Screw the Roth, Max Your Pre-Tax!


You don’t have to go to the Caribbean for your tax shelter.

It’s no big secret that large corporations hate paying taxes, and corporate accountants are very good at utilizing all available loop-holes to avoid doing just that. One common trick corporations use is moving their profits offshore to a tax haven. This can be done by selling all their patents to a subsidiary in a tax haven country, then paying that subsidiary for “using” its intellectual property. Might seem shady, but right now moving profits around like this is perfectly legal.

In most cases, these companies will keep the profits offshore until they see an opportunity to bring money back without paying high taxes. Even if they need cash, they will resort to taking out loans or selling stock to raise cash before paying the 35% corporate tax they owe the US government. They are further incentivized to do this because in 2004, the US Congress enacted a repatriation tax holiday for corporations. For a limited time, corporations were given a 5.25% tax rate for repatriated profits. They were able to keep 94.75% of their money, rather than paying 35% and walking away with 65%.

If that doesn’t seem like a lot, paying 29.75% less tax means keeping 46% more cash ( (94.75/65)*100% = 146%.) If they had paid the full 35% tax up front, they would have had to generate 46% more income to end up with that same amount of money. Obviously, many corporations took advantage of the tax holiday, and now with the anticipation that congress may give them another tax holiday, they keep their cash offshore and wait.

Big corporations have the advantage here, but there are some tax games that those of us on our path to financial independence can and should be playing. These tax games are less shady. In fact, they simply take advantage of programs the US government has created to help us reach retirement. Pre-Tax accounts like the 401k, 403b, 457, HSA, and Traditional IRAs are our tax havens. And by utilizing them, we can also hoard away cash in anticipation of our own retirement tax holiday.

Pre-Tax accounts like the 401k or 403b can be converted to traditional IRAs. So to keep things simple, I will simply refer to Roth and Pre-Tax accounts.

So why hate on the Roth?

A Roth sounds great – no taxes forever on all the growth in your account is nothing to sneeze at. And with compounding interest, that can be a huge sum of money. But whether you pay 28% taxes now on your initial investment, 28% after 5 years, or 28% after 10 years, you will end up with the same amount of money. Taking away a set percentage of your portfolio has the same effect no matter when it happens, even if you have compounding interest. So if the tax rate is the same now as it will be in retirement, then Roth and Pre-Tax have the same advantages.

 Paying 28% tax at different times, with 8% compounding interest for 10 years

Paying 28% tax at different times, with 8% compounding interest for 10 years

However, for a tax holiday strategy, you want to put off paying your taxes until you can pay them at a much lower rate. If you are on the path to early retirement, you will most likely be in a lower tax bracket when you get there. If you are making $100k and living off of $40k, then you have a healthy savings rate of 60% (which can get you to FI in 12 years – see here) and probably plan to continue living on $40k in retirement.

The money you put into your Roth accounts comes off the top of your income and is taxed at the highest marginal rate. For a single filer, earning $100k with standard deductions, the marginal rate would be 28% (based on 2016 tax rates.) In this case, If you take $18k off the top of your income, it would be taxed at 28% and you would have $12,960 to put in a Roth, or you could just put the entire $18k into a Pre-Tax account.

Years later in retirement, you might withdraw that money from your Pre-Tax account to fund living expenses. For a single tax payer with standard deductions, $40k of income would have an effective tax rate of 11.5%. This effective tax rate is much lower than the marginal rate you would have paid on that money while working. The effective tax rate for $40k of income is low because you pay 0% tax on deductions, and the rest is taxed in 10% and 15% tax brackets. Paying the effective tax rate of 11.5% in retirement leaves you keeping 88.5% of your initial investment verses paying the 28% top marginal rate while working and putting only 72% of your money in a Roth. By waiting to pay taxes until retirement, when income is much lower, the Pre-Tax account will be worth 23% more ( (88.5/72)*100% = 123%) than the Roth.

 Paying tax in retirement vs while working, with 8% compounding interest for 10 years

Paying tax in retirement vs while working, with 8% compounding interest for 10 years

This is just a conservative example – you can optimize even further. Any income below your deductions, whether you use a standard deduction ($6,300 for single filer) or itemized deductions, is taxed at 0%. So during retirement, if you only withdraw from your  Pre-Tax account an amount less than your deductions, you will pay no taxes on it. The rest of your expenses could be covered by cash from after-tax accounts. Long-term capital gains and qualified dividends in after-tax accounts are taxed at 0% for the first two tax brackets.

