In 20's 401k vs roth 401k

[sinusone]

Hi everyone! My name is Joe and I'm new here. I'm pretty young (24) and looking to retire early. I live in southern california. I gross 67k as an engineer, so 28% tax bracket, and contribute the max amount to my 401k (on my 2nd year) and Roth IRA. I most likely will not have a pension plan.


** Actual Question **
My employer will add the roth 401k option in a few months. I've read some of the topics between the pros and cons of each. I understand we would like to have enough income to fill in the lower brackets where the traditional 401k would do well. But given my age is a roth 401k a better choice right now? . I could always put into a traditional at future companies or change it up when I have a higher income or something.

The caveat
I would (hopefully if possible) like to retire early but ALSO I would like to live somewhat of a lavish lifestyle. I want to travel the world mainly, nice restaurants, etc. So given I probably will take a good chunk each year...I might have a lot of tax if I use a traditional 401k. I haven't figured out an annual amount I want to live off of...just kind of doing what I can to save and invest for a good retirement. The amount will depend on how the markets go =)

** Some other things that may be useful **
401k - 25k
Roth IRA - 12k
taxable - none yet =(

 

[growing_older]

Your salary is likely to rise and put you in a higher bracket in a few years. If you can handle the tax implications, for you Roth 401k is on sale at this point in your career, at least until you move up in tax brackets. If I were in your shoes, I'd do Roth until my salary moved me up in brackets.

 

[LOL!]

The Roth 401(k) is NOT for you. You will have more money if you use the Traditional 401(k).

In the future when you are in a lower tax bracket and retired, you can convert your 401(k) to a Roth IRA. Many folks around here do exactly that. They didn't pay 28% tax when they contributed to their traditional 401(k) and they paid 0% tax when they converted. So why do the Roth 401(k) and pay tax? That just doesn't make sense to me.

 

[LOL!]

This is a frequently asked question. See, e.g. AND THE LINKS THEREIN:
Bogleheads :: View topic - Roth 401K vs Standard 401K

 

[Shawn]

A Roth can be good for someone who has or expects to have a decent pension when they retire. Since you do not expect to have a pension, the traditional 401k may be the better choice for you.

One thing to keep in mind is that a Roth contribution today will be taxed at your marginal tax rate. For you, this is 28% plus 9.55% for California state tax, minus 28%*9.55% if you itemize. Let's call it 35%. If you do not have a pension or other significant sources of income, traditional 401k withdrawals in the future will be taxed at your effective tax rate. This is true even if you are in the same tax bracket as you are today (e.g., if you are withdrawing $67K/yr from your 401k when you retire). Your effective tax rate might be 15-25% depending on the amount you withdraw and the state you live in after you retire. Let's call it 20%. If this is the case, the Roth 401k will cost you an additional 15% in taxes.

Sure, taxes may be higher when you retire, although they are unlikely to be 15% higher. Alternatively, income taxes could be lower if a different tax system is imposed (e.g., national sales tax). No one knows.

Also, if you are in a position to live on taxable investments when you early retire (before RMD's at age 70.5), then you may have close to zero taxable income and your tax rate may be near zero. Traditional 401k to Roth IRA conversions during the period between when you retire and when with begin withdrawals from your 401k could be very advantageous.

As an aside, you may want to read about the "backdoor Roth" strategy. If you are maxing out your 401k and IRA contributions, your employer *may* allow after-tax 401k contributions that can be immediately converted to a Roth IRA (in service withdrawals). If this is the case and you have additional funds that would otherwise go into taxable investments, pursuing this strategy is almost definitely a no-brainer.

 

[pb4uski]

The Roth 401(k) is NOT for you. You will have more money if you use the Traditional 401(k).

In the future when you are in a lower tax bracket and retired, you can convert your 401(k) to a Roth IRA. Many folks around here do exactly that. They didn't pay 28% tax when they contributed to their traditional 401(k) and they paid 0% tax when they converted. So why do the Roth 401(k) and pay tax? That just doesn't make sense to me.

+1 I think you are better to avoid 28% taxes today, let the Traditional 401k grow tax deferred and pay minimal tax in retirement. Worst case, if your tax rate is 28% in retirement then you are even. If you tax rate in retirement is more than 28% then it likely means you have been very successful and won't much care that you lost a bit on taxes by going with the 401k rather than the Roth 401k

 

[gerntz]

If you contribute enough to the regular IRA to knock you down a bracket or two, then I'd contribute the balance to the Roth - assuming you can split the contributions.

I commend you on your early commitment to savings. My guess is that if you keep this up till retirement, you may never be in a lower bracket when you withdrawal. If that's the case, then I'd take the 28% hit upfront & never need to worry about taxes again - unless our government screws you/us later as they are prone to.

 

[Gone4Good]

Do both.

You have at least 35 years before you can even withdraw this money without penalty. In all likelihood, it will be closer to 45 before you start drawing this money down. There is no way to even guess what tax laws will be; how high rates are; whether or not we have a national sales tax; whether Roth conversions are even allowed; . . . . Any calculation regarding which choice is better based on today's tax law is completely meaningless.

