INSIGHT: Myths About the Traditional and Roth 401(k)/IRA That Affect How People Use Them

You may not realize that your traditional 401(k)/IRA is a joint venture between you and the government (federal and state) and that your interest in this venture is roughly equivalent to a Roth.

This is easier to understand with the initial assumption of a constant flat income tax. (Later, I shall relax this condition.) This assumption aids in comprehending the fundamental nature of the traditional and Roth. Also, the flat tax analysis applies when the marginal tax rate at contribution (or Roth conversion) is the same as at distribution from the traditional to you and your beneficiary. (Your marginal tax rate is the rate that applies to the next dollar of income.)

This parity often exists. Here are two examples. First, for a couple, the 2020 federal rate of 24% applies to taxable income between $171,051 and $326,600, a wide range. Each year, a retired couple could have a stable taxable income within this tax bracket. Second, early in her career, someone may be in the same marginal tax bracket as at retirement.

The Roth is beneficial when your marginal tax bracket at Roth contribution or conversion (using outside money) is the same as at distribution from your traditional to you and your beneficiary. The constant flat tax analysis below applies.

Suppose you will have the same marginal tax rate at conversion and at distribution to both you and your beneficiary. If you have the outside funds available to pay the “tax,” you should consider annually converting your traditional to a Roth until reaching the top of your current marginal tax bracket. You probably should not convert if, in the subsequent years, your (and your beneficiary’s) marginal tax rate will be lower for any reason, including a decline in future required minimum distributions (RMD) as a result of the contemplated conversion.

I shall now explain the essence of the traditional and Roth 401(k)/IRA.

Assume a constant flat income tax of 30%. Suppose you put $1,000 of salary in a traditional 401(k)/IRA account. In effect, the government “collects” $300 income tax and invests $300 in the account. You invest the $700 balance. The government is your 30% partner and takes 30% of every dollar withdrawn.

Here are nine myths about the 401(k)/IRA.

Myth One: Traditional and Roth contributions are completely different.

With a constant flat tax, the traditional and Roth contributions are roughly equivalent, but the Roth has some advantages.

In the 30% tax example above, in the traditional you wholly own your 70% interest, which is never subject to tax, including on withdrawals. In effect, your 70% is a “Roth” within the traditional. The only tax benefit of the traditional is the “Roth” within.

Suppose your employer offers both a traditional and Roth 401(k). Assume you can afford either $1,000 pre-tax in the traditional or $700 after-tax in the Roth.

With the traditional, you start with 70% of $1,000, or $700, not subject to tax. With the Roth, you begin with $700 owned outright and exempt from tax.

Unlike the traditional and “Roth” within, the standalone Roth IRA is exempt from RMD when held by you and your spouse beneficiary (if she elects to become owner). (A Roth 401(k) is subject to RMD. To avoid RMD, you must roll it over to a Roth IRA.)

The Roth has another advantage. The tax law imposes a maximum annual employee contribution to any combination of traditional and Roth 401(k).

Assume the annual maximum is $1,000. Unlike earlier, suppose you can afford $1,000 after-tax (and more pre-tax).

A $1,000 contribution to the Roth rather than traditional gives you “more bang for the buck.” You get $1,000 in a standalone Roth, rather than $700 in a “Roth” within a traditional.

Similarly, as discussed later, if you start with a traditional and later have the spare outside funds to pay the required “tax,” a Roth conversion also results in an advantageous larger amount in the Roth.

(As mentioned near the end, if the marginal tax rate at distribution is lower than at traditional/Roth contribution, the Roth contribution may be inferior to the traditional.)

Myth Two: The amount in your traditional 401(k)/IRA statement is all yours.

The government is a joint owner. Your periodic gains or losses may be less than you think. Recognizing this may make you sleep better. It may even cause you to increase the total account’s percentage in equities.

Myth Three: The “tax” on a traditional 401(k)/IRA distribution makes you worse off.