That would allow you to keep 100% of your money versus the 72% you would have put in your Roth. That’s 39% more cash – one hell of a tax holiday.

But will I have too much money locked up in my 401k in early retirement?

As mentioned earlier, money in pretax accounts like the 401k or 403b can be converted to traditional IRA accounts. And there are multiple ways you can access the funds in a traditional IRA well before you are 59.5 years old with no penalty.

You can setup a SEPP (Substantially Equal Periodic Payments) where you have a fixed amount distributed from your IRA penalty-free every year. There are several formulas the IRS has for calculating how much can be distributed each year, and the payments must be distributed for a minimum of 5 years.

Another, better option is a Roth IRA conversion ladder. In this case, you roll your 401k into a traditional IRA when you leave your job, then transfer some amount into a Roth IRA annually. This converted amount is taxable, so it should be optimized according to your tax strategy. The principal can then be withdrawn from the Roth IRA after 5 years without penalty. Do this every year and you can have steady withdrawals without paying a penalty.

There are many other cases for which the IRS allows you to tap into your 401k funds without penalty. Even if you need the money for some other reason early into your retirement, you could just pay the penalty. The 10% early withdrawal penalty and 11.5% tax rate still leave you with more money than paying a 28% tax to put that money in a Roth.

So is there any case to contribute to the Roth?

Compared to after-tax accounts, the Roth IRA still has the advantage of tax-free growth. But if you invest in equities in your after-tax accounts, such as a total market index fund which pays ~2% in dividends yearly, only the dividends will be taxable while the account grows. The taxes on capital gains wouldn’t be due until you sell. By paying a small amount of tax on dividends to keep the money in an after-tax brokerage account, you could have the full sum available in early retirement.

Furthermore, if you end up in the first two tax brackets during retirement, your capital gains and qualified dividends tax rate will be 0%. In this case, the Roth has no advantage over a traditional taxable brokerage account holding equities. Investments that generate taxable income, such as bonds and REITS, can simply be held in your Pre-Tax account.

Work less, and retire sooner.

I know it might feel better to pay your taxes now, and not have to worry about them later. But waiting patiently for a retirement tax holiday is an extremely powerful tool. Tax avoidance strategies yield guaranteed gains, and saving 20-50% more means shaving years off your journey to Financial Independence.

I'm not working 40% more.

It’s tough getting here, I’m not working any more than I have to.

If for some reason your 0% tax holiday in retirement never comes… awesome! That means you somehow have unexpected extra income. Even if you hit the point of having Required Minimum Distributions, your effective tax rate in retirement will most likely be less than your marginal tax rate while working. And until then, the money you stored away in Pre-Tax accounts can be your cushion that keeps growing without costing you anything in taxes.

34 thoughts on “Screw the Roth, Max Your Pre-Tax!

  1. I totally agree. I have been kind of surprised when the common advice from the financial independence community is “max 401k, max Roth IRA” because it seems to make a lot more sense to use a traditional IRA and delay the taxes until you are in a lower tax bracket and have the opportunity to execute a Roth conversion ladder while additional income is minimal. Thanks for the post!

  2. I have to disagree. It is likely to qualify for a Roth but not a pre-tax IRA. Ie it’s not necessarily one or the other. Also you have the benefit of diversification if Congress chooses to change the laws. Also your Roth can act as an emergency account for contributions. I wouldn’t roll to Roth unless the market and your pay rate were depressed at the same time(2008), but I wouldn’t stop contribution.

    • For someone who has maxed out their Pre-Tax options, there is a good chance they still have the option of the Roth. But if you plan to retire early a typical brokerage account might be a better option.

      By putting that money into a regular brokerage account and investing in stocks, you only have to pay tax on the dividends. The benefit is that the full sum will be available to you in early retirement, at which point the tax on those dividends (as well as capital gains) can go to to 0% (if your income is in the first two tax brackets.)

      The money in your brokerage account will still be there for you in an emergency, and with taxes paid it is not affected by congress upping tax rates.

      If you already have more than you need in your brokerage account for early retirement, then you might want to consider the Roth.

