k or Trad 401k?
« Reply #8 on: February 05, 2019, 11:53:13 AM »
This is a good primer on how to answer this question -

https://www.madfientist.com/traditional-ira-vs-roth-ira/



simonsez

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Re: Roth 401k or Trad 401k?
« Reply #9 on: February 05, 2019, 01:36:10 PM »
I did traditional, almost like a bet against future me.

If my future income is lower, I'll gladly pay the taxes on my huge , deferred taxes saving.

If it's higher than it is now, well that means I'm making more money than I planned.  I certainly wouldn't be mad at younger me for not doing a Roth.  I'd gladly pay the higher taxes that are associated with having more income than expected.
Exactly, traditional is better side to err on when the calculus isn't obvious in any single direction.

Sugaree

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Re: Roth 401k or Trad 401k?
« Reply #10 on: February 05, 2019, 01:52:38 PM »
Something I've been thinking of as of late.  Because I have the kiddo now and am getting the credits that go along with that, would it be better to do Roth now because I'm paying less taxes now than I will be once he's no longer a dependent?  Or is it a wash because I can't afford to put the same percentage in a Roth that I'm putting in the Traditional?  Or am I totally off-base with my thinking that the kid makes any difference?

DadJokes

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Re: Roth 401k or Trad 401k?
« Reply #11 on: February 05, 2019, 02:32:24 PM »
Something I've been thinking of as of late.  Because I have the kiddo now and am getting the credits that go along with that, would it be better to do Roth now because I'm paying less taxes now than I will be once he's no longer a dependent?  Or is it a wash because I can't afford to put the same percentage in a Roth that I'm putting in the Traditional?  Or am I totally off-base with my thinking that the kid makes any difference?

The quick way to calculate it is to compare your marginal tax rate now with your average tax rate when you withdraw the money.

For example, I also have a child and have an AGI of $83,000 before considering 401(k)/IRA. After the standard deduction, that puts me near the top of the 12% tax bracket in 2019.

Assume that in retirement, I withdraw 72,000 per year from traditional and have no other income. Under the current tax law, the tax bill for that would be roughly 7.4% of the withdrawn amount.

Under the Roth, I would be paying 12% tax up front to avoid paying 7.4% when withdrawing. The only time when I think a Roth is better is when your tax liability is zero.

robartsd

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Re: Roth 401k or Trad 401k?
« Reply #12 on: February 05, 2019, 03:13:24 PM »
The only time when I think a Roth is better is when your tax liability is zero.
Understanding marginal and effective tax rates in our progressive tax structure helped me realize that this generalization is close enough to true. As long as you make the assumption that tax brackets for the same inflation adjusted income will remain close to what they are now, it is difficult to think of scenarios where your current marginal rate is lower than your retired effective rate which would make Roth an optimum choice. This is especially true for people with high savings rates who are targeting FIRE.

Reasons to take a closer look:
  • You plan to retire in a place with higher income taxes than where you earn now
  • You plan to spend a more in old age than you earn now

MDM

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Re: Roth 401k or Trad 401k?
« Reply #13 on: February 05, 2019, 03:54:20 PM »
The quick way to calculate it is to compare your marginal tax rate now with your average tax rate when you withdraw the money.
Understanding marginal and effective tax rates in our progressive tax structure helped me realize that this generalization is close enough to true. As long as you make the assumption that tax brackets for the same inflation adjusted income will remain close to what they are now, it is difficult to think of scenarios where your current marginal rate is lower than your retired effective rate which would make Roth an optimum choice.

Traditional will likely serve most people better than Roth, but comparing marginal now vs. effective (aka average) later is not correct.  It overstates the case for traditional.

See Traditional versus Roth - Bogleheads for details.

See also Marginal tax rate - Bogleheads and Marginal Vs Effective Tax Rates And When To Use Each.

After reading those, does it make sense why comparing marginal vs. marginal provides the actual result?

Arbitrage

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Re: Roth 401k or Trad 401k?
« Reply #14 on: February 06, 2019, 08:11:26 AM »

After reading those, does it make sense why comparing marginal vs. marginal provides the actual result?

