Is FICA Tax the Key to Solving the Traditional vs. Roth 401(k) Debate Once and for All?

Is FICA tax the key difference maker in the Roth vs. Traditional 401(k) debate?

This blog post will hopefully be quite a bit shorter than the ironically named “Ultimate Traditional vs. Roth 401(k) Debate” post I wrote previously and slightly shorter than the “Will You be in a Higher Tax Bracket in Retirement? Maybe, But It’s Unlikely” post that came more recently. 

Why? Because it’s more of an ‘addendum’ than a knock-down, drag-out brawl.

Take a walk with me down memory lane, will you? Previously, I’ve made one primary argument in favor of Traditional. It’s mostly been based on logic that seems ironclad to me:

When comparing your tax rate in your working years (applies to Roth contributions) to your tax rate in retirement (applies to Traditional distributions), you’re not comparing apples to apples: You’re comparing your marginal rate now (likely 24% or 32%, depending on how much money you make) to your effective tax rate later (likely sub-20% in retirement, depending on how much money you spend). Not only that, but investing in a Traditional 401(k) frees up more investable take-home pay because it lowers your tax bill.

Still, I heard pushback both times from passionate Roth advocates: “But I’m paying taxes on the seed, not the harvest!” They’d argue, poetically—and also completely missing the point.

If you chop off enough of the seed before you plant it, your harvest is smaller.

Not only that, who eats their entire harvest all at once? Why not grow the bigger harvest and then pay as you go?

I thought my reasoning (and the math) made a metric dick ton of sense. In fact, the only compelling argument I’ve really ever heard in favor of Roth is that of RMDs: That once you turn 72, the government looks at the size of your pre-tax bucket and says, “All right, you gotta start withdrawing more (maybe), and paying taxes on it.”

That event—in which the government may wrest back control and force you to use your own money—means you no longer have total control over your tax rate, and it’s a valid criticism (though it’s also one of those problems where you have to admit you’d be happy to have it, if it means you have so much money the government starts making you spend some of it).

Now that we’ve summarized memory lane and you’re up to speed, let’s talk about FICA taxes

What the FICA?

FICA taxes = payroll taxes = Social Security and Medicare.

These pesky little buggers take an extra 7.65% from your paycheck. You probably noticed it early on in your career when your paycheck was even smaller than you anticipated after taxes.

And you know what FICA taxes apply to? Employee elective salary deferrals. Also known as: Your contributions to your retirement accounts. 

That’s right. You pay 7.65% on your Traditional and your Roth contributions to your 401(k), even if your Traditional contributions are exempt from federal and state taxes. Bummer, huh?

That means your effective tax rate on your Traditional contributions is 7.65%, but your effective tax rate on your Roth contributions is your marginal tax rate + 7.65%. 

You thought you were paying 24% on your Roth contributions? Think again: You pay 31.65%.

That’s almost a third of your contribution that gets eaten up in taxes if you’re in the common 24% bracket! Take your seed and slice off a third, not a quarter.

At the outset, this really doesn’t make a difference—after all, the tax applies to both Traditional and Roth contributions, so in a way, it’s like it applies to neither. In the contribution phase, its net effect is zero when weighing one option against the other. 

But in retirement? When you’re using that money? Here’s the kicker: You don’t pay FICA taxes on your distributions. None of your retirement income from your retirement accounts is subject to FICA (payroll) taxes, making your effective tax rate even lower than I thought. 

This thought originally came to me while writing a podcast episode that referenced a T. Rowe Price analysis that finds the income needed in retirement is around 75% of your income in your working years—it casually noted that the “reduction in taxes” retirees experience lowers their expenses. 

I was like, “Wait a second, we’re just going to gloss over the fact that this T. Rowe Price whitepaper is tossing in lower taxes as a given in retirement?”

Technically, it’s not the FICA tax itself that makes the difference, but our perception of our post-tax income 

Since we pay FICA taxes on our contributions on both the pre-tax and Roth options, but pay FICA on neither set of distributions, its true net effect is zero. 

But it’s still impactful: Why? Because your own perception of your post-tax income is nearly 8% lower because of FICA taxes. 

Your entire paycheck gets taxed with these payroll taxes (and if you’re self-employed, you pay 15.3%—the employer and employee portion) up to $147,000 in 2022, where your social security liability tops out.

For example, if you make $100,000 per year, your experience of your take-home pay (omitting state taxes) is $77,341. We’ll assume you’re single and this money is just for you.

That’s after you pay $15,009 in federal taxes and $7,650 in FICA taxes.

Your total tax liability is $22,659. 

It’s natural to look at your experience (take-home pay of $77,341 per year, or $6,445 per month) and say, “I feel like I might want to spend more than $6,445 per month in retirement,” and assume that it means you’ll need to withdraw >$100,000 per year in order to do so.