      Thanks for the comment!

  3. The only Roth I contribute to each year is the “backdoor Roth.” Monies that end up there would otherwise be invested in the growing taxable account.

    The 401(k) and 457(b) are 100% tax deferred.


    • Nice work POF!

      I was doing the backdoor Roth for a while. But I stopped all Roth contributions when I realized that in early retirement I would be better served having that money in a brokerage account.

      Currently we keep any dividends (taxed at 15%) to go towards living expenses while still maxing out Pre-Tax savings to reduce our income. In the near future there is a good chance we will be paying a 0% tax rate on dividends and capital gains.

  4. I’ve read a ton of posts about how a Roth isn’t the right move for the early retiree. From what I see, it makes sense if you’re anticipating your income to be low.

    I currently contribute to a Roth and don’t put anything into a deductible IRA. The reason I’ve been doing that is because I want to give myself the option for a backdoor Roth, since my household income will be well above the income limits in the next few years.

    We’re not necessarily an early retirement household however, so it seems likely that our income will stay pretty high. We just want to get to financial independence so that we can work without fear basically.

    • The case for a Roth does get better with a traditional retirement. However, doing Pre-Tax over the Roth still makes sense in most cases even if you anticipate higher income. The reason is because while working and contributing, the money is taxed at your top marginal rate (in my example it was 28%.) But in retirement, even a traditional retirement, that money will be taxed at your effective tax rate. To reach an effective tax rate of 28% after retirement you would need to pull ~$350,000 from your fund.

      Aside from the Roth, other options like the Vanguard Total Stock Market index fund are pretty tax efficient on their own, and leave you with more options down the road.

      Thanks for the great comment, Panther!

  5. Great write up Mr. Crazy Kicks, and well reasoned.

    There are some people that argue taxation on capital gains and dividends is at an all-time low. They argue those taxes will rise significantly in the near future.

    Say for example, in 5 years those taxes double. In that scenario the Roth might not be such a bad deal….but given all the boomers retiring now I doubt that kind of taxation change would get political traction.

    • Agreed, If the capital gains tax rate went up significantly, the Roth would become more attractive as compared to a brokerage account. But if in 5 years you retired early, you would probably still want to have those dividends and capital gains available to cover expenses.

      Great comment, Mr. Tako!

  6. Great write up and it really has me thinking. I think originally I started to do a Roth IRA because that was the en vogue thing to do when it first got passed.

    As time went on I reasoned that it made sense to contribute to a Roth IRA because my effective tax rate was so low and with the way the US is spending that tax rates would inevitable rise.

    I thought if I could max out my pre-tax 401k and then max out my Roth IRA that I could hedge against the risk in the future. I need to rerun the analysis but you lay a very good argument.

    Thanks for sharing!!!

  7. Great explanation of the benefits of pretax investments over the Roth. We started off with a Roth several years ago, simply because it was the standard advice and it seemed to make sense. Once we started doing our research and focusing more on early retirement, we stopped contributing to the Roth and now fund just the traditional IRA for the exact reasons you outline in the post.

  8. I disagree because I cannot imagine the government not raising taxes for universal health care or even just to square our national debt. And I really doubt property taxes will stay fixed for non-Californians. Given the cries on both sides of the aisle, capital gains taxes will be higher soon and affect anyone with pensions and investments in retirement. I know I am unusual with both my husband and myself on an early pension track with a decent portion of our income non-taxable and living in a state without income taxes, so circumstances dictate. We may retire in a state with income tax for lifestyle reasons.

    Most PF bloggers hold tight to this notion of not increasing spending at retirement to calculate FIRE, but I think I will have more time to travel and free time (which is usually translates to spending money at least some of the time) and potentially higher health costs so I budget needing at least twice as much as I currently spend. Also, for you bloggers who have strong blogging income — how do you know it won’t grow into the next tax bracket — most FIRE people are entrepreneur types with rental income or side businesses (blogs included). Sure, I can make grand home cooked meals and spend all my time reading and gardening at home. But even my local knitting club meets at B&N and eat/drink at the cafe. While some time may be spent volunteering, realistically, I also want to cruise the world and not let money be a major factor in every choice. Living on 40k or one million is pretty close to paycheck to paycheck for most areas with families if you still have a mortgage or need to account for your kids’ 529 contributions without touching principal. And time for the grandkids usually means taking the grandkids out for at least an ice cream if not Six Flags or Disney World. Who knows what new ‘necessity’ will be available in the next decade or two? Cell phones and plans are a new expense. Heck, Spotify and Netflix are new to my family because they are so cheap. No cable and using the radio instead of buying CDs/mp3s now does not translate to never paying for Netflix and Spotify in the future. Google fiber is great conceptually as it spreads, but still more than I pay now.