I've made this case myself, but it does rely upon having a significant bucket of either income or pretax holdings in order to 'fill up' the lower tax brackets.  Someone contributing fully to a Roth 401k does risk having 'too much' in Roth, and renders the comparison of marginal vs. marginal to overstate the case for Roth (Roth withdrawal savings wouldn't be strictly at the marginal rate, as some of the lower tier brackets would be insufficiently filled with taxable withdrawals).

The truth is somewhere in the middle, but is case-by-case.

edit: To clarify the statement above - the withdrawal marginal rate would potentially be different for the Roth withdrawal case vs. the Traditional withdrawal case.  If a chunk of Traditional money causes the retiree to jump tax brackets, the impact is neither at the tax bracket for the retiree when full Traditional was used, nor the tax bracket when full Roth was used.  Unless the tax brackets are managed carefully, the Roth savings will be lower.  One would need enough in both buckets to manage tax brackets that carefully.
« Last Edit: February 06, 2019, 08:18:47 AM by Arbitrage »

Boofinator

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Re: Roth 401k or Trad 401k?
« Reply #15 on: February 06, 2019, 08:33:03 AM »
This question has a clear, easy answer for most Mustachians*, assuming we can not predict the future regarding major changes in the tax code.

1) As others have stated, Traditional and Roth have the exact same expected value at the end if one assumes identical tax brackets (actually Roth comes out slightly ahead due to the larger amount of post-tax money going in). However, contributions get pulled off of earnings, whereas distributions only go up to the amount required for spending. Since for Mustachians, spending tends to be much less than earnings, and since tax brackets are progressive, Traditional will more than likely outperform Roth.

2) The second reason calls to mind game theory. You have two options (Roth versus Traditional), and two possible outcomes (lower tax bracket in retirement versus higher tax bracket in retirement). Roth wins with the higher tax bracket in retirement, and Traditional wins with the lower tax bracket in retirement. If you have a higher tax bracket in retirement, it means you're rolling in the dough, so it isn't too big a deal to pay a bit more taxes if you had gone Traditional. If you're in a lower tax bracket in retirement, you'll be thankful for every dollar you saved by going with Traditional, and it will be a big deal that you didn't go with Roth (due to the marginal utility value of money: https://www.mrmoneymustache.com/2012/02/09/brave-new-life/).

*The big exception being those in the 0% tax bracket, who should definitely contribute to Roth.

DadJokes

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Re: Roth 401k or Trad 401k?
« Reply #16 on: February 06, 2019, 09:12:53 AM »
1) As others have stated, Traditional and Roth have the exact same expected value at the end if one assumes identical tax brackets

My math may be off here, but I'm not sure that's correct.

I hate walls of text, so I didn't get much out of the links posted, but here are my calculations:

TraditionalRoth
Gross100,000100,000
Invested30,00026,400
AGI70,000100,000
Tax Paid in 20185,1398,739
Take Home64,86164,861

After 20 years of investing that amount annually with the 4% rule, the traditional would have $893,342, and the Roth would have $786,141. Assuming you want the exact same take home in retirement and the same tax law, the withdrawals would look like this:

TraditionalRoth
Withdrawn70,47764,861
AGI70,4770
Tax Paid5,6160
Take Home64,86164,861
Effective Tax Rate7.97%0%

The way I understand this, by going with a Roth, you pay 12% now to avoid paying 8% in retirement. I think the reason it is not a perfect balance between the two is the standard deduction, which benefits the traditional without providing the same benefit to the Roth. Obviously, there is probably a balance in there that is optimal, but that requires far more speculation and spreadsheet work than I am capable of. Maybe, only investing enough in traditional to withdraw $24,000 per year (or whatever the inflation-adjusted standard deduction is) in retirement would result in the two options being identical.

Beyond that, withdrawals/tax rates would have to increase when retired for Roth to make any sense if your current tax liability is anything other than zero.

Boofinator

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Re: Roth 401k or Trad 401k?
« Reply #17 on: February 06, 2019, 09:22:34 AM »
1) As others have stated, Traditional and Roth have the exact same expected value at the end if one assumes identical tax brackets

My math may be off here, but I'm not sure that's correct.