By putting money on both sides you essentially diversify your tax law exposure. In some cases the traditional 401(k) will have been the right choice in some cases the Roth. No way to know today, so it makes sense to spread a little around.

 

[OrcasIslandBound]

Welcome to the forum Joe!

I too charged off into the world of engineering almost exactly 30 years ago. I have used exclusively the normal 401K for my retirement savings vehicle. I just kind of figured that I would be really lucky if my taxes turned out to be higher after retirement then before retirement. I suspect that is also the case for you. However, engineers tend to have climbing salaries, and I wouldn't be surprised if yours doubled in the next 10 years. Thus, for a while, you might actually gain a slight benefit by putting 25 - 50 % of your intended savings into the Roth 401K. This is a bet that your retirement income will be greater then your present salary. Probably a reasonable bet for someone your age. Also, this "diversifies" your savings a bit.

My initial savings went towards a house the first couple of years in 1981-1982. Bought the house in June of '82, less than one year after starting work as an engineer by assuming a VA mortgage (from a vet, but I didn't have to be a vet). This mortgage was 58% of my gross monthly income of 2K/month at the time. The house was $96K and went up to a peak of $525K and is now worth about $375K.

The point of all this is that a house is the same pain in the neck to buy whether you are 25, 35, 45, 55 or 65 years old, but the benefits are much greater if you buy it earlier.

 

[sinusone]

Thanks for all the great responses everyone, definitely have a lot to think about! If my retirement accounts are healthy before I can touch them without penalty, I was thinking of taking "substantially equal periodic payments", that 72t exception. Remember I would like to retire early and spend my money while I can actually travel, buy a nice car, etc. In that case, I might even take out enough money that will push me (assume tax's never changed) past my salary now if I took a lot of trips or vacations.

Side note: I don't want to leave any money to my children. I will teach them to be responsible and make their own money, at least thats the plan

 

[Gone4Good]

Remember I would like to retire early and spend my money while I can actually travel, buy a nice car, etc. In that case, I might even take out enough money that will push me (assume tax's never changed) past my salary now if I took a lot of trips or vacations.

It's quite possible 28% is the lowest tax bracket you'll ever be in. I strongly suspect that taxes will be heading higher as a matter of necessity. I came across an interesting report that outlines six long-term budget proposals from six different 'think tanks' who's politics run from 'conservative' to 'liberal'. Each were putting forward their vision for getting our Federal budget to a sustainable position over the next two decades. The lowest tax proposal of the group (from the conservative Heritage foundation) had tax receipts unchanged from their long-run average. Everyone else had higher tax assumptions. The highest of the group advocated a 33% increase.

I think that probably reflects the bounds of future tax rates: somewhere between no change and much higher. The chance for lower rates is as close to zero as you can get.

 

[Gone4Good]

I was thinking of taking "substantially equal periodic payments", that 72t exception. Remember I would like to retire early and spend my money while I can actually travel, buy a nice car, etc.

You'll probably end up reconsidering this for two reasons:

1) A good portion of your assets will likely be in taxable accounts. If you plan to retire early, with a high income, the 401(k) contribution limits are going to prevent you from accumulating as much as you'll need in those tax advantaged accounts ($15K per year, growing at a before inflation rate of 5% only grows to $1MM over 30 years). So to retire early the way you say you want to, you'll need substantial savings outside of your 401(k) accounts.

2) You'll want to continue to shelter some of you investment income from taxes for as long as you can. It makes sense to consume your taxable accounts first, and leave your other assets to continue to grow tax free until you really need them.

 

[sinusone]

You'll probably end up reconsidering this for two reasons:

1) A good portion of your assets will likely be in taxable accounts. If you plan to retire early, with a high income, the 401(k) contribution limits are going to prevent you from accumulating as much as you'll need in those tax advantaged accounts ($15K per year, growing at a before inflation rate of 5% only grows to $1MM over 30 years). So to retire early the way you say you want to, you'll need substantial savings outside of your 401(k) accounts.

Since I'm looking to retire early, am I contributing too much to these tax sheltered investments? What will I do with a $1 million at 65? I currently have $0 in taxable. I was under the impression I would start taxable once my income starts to increase...

Is it a better idea to lessen my 401k, contributions and put it towards taxable accounts, given my goals?

 

[Webzter]

Since I'm looking to retire early, am I contributing too much to these tax sheltered investments? What will I do with a $1 million at 65? I currently have $0 in taxable. I was under the impression I would start taxable once my income starts to increase...

Is it a better idea to lessen my 401k, contributions and put it towards taxable accounts, given my goals?

As a function of your income, you'll likely have extra funds to contribute to taxable in the years ahead. Or, in other words, you probably won't be retiring significantly earlier if you max out the 401(k) and then call it good. You know that, though. (of course, your goals and needs and retirement may obviate a taxable account also.. ymmv)

As you start to do both, you'll end up at a point where you might have enough in taxable that you'll use that to bridge the gap from retirement to 65 (or 59.5). You might also end up deciding to semi-retire and work part-time as a consultant down the road.