    Don’t underestimate future spending. Or future tax brackets. Or potentially sky high taxes on the self employed. Rental income for most FIRE types probably hasn’t been trending down and is probably the most common source of passive income.

  9. Good post. It makes sense – for a frugal retireee – to maximize pre-tax contributions during high earning years and then gradually withdraw them during retirement practically tax free. That’s the strategy I use. Roth conversion is not required unless you retire very early and would like to take out the funds in 5 years penalty free and on the year of Trad IRA to Roth conversion, your earned income is zero or very less. That’s where Roth’s benefit comes.

  10. I should be so lucky to have so many choices. As a single filer, in order to put pre-tax money into a Traditional IRA, the MAGI limit is $71k if you have a 401K at work (as of 2016). For the Roth, MAGI limits are $117k for the full amount, decreasing to zero at $132k. Complicating things further, I cannot even contribute to the 401k limit because of a silly IRS thing called “highly compensated employee” which is anyone earning more than $120k. Because of this, they limit the percentage of my check I can put into 401k, which is less than the contribution limit. So, I have no other choices other than to put all excess cash into a taxable brokerage account.

    That said, I completely agree that maxing out pre-tax savings is best, as contrary to common teachings, you’ll likely have a LOWER tax bracket in retirement, just as you suggest.

  11. This works for people that end up paying the tax man every year… but for my family the ROTH makes sense. Our taxable income is around $37,771 plus a few hundred from interest. For 2016 our Standard Deduction is $12,700+ Personal exemption $16,200 + Child tax credit $17,783= $46,683 so we pay $0 in taxes. When we move back state side and I get a job we will definitely start contributing to traditional 401ks when the math makes sense 🙂

  12. Determining whether to invest for retirement using “pre-tax” vs. “Roth” deferrals (401(k) and 403(b)) or contributions (IRAs (Traditional, After-Tax, or Roth)) depends primarily on your MARGINAL income tax bracket when you are making the contributions compared to the MARGINAL income tax bracket that money will be in when you withdraw it from your retirement account. If your marginal income tax bracket is higher when you make the deferrals or contributions than when when you withdraw the money in question, than pre-tax is mathematically the way to go. If not, then the mathematical answer is Roth.

    For all those readers who are single and earn $100,000 today and plan to live on $25,000 of income when they retire, then sure…since their marginal tax bracket today (while they are working) will be higher than their marginal tax bracket will be when they “retire” on $25,000 of income taking advantage of pre-tax contributions/deferrals is the appropriate choice. Assuming the tax brackets and rates remain unchanged.

    Those $100,000 single wage earners who max out pre-tax deferrals and contributions hit the elective deferral max for 401(k) at $18,000 and so that leaves a lot of wages left to be invested it they are saving 60-75% of their $100,000 of earned income.

    Those dollars over and above the elected deferral limit should be invested in say a mutual fund that spits off qualified dividends. Most likely, it will be that income (from these “non-qualified” (i.e. non-IRA, non-401(k)) buckets that will generate the $25,000 of passive income when they are 40 or 50 years old. That allows their qualified money (IRA and 401(k)) to continue to grow until they are age 59 1/2 or older thereby avoiding the 10% premature distribution penalty tax (and the need for a “Roth Conversion Ladder”). And eventually when the qualified money begins to provide income, the individual will be receiving more of it (income) in total thereby keeping up with inflation.

    When it comes to income tax planning, it’s all about “the margins” and understanding what’s included in “taxable income” (e.g. after either the Standard Deduction (or Itemizing) and your Personal Exemption(s)).

    Of course, no one knows what will happen in the future with regard to marginal income tax brackets and rates.The federal debt is about $19 trillion at this point. Or for that matter if someday the U.S. will replace the income tax system with some sort of a national sales or value-added-tax.