While the data would suggest that that’s unlikely for a single person (data from JP Morgan Asset Management shows that spending tends to peak in the late forties and early fifties and then decline steadily by 1% per year), let’s assume you’re able to spend that much in retirement. 

(I say “able” because—in today’s dollars—you’d need about $2M invested in order to spin off $6,445 per month before taxes.)

Assuming you’re only saving inside your 401(k) and striving for a total balance of $2M (in other words, you have no other investment accounts), you’d need to withdraw $6,445 per month from that account to have the exact same amount of total income you had in your working years.

In order to have $6,445 per month in your working years, you had to earn $100,000 because taxes ate up the rest. You paid $22,659 in taxes.

But in order to have $6,445 per month in retirement, you just have to withdraw that amount per month from your 401(k) and declare it as income.

But you won’t pay FICA taxes on that income, which means you won’t need to withdraw $100,000 to end up with $6,445. You’ll only need to withdraw about $90,400 to pay yourself $6,445 per month and pay your tax liability. 

That’s because your tax liability on $90,400 is $12,876, leaving you with about $77,524 to spend – or $6,460, roughly the same as your “take-home pay” during your earning years.

But wait—how did we accrue that 401(k) balance of $2 million in the first place? By saving a portion of that $6,455 each month.

We still have to account for the fact that you weren’t spending your full $6,445 per month in your earning years—you would’ve needed to save substantial chunks of it to end up with $2M in your 401(k). 

In this example, we’re controlling for inflation by ignoring it entirely, but the apples to apples comparison is:

$100,000 of income produces $6,445 of take-home pay per month (some of which had to be set aside and invested) while working and generates a $22,659 tax bill (or an $18,128 tax bill if you were contributing to a Traditional 401(k), which this example presumes you were)

$90,400 of annual distributions produce $6,460 of take-home pay per month (none of which has to be set aside and saved) while retired and generates a $12,876 tax bill

See where I’m going with this?

Thanks to payroll taxes, it takes less “income” in retirement to produce more take-home pay (and therefore a smaller tax bill)

So what about those RMDs? Well, one way to avoid them is by converting your pre-tax funds to Roth. 

“But wait, shouldn’t we have just started with Roth then?” 

Not while you’re making $100,000/year, honey!

Why not start converting to Roth and paying your effective tax rate on those conversions as soon as you retire when you have no other earned income?

Realistically, our example above is even more dramatic than I made it look, because—as noted—some of that $6,445 of take-home pay would’ve needed to be invested to become $2M. If we work for the average timespan of 40 years and get an average real rate of return of 7%, we’d have to set aside about $900/mo. to hit $2M in 40 years. 

(Again, ignoring inflation through-and-through for simplicity.)

That would make our real take-home pay during our working years closer to $5,500, or $1,000 less than our monthly retirement income. 

So even if you DID somehow finagle a way to spend more in retirement, you can spend a full $1,000 more per month in retirement than you’re experiencing as take-home pay now and still pay about 30% less in taxes!

That means if you’re concerned about RMDs, you can just maintain your same $5,500/mo. lifestyle and convert the additional $1,000 per month to Roth (paying the exact same taxes outlined above, but shrinking your pre-tax bucket and growing your Roth bucket proportionally). 

If our hypothetical example Rich Girl had initially contributed those funds to a Roth 401(k) instead at the same savings rate ($10,800/year), she would’ve paid her marginal rate of 24% and another 7.65% for FICA: $3,418 in taxes each year, or an effective tax rate of 31 cents per dollar. That money has to come from somewhere, and usually, the money that pays our taxes is money that otherwise would’ve been invested (as savings are more likely than spending to be cut in response to lower take-home pay).

Instead, you’ll pay $12,876 on the entire $90,400 of distributions ($12,000 being converted to Roth if you’re trying to keep spending consistent and complete some Roth conversions; the other $66,000 being spent), an effective tax rate of 14% (14 cents per dollar). And remember, this example presumes you’re single when you take these distributions—if married, the tax rate is roughly half that. Even better news for those who are earning the $100,000 single and spending it in retirement while married.

The FICA payroll taxes we’re accustomed to (and the fact that we’re saving part of our income) distort our perception of how much we really need

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A $100,000 salary in our working life and $100,000 in distributions from our retirement accounts aren’t created equal.

And remember, just because you don’t invest in a Roth 401(k) doesn’t mean you can’t invest in a Roth IRA—but that’s why I like utilizing the $20,500 of available pre-tax investment “space” to generate some tax savings, and then invest my next $6,000 per year in a Roth IRA. Two birds with one stone: Pre-tax contributions create more investable income, and contributing to both types of accounts creates more flexibility in tax planning later.

You can open and invest in a Roth IRA with Betterment. Simply answer a few questions about what you’re investing for (if it’s a Roth IRA, you’ll go down the “Invest for Retirement” path). You can even set up a semi-monthly cash transfer from your checking account after pay day.