Should I use a Roth 401k? #illumedati

Hey everyone, it’s Finance Fridays again. I’ve talked about this before, but I think it’s worth looking at again. Today we’re going to answer the question “Should I use a Roth 401k?”

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Should I use a Roth 401k?

I’ve talked about this before, and in general, I think the best (and only) time to use a Roth 401k is when you are in residency. You can read about it here:

Roth 401k/403b in Residency

However, this post isn’t about the Roth 401k in residency, it’s about using a Roth 401k in general, so basically, as an attending. The reason I’m bringing this up is because a colleague of mine asked me about the difference. He was advised to put half his max contribution into a Roth 401k and half into a Traditional 401k.

What’s the difference?

Basically the difference is that you are paying the tax upfront when you use a Roth, whether it’s a Roth 401k, 403b, or IRA. For simplicity, “Roth” means you’ve already paid the tax.

In theory, that sounds great, having your retirement account grow tax-free is the dream right? Then in retirement you would just pull out that money that has grown tax-free without a problem, as much as you want/need.

This is true — not having to pay taxes in retirement is awesome. However, you must remember that you did pay the taxes, you just did it back when your originally put the money away. More so than that, you paid the taxes while you were in your highest possible tax bracket — when you were an attending.

Why does this matter?

Well, let’s say you’re a full time attending and you are making $250,000/year.

2018 Income Tax Brackets

So you will be paying up to a 35% marginal tax if you utilize a Roth 401k.

However, when you retire, your income will likely not be as high as when you were an attending. Let’s say you withdraw $75,000/year in retirement. If we assume the same (or similar) marginal taxes, then your marginal tax rate will be up to 22%.

Hmm…

So when I say it’s probably better to not use a Roth 401k, I am making two assumptions.

You will make less money in retirement
The marginal tax brackets will remain similar

I can’t tell you whether #1 will be true for you or not. It is possible that you will win the lottery or get a significant inheritance, making your retirement income higher than your income as an attending. However, I think for the majority of us, this is unlikely.

No one can tell the future of marginal tax brackets. Is it possible that the United States shifts over to a more socialist model by the time we retire and you end up paying a marginal 45% tax at $75,000/year in retirement? Yes, it’s possible, but I don’t think it’s likely.

I think it is more likely that the US Dollar will continue its inflation over the next 30 years. As such, the IRS will set the marginal tax rate differently. For example, if you plan to retire in 2055, the marginal tax bracket for $75,000/year may only be up to 12% instead of the current up to 22%.

Whoa, if my $75,000/year in retirement is taxed less, won’t I have more money?

Well, yes and no.

In my hypothetical situation, the marginal tax rates on the $75,000/year will be decreased, but inflation will almost have certainly occurred, making your $75,000 not have the same buying power it does today. This is the best reason to also utilize a Backdoor Roth IRA.

By contributing yearly to your Backdoor Roth IRA, you will have a significant amount of post-tax money from which to draw from in retirement, in addition to your taxed 401k. In retirement, you can have a plan in place for how much to withdraw from each of these pre and post tax buckets in order to be most efficient with your taxes.

Why do non-doctors use Roth 401ks?

Well, it’s pretty similar to us actually.

I advocate utilizing a Roth 401k in Residency because you are essentially “learning your trade” and in your lowest career marginal tax bracket. However, you will eventually become an attending and be in a much higher marginal tax bracket.

Similarly, if you just come out of trade school or university and accept your first entry level job, then it makes sense to do a Roth 401k. You will have effectively locked in paying your taxes at its lowest point. Then you have the ambition to eventually move up and make more money as you gain more experience/skills and become more senior. Hopefully, at some point you decide to change over to a Traditional 401k when you reach a point where you believe your salary right now is higher than it will be in retirement.

Why do people do half Traditional 401k and half Roth 401k?

To be honest, I’m not really sure where this idea came from, but I think there are two scenarios.

You’ve just started a new entry or mid level job (not as a doctor), and you realize a Roth 401k is your best option. However, you don’t make enough money to “live” and maximize a Roth 401k. So you split the difference into a Traditional 401k and Roth 401k. Then as you get a few bumps in salary you move slowly toward a 100% Roth 401k. Then when you become more senior, at or near the peak of your salary range, which you believe will be higher than your retirement income, you switch over to a Traditional 401k.
You’re hedging. Maybe some part of you believes that the United States will become more socialist and/or tax rates will skyrocket by the time you retire, but you aren’t sure of it. So instead of doing one or the other, you split the difference and do both.

I think #1 is a good approach. It demonstrates an understanding for the need to maximize contributions as well as the benefits of a Roth during early career.

There isn’t anything wrong with #2 persay, but I don’t think it’s very efficient. Remember, the money you “save” from doing a Traditional 401k instead of a Roth can go somewhere else. For example, it can go into a Taxable Account or the 529s for your kids. You can use that money for any host of other things.

To be honest, I don’t see a compelling reason for an attending physician to do this.

Is there any other case for doing a Roth 401k as an attending?

Well, like I said, if you are a believer that you will either make more money and/or the marginal tax rate will be higher in your retirement, then yes a Roth 401k makes sense.

The only other case you could maybe make for a Roth 401k is that you’re very bad with spending and don’t ever want to see that money. Like I said, this will likely be very inefficient. You are basically giving the government free tax money on the front end.

However, if you’re reading my blog, I think you’ve taken enough responsibility for your financial future to not do that.

TL;DR

Roth 401k makes sense as a resident.

Traditional 401k makes more sense as an attending — unless:

You are expecting a large inheritance and/or will have higher income in retirement
You believe that marginal income tax rates will increase more in retirement. (above your current rate as an attending compared to your proposed retirement income)

Half Traditional 401k and Half Roth 401k is probably only worthwhile for people who can’t quite do a full Roth 401k but do want to maximize contribution.

No one knows the future, but I think the likelihood is that because of inflation, even if marginal tax rates increase — it won’t be enough to offset the higher marginal tax rate we currently pay as attendings. The marginal tax brackets will likely adjust accordingly.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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Senior Resident

△ #illumedati △ – Life After Med School