  13. Don’t forget that Roth contribution principal amounts are always available to you tax free and without penalty! So, compared to putting that money in a brokerage account its a no-brainer. In a regular brokerage account you pay taxes on the dividends at minimum. Plus in a Roth you are totally free to move money between equity positions at will, without any regard to the tax implications. I use all three types(401K, Roth, and brokerage) to realize the benefits of each. In early retirement I can tap those Roth contributions tax free, and the gains tax free at 59.5.

    • “In a regular brokerage account you pay taxes on the dividends at minimum.”

      That depends…

      Under the current IRC, “qualified dividends” are tax-free if they would otherwise be taxed at the 10 or 15% marginal rate.

      Here is what the IRS says:

      “The maximum rate of tax on qualified dividends is:

      0% on any amount that otherwise would be taxed at a 10% or 15% rate.

      15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6%.

      20% on any amount that otherwise would be taxed at a 39.6% rate”

      Many, many mutual funds distribute “qualified dividends” – check the prospectus. For individuals planning to retire on $25,000 of annual income, qualified dividends would be income tax-free. That’s why building up a significant amount of money in say Vanguard Total Stock and “living” on the dividend income is appealing for retirees planning on say $25,000 of income.

      Of course, tax laws are subject to change (which makes executing a tax-savvy retirement plan at any age problematic). Who knows what tax laws will be five or twenty-five years from now.

      • Correct, if you are in a low tax rate you might be able to avoid tax on the dividends. However if it will be a while before you retire then chances are that most of us aren’t currently in the zero tax bracket right now, thus incurring taxes on dividends at least temporarily. Plus with the opportunity to take out the principal any time on Roth yields little downside cost versus brokerage. More important to me is the ability to move money between investments without tax consequences.

  14. For about 2 years I threw a bunch into my 401(k) as a Roth deferred contribution. I arrived at the same conclusion as you did here. Changed it back to all pre-tax, and had more for my brokerage account.

  15. Great post. I do however, respectfully disagree. The first problem I have with most negative Roth articles I read is that the writer always assumes people will earn a lot less in retirement. Maybe for some, but not all. Most people I know are working hard to have more money or at least equal money in retirement.

    The more risky side of this argument is the assumption that overall tax rates will remain constant. I don’t see a scenario where the government doesn’t drastically raise taxes. This will be needed to cover failed programs, Social Security, Medicare, Obamacare, etc. When it does happen, even lower tax brackets will be higher.

    I prefer a mix of both traditional and Roth IRAs.

  16. Don’t forget about the fact that Roth’s do not have RMD’s like traditional IRA’s or 401k’s. RMD’s can force the payment of taxes as well as impacting other issues like the taxation of Social Security or the size of your Medicare premiums.

    Also, should a non-spouse inherit the Roth IRA, they would have RMD’s, but they would be tax free. A traditional IRA/401k would also have RMD’s for the non-spouse beneficiary but would be taxable at their marginal rate (which may be higher if they were still working).

  17. I agree that for most people your 401(k) should be pre-tax, but once you’ve maxed out that I see no reason why you shouldn’t fill up your Roth IRA bucket before moving to a taxable account. That advantages of the Roth IRA (tax-free growth, no RMDs, tax diversification in retirement, Stretch IRA, withdraw contributions at any time) are too great.

  18. I agree completely. However, at some point you might do the math and realize you have way too much future value in your pre tax accounts. At that point I would suggest loading up your taxable accounts. Unlike a Roth, you can’t tax loss sell in a Roth. Once I rescued our Roth Principle, we did some tax loss selling and took that deduction against our ordinary tax rate of 25%. Anyone can do this, and anything over 3k per year carry forwards. It’s a great tax shelter we have until I retire early.

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  20. Both me and my wife have already been putting the “max” into our pre-tax so the only “logical” place left is to put some of the left over into a ROTH. Afterall, a self-managed ROTH account gives you all of the investing options that you would have in any investment account (Stocks, bonds, index, etc) so why not, right?

    • There is nothing wrong with using the Roth after maxing out pre-tax options. But, as I mention in the post, if you plan to retire early a typical brokerage account might be a better option.

      The capital gains tax rate for retirees in the first two income brackets is 0%, so the incentive of using a Roth goes down. Especially if you might need to access the money, or want to live off of dividends.

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