Maximize Your Employer Match before Using a Roth 401(k)

While the Roth 401(k) is still a fairly new¹ option in the 401(k) world, half of employers now offer a Roth option. While contributing to a Roth is not necessarily the best choice for everyone, it can be a good choice for younger workers who haven’t reached their peak earnings potential (and tax bracket).

However, younger workers also tend to be those who are struggling to survive and may have a hard time contributing enough to get the full match that their employer provides. For workers in this donut hole, it may make more sense to contribute to the traditional 401(k) to get the maximum benefit.

Example

Let’s look at a hypothetical example. Let’s say your employer matches 50% of your contribution up to 8%. So if you are able to contribute 8%, the company will match 4%. And let’s assume you are single and making $75,000 which puts you in the 25% tax bracket. Further, let’s assume that the most you can afford to contribute to your 401(k) is $6,000 (before taxes) or 8% of your income. In other words, in order to cover your cost of living, you need an income stream of $69,000/year after your 401(k) contributions are taken out.

If you’re contributing to a Roth, your $6000 becomes $4,500 after taxes which is how much you can actually afford to contribute. In this scenario, you are getting 3% of the company match, but are missing out on the other 1% of free money that your company could match.

Conversely, if you defer your taxes and contribute the entire $6,000 to a traditional 401(k), you will get the entire match from your employer which amounts to an additional $750 added to your 401(k).

Of course, eventually you will have to pay taxes on your traditional 401(k) contribution. If your future tax rate is still 25%, then you will pay the same $1,500 (adjusted for gains) as you would have in the Roth case. So you’re still ahead by $750 (plus future gains). Or in percentage terms, you would be ahead by (6000(1-0.25)+3000)/(6000-1500+2250) or 7.14%.

If you are able to reduce your tax rate in retirement, which most early retirees do, then the gain is even higher. For example, if you pull your money out while in a 15% tax bracket, then your potential gain is (6000(1-0.15)+3000)/(6000-1500+2250) or 20%! A 20% future gain just by picking the right type of 401(k) is a pretty big deal.

What if your rate is higher in the future? At what higher tax rate would you break even? To figure that out we solve the equation 6000(1-rate)+3000 = 6000(1-0.25)+2250 which gives a rate of 37.5%. That means your future tax rate would have to be above 37.5% in order for the Roth to be the right choice in this scenario. And since you’d have to earn over $425,000 to hit the 39% tax rate, this is what I would call a good problem to have and you can afford to hire a financial advisor to help you figure it out.

Counter Example

What if you have enough money to contribute fully to either a Roth or a traditional 401(k)? In the above example, instead of assuming you can invest $6000, let’s assume you can invest $8,000 (and live off of $67,000) which will give you the maximum employer match either way.

In this case, it comes down to what your current tax rate is versus your future tax rate. With these numbers the comparison is between (8000(1-current_tax)+3000) (Roth) and (8000(1-future_tax)+3000) (traditional). In other words, the decision comes down to a simple comparison of tax rates and whether you think you will be able to reduce your future tax rate.

But there’s actually more to it than that. It’s really a comparison between today’s marginal tax rate versus your retirement’s total tax rate². Why? Because if you’re living off of your money in the future, some of the money you withdraw will be at a 0% tax rate, and some at 10%, and so-on up to your marginal tax rate. So even if your future marginal tax rate is the same as your current tax rate, your future total tax rate would be lower because you have to fill in those lower tax buckets first. In other words, there’s a good chance that the traditional 401(k) will still fare better than the Roth 401(k) if you don’t inflate your future lifestyle spending.

Summary

Younger workers in lower tax brackets are often encouraged to invest in the Roth option provided by their employers so that they can take advantage of their lower career tax rates. However, these workers should also consider that they could be giving up free money if they are unable to contribute up to the full value matched by their employers. When in doubt, make sure you get your full employer match using traditional 401(k) contributions before contributing to a Roth 401(k).