I hate walls of text, so I didn't get much out of the links posted, but here are my calculations:

TraditionalRoth
Gross100,000100,000
Invested30,00026,400
AGI70,000100,000
Tax Paid in 20185,1398,739
Take Home64,86164,861

After 20 years of investing that amount annually with the 4% rule, the traditional would have $893,342, and the Roth would have $786,141. Assuming you want the exact same take home in retirement and the same tax law, the withdrawals would look like this:

TraditionalRoth
Withdrawn70,47764,861
AGI70,4770
Tax Paid5,6160
Take Home64,86164,861
Effective Tax Rate7.97%0%

The way I understand this, by going with a Roth, you pay 12% now to avoid paying 8% in retirement. I think the reason it is not a perfect balance between the two is the standard deduction, which benefits the traditional without providing the same benefit to the Roth. Obviously, there is probably a balance in there that is optimal, but that requires far more speculation and spreadsheet work than I am capable of. Maybe, only investing enough in traditional to withdraw $24,000 per year (or whatever the inflation-adjusted standard deduction is) in retirement would result in the two options being identical.

Beyond that, withdrawals/tax rates would have to increase when retired for Roth to make any sense if your current tax liability is anything other than zero.

If I understand correctly, the implication from having 0 adjusted gross income is that all of your income would come from a Roth account in retirement. I'm not sure this is a good assumption for most Mustachians, who tend to have taxable accounts that will spit out dividends and capital gains; I'm also not totally familiar with how Social Security is taxed in retirement, but this may affect it as well.

MDM

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Re: Roth 401k or Trad 401k?
« Reply #18 on: February 06, 2019, 12:11:38 PM »
I've made this case myself, but it does rely upon having a significant bucket of either income or pretax holdings in order to 'fill up' the lower tax brackets.  Someone contributing fully to a Roth 401k does risk having 'too much' in Roth, and renders the comparison of marginal vs. marginal to overstate the case for Roth (Roth withdrawal savings wouldn't be strictly at the marginal rate, as some of the lower tier brackets would be insufficiently filled with taxable withdrawals).
The marginal tax rate for a Roth withdrawal is 0%.

If a "lower tier" bracket isn't completely filled, the marginal rate on traditional withdrawals may simply be "that bracket".

Quote
The truth is somewhere in the middle, but is case-by-case.
Don't understand the "somewhere in the middle" part, but definitely agree with the "case-by-case" part. :)

Quote
edit: To clarify the statement above - the withdrawal marginal rate would potentially be different for the Roth withdrawal case vs. the Traditional withdrawal case.  If a chunk of Traditional money causes the retiree to jump tax brackets, the impact is neither at the tax bracket for the retiree when full Traditional was used, nor the tax bracket when full Roth was used.  Unless the tax brackets are managed carefully, the Roth savings will be lower.  One would need enough in both buckets to manage tax brackets that carefully.
Marginal rate for this purpose isn't based on a "single dollar" (let alone "single cent"), but rather on "the amount of money in question."  So yes, if a contribution or withdrawal amount spans a bracket boundary the marginal rate will be a blend of the two brackets.  Or one can choose not to span the boundary - e.g., contribute to traditional until dropping from 22% to 12%, and using Roth for any further contributions that year.

MDM

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Re: Roth 401k or Trad 401k?
« Reply #19 on: February 06, 2019, 12:20:45 PM »
1) As others have stated, Traditional and Roth have the exact same expected value at the end if one assumes identical tax brackets
My math may be off here, but I'm not sure that's correct.
It is correct if one assumes
1) identical marginal rates (same as "identical tax brackets" if there aren't any credits, phaseouts, etc. involved), and
2) the pre-tax amount needed for the Roth contribution is less than or equal to the IRS maximum for traditional contributions.

For #1, see the commutative property of multiplication.

For #2 in short: any tax drag on a taxable "side account" needed for a fair comparison causes Roth to be better even for equal marginal rates.  See Maxing out your retirement accounts for the detailed wall of text. ;)

FIPurpose

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Re: Roth 401k or Trad 401k?
« Reply #20 on: February 06, 2019, 12:26:31 PM »
1) As others have stated, Traditional and Roth have the exact same expected value at the end if one assumes identical tax brackets

My math may be off here, but I'm not sure that's correct.