With a constant flat tax, the distribution is a partial liquidation of the joint venture with each party taking the portion already owned. The “tax” does not harm you, but the share you receive is a partial redemption of your tax-exempt “Roth” within the traditional.

Another way of understanding why the tax on RMD does not make you worse off is to examine how you can mitigate or reverse RMD’s effect.

If you want to continue saving but must take RMD, an imperfect substitute would be lower-yielding tax-exempt bonds, a 529 plan, and/or non-dividend-paying stock held until death’s stepped-up basis. Those securities would escape taxation, like the “Roth” within the traditional (or standalone Roth).

With a constant flat tax, a better way to reverse RMD would be to use the after-“tax” proceeds of the distribution to pay the “tax” on a Roth conversion. As demonstrated below, the result is an exact reversal of the RMD. (This analysis also relates to “Myth Four,” that you are worse off If you withdraw “inside” funds from the traditional to pay the “tax” on the Roth conversion.)

Assume a RMD of $10,000, and, again, a constant flat tax of 30%.

First, you withdraw the $10,000 RMD from your traditional and pay “tax” of $3,000 to the government.

Second, you take the after-“tax” $7,000 received in step one and pay the exactly $7,000 “tax” necessary to convert $23,333.33 of other traditional to a Roth. Seven thousand dollars is exactly 30% of $23,333.33.

With step one, you have $10,000 less in traditional. Of that, $7,000 was yours (a “Roth” within the traditional).

With step two, you converted $23,333.33 of other traditional (70% of which, or $16,333.33, was already yours) to $23,333.33 of Roth, all of which is yours. You now have $23,333.33 in a standalone Roth, versus $23,333.33 in “Roths” (within the traditional) before: $7,000 plus $16,233.33.

You have restored your original position.

Regardless of age, until retirement you usually need not take RMD from your current employer’s 401(k). To avoid RMD’s so-called “tax,” some may continue working, but RMD may not be as bad as they perceive and, with a constant flat tax, is possible to reverse.

(With the actual progressive income tax, only a part of RMD may be reversible because otherwise the income from both the distribution and the conversion would result in a higher tax bracket.)

The final six myths are about Roth conversions.

Myth Four: You are worse off If you withdraw “inside” funds from the traditional to pay the “tax” on the Roth conversion.

As just shown, with a 30% constant flat tax, you can exactly reverse RMD at no cost. Suppose you are not subject to RMD but voluntarily withdraw $10,000 and use the after-“tax” $7,000 to convert $23,333.33 of other traditional. As before, the result is a wash. You end up with the same holdings in traditional and “Roth” (standalone or within a traditional).

(Later, I shall relax the assumption of a constant flat tax and note that if the tax bracket at would-be distribution will be higher than at conversion, you are better off with conversion even using “inside” funds to pay the “tax.” If the tax bracket at would-be distribution will be lower than at conversion, you are worse off with conversion if you employ “inside” funds for the “tax.”)

Myth Five: To convert (using “inside” or “outside” funds), your income cannot exceed a limit.

Conversion is available regardless of income.

Myth Six: You may convert only an IRA, not a 401(k).

Examples of traditional 401(k) conversion opportunities generally include (1) a past employer 401(k) (although using “inside” funds before age 59 ½ generally involves a tax code penalty); and (2) after age 59½, using “inside” or “outside” funds, the current employer 401(k), with employer permission.

Myth Seven: In return for future benefit, conversion using “outside” funds has a present cost, the income tax on the amount converted.

With a constant flat tax, this conversion transaction has zero net cost.

Again, assume a 30% rate. Suppose you have $3,000 in an outside taxable account, plus $10,000 in a traditional 401(k)/IRA. Of the traditional, you own $7,000; the government owns $3,000. To convert the $10,000, you use the $3,000 outside money for the “tax” to purchase the government’s $3,000 share. You pay $3,000 to get $3,000.

