Why We Switched to Roth 401Ks

It started with a couple of posts on The Wealthy Accountant.

These are articles that are worth reading in their entirety, but caused me to reconsider what was previously an unyielding vote in favor of pre-tax contributions.  Some of these are in the category of “stop complaining when you’ve already won,” but in combination, they were compelling enough to cause us to switch to Roth 401Ks in mid-2020.

 

We already save enough.

I will never feel like I am able to save “enough”, but in 2020 we were able to hit all of the items on my savings order of operations.  Even with a return of childcare costs in 2021, we will likely manage to meet all of these goals again.  With our mortgage refinance in 2020, the actual return on mortgage prepayments is minimal. The ~$10K extra we pay in taxes feels less painful than in previous years; it is no longer a choice between college savings or mortgage principle reduction.

It’s also worth noting here that we wouldn’t qualify for expanded child tax credits or COVID stimulus payments with the additional tax deduction.  I am glad for our high incomes and don’t begrudge others these benefits.  

 

We may not be able to keep income super low in early retirement.

2020 was eye-opening in terms of the limits of our frugality.  Our food spending was 50% higher.  We had house repairs, including replacing an air conditioner.  We got a dog (worth. every. penny).  And we had some non-COVID medical issues.

Better bloggers than I have discussed the myth of level spending in [early] retirement, perfectly illustrated in those spending spikes.  Health coverage is another enormous question mark that will greatly affect retirement spending/income; it’s possible we could need 50% more income than my current estimate.

The more we spend, the more we need to pull out of retirement funds, and the more we are on the hook for taxes.

 

We don’t have a viable drawdown strategy for early retirement.

We’re close enough to FI that I started a spreadsheet to figure out how we would pull money out of accounts and the tax implications.

Turns out, optimizing our retirement income is trickier than I planned. Managing our Roth basis, cash accounts, and rollovers for a Roth conversion ladder showed me one glaring error in our strategy: we don’t have enough Roth basis or taxable investments/cash to cover the first five years of spending. Yes, I know about 72(t) withdrawals, but I have commitment issues and 15-20 years of required income is… terrifying.  The easiest path is to increase the amount of money we save in more accessible accounts.

 

There’s a tradeoff between a lower percentage tax, but a higher dollar amount of taxes.

This was not exactly intuitive to me, but each variation of the spreadsheet I ran gave the same answer: we pay more total dollars in taxes over a lifetime by opting for the traditional 401K.  There are exceptions, notably if we can keep taxable income very low or if we die before the age of 76.  Given that my two greatest early retirement “fears” are a.) having to be very frugal, and b.) running out of money when we’re in our 80s, these exceptions are interesting but not a problem.

Also worth noting that my calculations didn’t consider that…

 

Required Minimum Distributions (RMDs) will get us.

Most of my FI-related calculations focus on laughably conservative assumptions – usually growth is only a percent or two above inflation, with worst-case spending assumptions.  Adjust as needed until I’m skidding into Age 100 with $100,000 left to my name.

There is the other end of the spectrum, though, where the market returns 8% and we have tens of millions of dollars by the time we’re in our 70’s.  This is totally a problem where we have won the game and should stop complaining, but it is a mathematical tradeoff that absolutely deserves a place on this list.

 

This was the right decision for us in late 2020 and for 2021.  It may not be the right decision in future years, and it may not be the right decision for you. Have you considered switching from traditional to Roth accounts?  

 

 

 

8 Responses

  1. Thanks for writing this. It is making me go back to my original savings priority list, and note that I’m not following it, because I’m prioritizing anything pretax. And you bring up several good points that I’ve never thought in depth about. We definitely don’t have any real drawdown strategy… but we also are not very serious about the whole RE thing. But we might be someday! I’m definitely inspired to do some more thinking and reading about this, and I’m very likely going to change my strategy.

    We unfortunately only have access to Roths of the mega backdoor variety, rather than a direct choice of a roth 401k. I likely go with that, despite the wealthy accountant post saying they are “probably illegal”. The only other option is straight up regular taxable. The wealthy accountant post also assumes people don’t invest the “extra” take home pay they get due to tax savings, which really has not been a good assumption for us in the past. But all in all, the arguments are pretty compelling.

    • I don’t know that I’ll ever be able to pull the trigger on RE either, but the power to leave whenever I want has gotten very, very attractive as I’ve gotten more burned out.

      Fidelity had a seminar at my workplace about the MBDR, so I am skeptical that it will ever end up being illegal (though I can definitely see it being disallowed in the future).

      I was definitely offended when he said people don’t save the tax savings! Doesn’t he know who I am??

  2. […] vote was for option b, T’s vote was for option d.  Then Sarah posted this food for thought about Roth versus traditional, and option e was added to this […]

  3. We switched all our IRAs to Roths back during the beginning of the great recession, which was useful since many of our accounts had actually lost money and we didn’t have to pay anything on the conversion. Since then we’ve only had backdoor Roth IRAs.

    During the Trump administration, I switched our 401k/403b to traditional as a form of protest, but now that’s over I’ve gone back to Roth. We have a bit of a mix with our 401k/403b because we didn’t always have Roth options.

    • I’ve always gone with Roth IRAs over traditional, as a tax diversification because we were contributing a lot to pre-tax 401Ks. Nowadays, we have to go through the back door.

      I love that you switched to pre-tax through the Trump years!! That’s brilliant!

      99% of our 401Ks are pre-tax! We are already screwed with RMDs, but it was hard to get over the mental hurdle of the 30% tax savings.

      • We’re old enough that we didn’t have the option to do a Roth once our income got high enough. All those traditional IRAs, including some we got no tax break for but I figured we should lock into retirement savings anyway got rolled over as soon as it became clear that was a legal thing to do.

  4. This past year’s spending hasn’t gone down one bit because we just traded childcare for many other expenses and that’s been an object lesson in, no, early retirement (if we did it) isn’t an automatic spending depressant. In fact, since we’re generally frugal with our job-related costs, and have eliminated most extraneous costs like spending on clothes or reduced our commute, we would tend to spend more when not working, not less. That’s even before we face the very uncertain healthcare question. Even without COVID being a factor, we’re not comfortable with not having a solid healthcare plan. This all makes ER feel quite out of reach for us, for the time being.

    Like I mentioned to StackingPennies, I seem to have some sort of mental block around understanding how Roth IRAs might fit into our retirement plan and have given up on trying to figure that out while I have so few brain cells spare.

    I AM focused on maxing out both our pre-tax 401K and filling up our post-tax brokerage though, and the latter is always going to get more money each year because there’s no limit on it. That might maybe be our answer to the megabackdoor IRA if I never figure it out.

    • I have some sort of mental block about non-qualified investment accounts, probably similar to your Roth aversion. I will probably be appalled when I realize it’s 3 clicks when logged into the Fidelity accounts we already have.

      We go to the doctor pretty infrequently, but I’m not bold enough to go the barbell, bikes, and salads route. Insurance is one of those things you don’t need until you really, really need it. Maybe if I save an extra $1M just for medical care I’ll feel safe!

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