I hate walls of text, so I didn't get much out of the links posted, but here are my calculations:

TraditionalRoth
Gross100,000100,000
Invested30,00026,400
AGI70,000100,000
Tax Paid in 20185,1398,739
Take Home64,86164,861

After 20 years of investing that amount annually with the 4% rule, the traditional would have $893,342, and the Roth would have $786,141. Assuming you want the exact same take home in retirement and the same tax law, the withdrawals would look like this:

TraditionalRoth
Withdrawn70,47764,861
AGI70,4770
Tax Paid5,6160
Take Home64,86164,861
Effective Tax Rate7.97%0%

The way I understand this, by going with a Roth, you pay 12% now to avoid paying 8% in retirement. I think the reason it is not a perfect balance between the two is the standard deduction, which benefits the traditional without providing the same benefit to the Roth. Obviously, there is probably a balance in there that is optimal, but that requires far more speculation and spreadsheet work than I am capable of. Maybe, only investing enough in traditional to withdraw $24,000 per year (or whatever the inflation-adjusted standard deduction is) in retirement would result in the two options being identical.

Beyond that, withdrawals/tax rates would have to increase when retired for Roth to make any sense if your current tax liability is anything other than zero.

I think you're somewhat misrepresenting the math there.

If you are eligible to have both a pre-tax and post-tax retirement accounts, you should. As mentioned, you will be allowed to withdraw a certain amount from pre-tax accounts each year without incurring any taxes.

But also take into account state taxes. Where will you be retiring, does your state tax Roth withdraws, how much do you plan on spending in retirement, what's your tax situation now.

You answer those 5 questions and you'll get some decent answers here.

MDM

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Re: Roth 401k or Trad 401k?
« Reply #21 on: February 06, 2019, 01:04:57 PM »
...does your state tax Roth withdraws
Pretty sure the answer to that - for "qualified" withdrawals - is an unambiguous "no".

DadJokes

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Re: Roth 401k or Trad 401k?
« Reply #22 on: February 06, 2019, 01:53:38 PM »

I think you're somewhat misrepresenting the math there.

If you are eligible to have both a pre-tax and post-tax retirement accounts, you should. As mentioned, you will be allowed to withdraw a certain amount from pre-tax accounts each year without incurring any taxes.

But also take into account state taxes. Where will you be retiring, does your state tax Roth withdraws, how much do you plan on spending in retirement, what's your tax situation now.

You answer those 5 questions and you'll get some decent answers here.

Since I was bored at work, I decided to run the calculations for different investment percentages in various increments between traditional and Roth. Like before, I assumed a $100,000 income, no state tax (sorry to you poor saps that live in states with a state income tax), and a desired take home pay of $64,861 after taxes and investing. Obviously, it's not the most mustachian lifestyle.

While 100% Roth was by far the worst option, I was surprised to see that 100% traditional was not the best option with those parameters. Instead, the best option out of those I tried came with around 70% of total amount invested going toward traditional. However, that option was only 0.2% better than 100% toward traditional.

I raised the gross income to $150,000 and the desired take home to $69,261 (gave a nice round 100% traditional contribution of 75,000) to see what changed. As the income rose, the ideal contribution rate moved toward Roth a bit more. Now, the ideal contribution rate was around 60-65% traditional, 35-40% Roth did not change much (edited, since I forgot to adjust tax brackets as income went up.

In my next test, I kept that income but dropped retirement spending from $69,261 to $50,000. When doing that, the preferred split crept back towards 100% traditional, though not all the way.

It was still a very simplified calculation, but I took the following from it:

Your income and post-retirement spending dictate what is best for your situation. Without taking state taxes into account (boo), the best balance is usually somewhere inbetween, but leaning heavily toward traditional.
« Last Edit: February 06, 2019, 02:04:49 PM by DadJokes »

Arbitrage

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Re: Roth 401k or Trad 401k?
« Reply #23 on: February 06, 2019, 02:00:08 PM »
edit: To clarify the statement above - the withdrawal marginal rate would potentially be different for the Roth withdrawal case vs. the Traditional withdrawal case.  If a chunk of Traditional money causes the retiree to jump tax brackets, the impact is neither at the tax bracket for the retiree when full Traditional was used, nor the tax bracket when full Roth was used.  Unless the tax brackets are managed carefully, the Roth savings will be lower.  One would need enough in both buckets to manage tax brackets that carefully.
Marginal rate for this purpose isn't based on a "single dollar" (let alone "single cent"), but rather on "the amount of money in question."  So yes, if a contribution or withdrawal amount spans a bracket boundary the marginal rate will be a blend of the two brackets.  Or one can choose not to span the boundary - e.g., contribute to traditional until dropping from 22% to 12%, and using Roth for any further contributions that year.

