401(k) - To Roth, or not to Roth, that is the question

[RetireOrDieTrying]

I solicit the minds of the assembled greats here to help me understand the pros and cons of this choice.

Scenario: I'm 53. I only very recently turned my financial world around after a divorce from Mrs. Financial Train Wreck (my case study is posted if you want the ugly details). Summary: because of insane debt, I only really recently got started on savings, and I'm up to about $160k, adding more-or-less $10k/mo.

I make about $220k/yr., and I'm currently saving about 61% of gross (not a typo - gross, not net), and living on about 21%, with 18% tax load. I'm maxing out 401(k) (including over-50 catch-up), maxing out IRA -> Roth IRA (currently $7500/yr. including over-50 catch-up), and maxing out HSA (never touched - goes into VTI and I let it ride).

With the scene set, now for the real question - because of my very short timeline to sock money away for retirement, a friend asked me if I'd considered whether it was numerically wiser to put pretax $ into my 401(k) and invest the tax savings in the market, betting on a lower tax rate at retirement, or to pay the tax now at the higher rate, reducing my investment pace to pay for the tax, so that the growth is tax-free.

He likely had no idea how many brain cells I've short-circuited trying to think this over. If I were younger, this would be easy - ker-plop it into Roth and let it build. The thing that has me second-guessing is my current high-ish tax rate and the very abbreviated timeline for growth, which means I will likely have modest disbursements in retirement, possibly helping with tax burden at that time.

Thoughts?

[seattlecyclone]

"Tax-free growth" is a red herring. Whether the growth happens before or after taxation is irrelevant if the tax rate is the same on either end.

Suppose you have $X of pre-tax money to invest, you expect it to grow by a factor of G by the time you withdraw, and your tax rate is T.

Invest in pre-tax and you put the full $X in the account, it grows to $XG right before you withdraw, and you then owe $XGT in taxes when you withdraw. This leaves you with $XG(1-T) to keep.
Invest in Roth and you pay $XT in taxes up front, leaving you with $X(1-T) to invest. It grows to $X(1-T)G by the time you withdraw, and you get to keep the whole amount.

If T is the same both now and in the future, you get to keep the same amount either way! But if T at retirement is lower than T now (which is very often the case, especially for someone like you who has a high salary while working), then there can be considerable money to be saved by deferring the tax.

A couple of extra considerations:
* If you plan to retire before Medicare age, be aware that the ACA healthcare subsidy phaseouts act as an additional tax that you likely don't have to pay while working. In many cases this tax can cause your overall rate to be higher during this first part of retirement than it was while working, even if you go down a bracket or two where the normal tax is concerned.
* If you're maxing out your retirement accounts, you can effectively shelter more money from tax by using the Roth, since the nominal limits are the same either way but a Roth dollar is worth more than a tax-deferred dollar. The correct comparison would then be to look at the Roth retirement account vs. the pre-tax retirement account plus putting the tax savings to grow in a taxable brokerage account. It seems you may have already thought about that though. At the end of the day I think this "you can put more in Roth" factor can be a nice tiebreaker if you expect your tax rate to be about the same in retirement as it is now, but is otherwise pretty minor.

[dandarc]

Roth vs. Traditional is "marginal tax rate today vs what I think my marginal rate will be in the future".

With $220K income as a single person, living on less than a quarter, and relatively little saved up right now, I'd personally be betting on my marginal rate being less in the future (retirement income is usually driven mostly by your living expenses). When expected MTR in the Future < known MTR Today, then traditional is the move - without all of your details, I'd say your friend is most likely offering good advice.

Edit to Add: Seems like you must already be contributing the max to Traditional 401K if your tax burden is 18% on such a high income?

[index]

Stick with the traditional. Your future tax rate will be much less with significantly less retirement income versus your high income now. Roth's are best for young people before they get in their peak earning years. Maybe consider an HDHP with HSA if you are relatively healthy for some extra tax savings. If you are socking all the money in VTI, going taxable with your excess should be fine too.

[simonsez]

Yep, you're spending ~85k a year now on living expenses and taxes.  The taxes would go down without W-2/1099 income, so call it (a VERY rough estimate of) 60k/year you would need to replace your spending in retirement.

The 60k could be from your traditional 401k or your taxable brokerage or any account you choose.  Keep in mind once you collect SS your retirement accounts will not have to provide ALL of your income.  E.g. if you will collect 30k/yr from SS, your 401k/IRA/brokerage/HSA would only need to produce 30k in those years.  Don't forget about inflation, of course.

If those numbers (the 60k) are different from your plan, plug in whatever would be more realistic but the point is to model your retirement and see how "bad" the tax numbers really would be with your current portfolio.  Looks like you'd be mostly in the 12% bracket with a little spilling over into the 22% bracket (assuming you're realizing traditional 401k).  I.e. 60k - ~14k single std ded =46k, 22% bracket starts at ~45k for 2023.  Tweak your retirement income as needed with your Roth IRA (qualified distributions, of course) to stay fully within the 12% bracket.  Does that tax situation sound okay to you or would it be better to pay more in taxes now at your current marginal rates?

[MDM]

I make about $220k/yr....

Using only that number, the first $24K of traditional 401k contributions will save 32% federal tax.  That seems a "go do" option.

Past that, you would be saving 24%.  For now, that probably still makes traditional correct.  As years go by and your invested balance grows, your projected marginal tax rate in retirement due to traditional withdrawals might approach that 24% (or whatever rate the tax code allows for current traditional contributions) and tip the scales toward Roth, but that's for some future year.

Investment Order and Traditional versus Roth - Bogleheads have more details.

What do you think?

[RetireOrDieTrying]

Seems like you must already be contributing the max to Traditional 401K if your tax burden is 18% on such a high income?

Correcct. This year I already maxed $30k in the 401(k) and am contributing $3850 in HSA. Additionally, I don't pay tax on the $64/mo. for all of my various health insurances (HDHP, Vision, Dental, etc.). Even more additionally, Social Security tax cuts out at $160k. All of these help keep a lid on my tax burden.

[dandarc]

Seems like you must already be contributing the max to Traditional 401K if your tax burden is 18% on such a high income?

Correcct. This year I already maxed $30k in the 401(k) and am contributing $3850 in HSA. Additionally, I don't pay tax on the $64/mo. for all of my various health insurances (HDHP, Vision, Dental, etc.). Even more additionally, Social Security tax cuts out at $160k. All of these help keep a lid on my tax burden.

Seems like the consensus here is to keep doing what you're doing then. Maybe switch to Roth once you have significantly larger balance in place, but that's a good while away.