A $900,000 Traditional 401(k) and a $900,000 Roth Show the Same Balance. They Can Buy Very Different Retirements

Two retirees open their year-end statements and see the same amount: $900,000. One holds it in a fully pretax traditional 401(k). The second saver has it in a Roth 401(k) whose withdrawals already qualify as tax-free. Only one of those balances belongs entirely to its owner. The other carries a tax bill that the statement leaves out.

These hypothetical savers have matching balances, but how much can each actually spend? The Roth saver comes out ahead, with one important catch. That retiree paid the income tax years ago, when the contributions went in.

What $900,000 Really Buys Once Federal Tax Takes Its Share

Let’s start with a simple illustration. Assume the traditional account’s withdrawals carry an average federal tax cost of 22% across all of them, with no investment growth and no other taxes.

That 22% is an illustrative average spread over every dollar withdrawn. A real retiree’s marginal rate changes from year to year with income, deductions, filing status and the timing of each withdrawal. Use the figure as a yardstick, since it makes no attempt to project anyone’s taxes.

On that assumption, the traditional account delivers $702,000 of spendable money, and $198,000 goes to federal taxes. The Roth owner keeps the full $900,000, because federal law excludes qualified distributions from a designated Roth account from gross income.

Tax-free withdrawals generally require two things. The saver must be at least 59½, and five tax years must have passed, counted from the year of the first Roth contribution to the plan. Disability or death can satisfy the first requirement, but the five-year requirement still applies. Otherwise, the earnings portion of a withdrawal can be taxable.

Matching Balances Hide Unequal Saving Effort

The spending gap calls for a quick conclusion that the Roth won. That conclusion discounts half the story.

Every traditional contribution came with an upfront deduction. The Roth saver paid tax on each dollar before it went into the account. Building an identical Roth balance therefore took more of a paycheck over a whole career.

To judge which account was really the better choice, you have to count those deductions plus whatever the tax savings earned if the traditional saver invested them. If that saver spent the savings, the Roth probably comes out ahead. If the savings went into a brokerage account and compounded, the gap narrows and can disappear, depending on how tax rates during working years compare with rates in retirement.

Flexibility Is Where the Roth Earns Its Keep

Tax rates explain part of the difference. Control over taxable income explains the rest.

A qualified Roth withdrawal never shows up in adjusted gross income (AGI), so it can pay for a new roof, a car or a year of care without pushing income higher. A traditional withdrawal of the same size counts as ordinary income. That extra income can make more of your Social Security taxable and can trigger income-based Medicare premium surcharges in later years. Because of that chain reaction, one large pretax withdrawal can cost more than its tax bracket suggests.

Designated Roth accounts inside an employer plan also have no lifetime required minimum distributions. IRS Publication 560 notes that required distributions from these accounts apply only after the participant’s death. Once required distributions begin, the traditional saver must take money out every year whether it is needed or not.

Pretax dollars still do useful work. In low-income years, such as the stretch between retiring and taking Social Security, deductions and low brackets can offset traditional withdrawals cheaply. Used on purpose, the traditional account becomes a source of low-cost income.

Map Every Account Before Converting a Dollar

For anyone holding mostly pretax money, a Roth conversion is a question of timing. It pays off when the conversion leaves you with more spendable money after taxes, including the cost of paying the tax bill now.

1. Sort every account by tax treatment. Group pretax, Roth and taxable holdings, then estimate how much of your yearly spending each group has to cover. A household relying almost entirely on pretax savings has fewer ways to cover big expenses without adding taxable income.
2. Compare today’s rate with tomorrow’s. Estimate the federal rate a conversion would face this year against the likely rate on future required withdrawals stacked on top of Social Security. A lower rate today strengthens the case, but also weigh future Medicare costs and where the money to pay the tax will come from.
3. Find your low-income window. The years after a paycheck stops and before benefits and required distributions begin are often the cheapest time to draw down or convert pretax dollars.

Two $900,000 balances can buy two very different retirements. Run this map once now, and again each year before December, while the cheapest conversion years are still ahead of you.

Contact [email protected] for any questions or corrections.