Yes, agreed.  However, the 'chunk of money' rather than the 'single dollar' analysis is the realistic situation; the true marginal dollar situation is nothing more than a pedantic exercise.  Nobody sits around figuring out each dollar when working, and we can't have that level of certainty when the contributions are made.  As I said, in order to choose not to span the tax brackets, you need to have sufficient taxable income and/or pretax balance to optimize your brackets in that manner.

Anyhow, tax diversification is a thing, but for most people, the Roth 401k is not the best way to achieve it.
« Last Edit: February 06, 2019, 02:05:18 PM by Arbitrage »

MDM

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Re: Roth 401k or Trad 401k?
« Reply #24 on: February 06, 2019, 02:17:03 PM »
Yes, agreed.  However, the 'chunk of money' rather than the 'single dollar' analysis is the realistic situation; the true marginal dollar situation is nothing more than a pedantic exercise.
No need for the "however" - we're both saying ~the same thing. :)

Boofinator

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Re: Roth 401k or Trad 401k?
« Reply #25 on: February 06, 2019, 02:22:06 PM »

I think you're somewhat misrepresenting the math there.

If you are eligible to have both a pre-tax and post-tax retirement accounts, you should. As mentioned, you will be allowed to withdraw a certain amount from pre-tax accounts each year without incurring any taxes.

But also take into account state taxes. Where will you be retiring, does your state tax Roth withdraws, how much do you plan on spending in retirement, what's your tax situation now.

You answer those 5 questions and you'll get some decent answers here.

Since I was bored at work, I decided to run the calculations for different investment percentages in various increments between traditional and Roth. Like before, I assumed a $100,000 income, no state tax (sorry to you poor saps that live in states with a state income tax), and a desired take home pay of $64,861 after taxes and investing. Obviously, it's not the most mustachian lifestyle.

While 100% Roth was by far the worst option, I was surprised to see that 100% traditional was not the best option with those parameters. Instead, the best option out of those I tried came with around 70% of total amount invested going toward traditional. However, that option was only 0.2% better than 100% toward traditional.

I raised the gross income to $150,000 and the desired take home to $69,261 (gave a nice round 100% traditional contribution of 75,000) to see what changed. As the income rose, the ideal contribution rate moved toward Roth a bit more. Now, the ideal contribution rate was around 60-65% traditional, 35-40% Roth did not change much (edited, since I forgot to adjust tax brackets as income went up.

In my next test, I kept that income but dropped retirement spending from $69,261 to $50,000. When doing that, the preferred split crept back towards 100% traditional, though not all the way.

It was still a very simplified calculation, but I took the following from it:

Your income and post-retirement spending dictate what is best for your situation. Without taking state taxes into account (boo), the best balance is usually somewhere inbetween, but leaning heavily toward traditional.

Sorry, but I'm not really following how you got those results. The logic for investing in Traditional over Roth is pretty straightforward:

1) For a given pre-tax dollar, the expected value following a period of investment and then distribution is identical for Traditional and Roth iff the tax brackets that dollar is subject to are identical now (Traditional) and during retirement (Roth). As others noted, this is a result of the commutative law of multiplication.

2) The corollary to 1) is that Traditional wins if tax brackets where those dollars are taxed are higher now, and Roth wins if tax brackets are higher later.

3) If choosing Roth, the taxes you pay are coming off the marginal dollars you earn during your earnings years. If choosing Traditional, the taxes you pay are coming off the marginal dollars you spend during your retirement years. (Actually, this is an oversimplification due to capital gains and potentially RMDs, but the concept still holds.)

4) Since many Mustachians spend much less than they earn, Traditional will almost certainly beat out Roth if tax brackets remain the same.

5) Two scenarios where Roth wins out: i) If tax brackets increase significantly in the future, Roth might win out, but we don't have any control or clairvoyance here. ii) If you end up making so much money that required minimum distributions are super high in retirement, Roth might also win out, but really who cares at that point?