Myth Eight: To benefit from conversion (using “outside” funds), you must hold the Roth a long time.

In the conversion example above, you start by owning $7,000 in a “Roth” within the traditional and end up owning $10,000 in a standalone Roth entirely exempt from tax. You effectively shift the outside taxable $3,000 into the Roth. The conversion’s advantage is tax exemption of the (formerly) outside funds. This no-cost benefit begins immediately.

The more “tax” paid the better―the more outside taxable funds shifted into the tax-exempt Roth.

Myth Nine: When you use outside cash to pay “tax” to convert a stock 401(k)/IRA, you do not increase your equities exposure.

In the example above, if the 401(k)/IRA is in stocks, you end up owning $10,000 in shares compared to $7,000, an extra $3,000. In effect, you move $3,000 from cash into equities. To negate the increased stockholding, you can shift $3,000 in your Roth to fixed-income.

Now, I shall relax the assumption of a constant flat tax.

Even with the present income tax schedule, the constant flat tax analysis applies when the marginal tax rate at Roth contribution/conversion is the same as at distribution from the traditional.

What if the marginal tax rate at distribution is not the same as at Roth contribution/conversion?

If the marginal tax rate at distribution will be higher, the Roth is either better or even better. With a Roth contribution, you avoid the traditional’s joint venture with a government that contributes a lower percentage than it takes at liquidation. With a conversion, you buy out the government at, say, 30% of total value and avoid a government demand for greater than 30% at liquidation.

If you are employed part-time or just starting your career, your earnings may be temporarily low and less than your future retirement income. If so, this period of relatively diminished pay may be opportune for the Roth contribution or conversion.

Under the recent SECURE Act’s 10-year mandatory distribution period for most non-spousal beneficiaries, an affluent retiree (or spouse) who leaves a large traditional to a child or grandchild might expose that heir to a large annual distribution that thrusts her into a higher marginal tax bracket. She might be in a higher tax bracket than the retiree’s bracket at conversion. The retiree (or spouse) should convert to a Roth at least up to the top of her current marginal tax bracket.

As demonstrated in Myth Four, under a constant flat tax, with the use of “inside” funds to pay the “tax,” the conversion is a wash. Therefore, employing “inside” funds is beneficial If the tax bracket at would-be distribution will be higher than at conversion, as might be true with the SECURE Act’s 10-year required distribution.

What if the marginal tax rate at distribution will be lower?

A traditional becomes a joint venture with a gratuitous decrease in the government’s percentage ownership at liquidation and consequent increase in the “Roth” within.

Again, the Myth Four analysis showed that, under a constant flat tax, with the use of “inside” funds to pay the “tax,” the conversion is a wash. Therefore, employing “inside” funds is disadvantageous If the tax bracket at would-be distribution will be lower than at conversion.

The Myth One discussion mentioned the maximum annual contribution limit on any combination of traditional or Roth 401(k). Using that maximum to contribute to a Roth gives “more bang for the buck” and starts you with a larger initial standalone Roth than the “Roth” within a traditional. The Roth conversion (with outside funds) also increases the amount in your Roth.

You must weigh the tax-exemption benefit of a larger Roth against the traditional’s free reduction in the government’s proportionate ownership at liquidation. If you or your beneficiary will be in a significantly lower tax bracket at distribution, you probably should avoid the Roth contribution or conversion even with outside funds.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Professor William K.S. Wang is a Sullivan Professor Emeritus at University of California Hastings College of Law. He has taught courses in Corporations and Corporate Finance. From January 2005 through January 2009, Professor Wang served as a member of the FINRA (formerly NASD) National Adjudicatory Council. In addition, from 1996 to 2011 he chaired the Investment Policy Oversight Group of the Law School Admission Council and served ex officio on the LSAC board. Since 2012, he has been on the board of directors of AccessLex Institute and on its investment committee.