Personally, I'd load up the trad 401(k) and bury myself as far down the progressive tax scale as possible (it's what I've done in the past). But I'm betting on my nominal bracket when I retire to not be significantly worse than my bracket now (and, if the low scale stays where it is, I'll be a bracket or two lower than now).

 

[ronocnikral]

of course, the roth 401k has only been available for 5 or 6 years, so someone 30 years ago will not have had this option until recently, if at all.

i personally use the roth 401k, I am 28. I will eventually shift to trad and there are certain triggers which will send me there (tax increases, moving into new tax bracket, % of assets in roth funds etc). I think it will be nice to have a roth bucket available to me prior to retirement. (editrior to reaching retirement age)

whatever you do, ensure you save the same amount as you would with contributing to a roth. in other words, if you invest in a trad 401k, save the difference. if you lack the discipline to do this (e.g. don't buy a new TV or think you can day trade with the difference), you are money ahead with the roth.

 

[jeffmete]

maybe I don't understand, but it seems like if your young and you put $10K into a Roth, your only taxed on 10K, even though you may draw out 30K after 30 years of compounding. But in a traditional 401, you don't pay taxes on the 10K, but you pay it on the 30K when you withdraw it. Seems like for a young person the Roth is the way to go.

 

[Gone4Good]

Since I'm looking to retire early, am I contributing too much to these tax sheltered investments? What will I do with a $1 million at 65? I currently have $0 in taxable. I was under the impression I would start taxable once my income starts to increase...

Is it a better idea to lessen my 401k, contributions and put it towards taxable accounts, given my goals?

What I was trying to say is that anyone who hopes to retire early without a pension has to save more (possibly far more) than what is allowed in these tax advantaged accounts. The comment about only having $1MM in a 401(k) after contributing the max for 30 years was supposed to illustrate that fact.

So yes, contribute all you can to the tax advantaged accounts. But plan on building additional substantial savings outside of those accounts if you really want to retire early.

 

[Webzter]

maybe I don't understand, but it seems like if your young and you put $10K into a Roth, your only taxed on 10K, even though you may draw out 30K after 30 years of compounding. But in a traditional 401, you don't pay taxes on the 10K, but you pay it on the 30K when you withdraw it. Seems like for a young person the Roth is the way to go.

As with everything, it depends.

People on this board tend, on average, to spend less than they make and save more than the median.

(For the sake of this example, assume all numbers extrapolate out in inflation-adjusted dollars).... So, suppose you make $70k a year but you live on $30k a year. When you retire, you might still plan to live on that $30k a year (or maybe less!). That puts you in a fairly low tax bracket. So, you're only paying taxes on the $30k a year that you pull out of that 401k.

Assuming the lowest tax bracket when you retire is still pretty low, you might end up paying very little to no taxes on the money you're living off of.

Additionally, that 401k contribution is pre-tax. That means that, dollar for dollar, you're always capable of contributing more pre-tax than post-tax. This can especially have nice ramifications if it keeps you out of the next progressive tax bracket.

Bottom line (imo), if you expect that you're currently at the lowest tax point you'll be, then a Roth probably makes the most sense. If you expect to be at a lower tax bracket when you retire, then a trad 401k probably makes the most sense.

That said, one should run the numbers (tax time just happened so see what your tax burden would be if you contributed to a trad 401k) and see what works best for them.

 

[Shawn]

maybe I don't understand, but it seems like if your young and you put $10K into a Roth, your only taxed on 10K, even though you may draw out 30K after 30 years of compounding. But in a traditional 401, you don't pay taxes on the 10K, but you pay it on the 30K when you withdraw it. Seems like for a young person the Roth is the way to go.

Let's say your tax rate is 25% (now and in the future) and you have $10K to invest. Let's assume that you will keep these funds invested for 30 years and your rate of return will be 8%.

With a Roth 401k, you will need to pay $2.5K upfront in taxes so you can really invest only $7.5K. After 30 years, this $7.5K will grow to $75.5K. Specifically, the equation is ($10K*(1. - 0.25))*(1. + 0.08)^30.

With a traditional 401k, you will not pay any upfront taxes so you can invest the full $10K. After 30 years, this $10K will grow to $100.6K before taxes, and $75.5K after taxes. Specifically, the equation is ($10K*(1. + 0.08)^30)*(1. - 0.25).

The returns will be identical if all parameters are the same.

Of course, the parameters are not likely to be the same so one choice likely will be better than the other. The key parameters are your marginal tax rate today (for the Roth) and your effective tax rate on the 401k withdrawals in the future (for the traditional plan) [for most people, the advantage here goes with the traditional 401k]. Another thing to keep in mind is that you can essentially invest more in the Roth 401k than you can in a traditional 401k if you max out your contributions (e.g., $16.5K/yr) [advantage Roth]. Also, if you roll the Roth funds into a Roth IRA, they will not be subject to RMD's at 70.5 [advantage Roth].

There are a lot of subtleties, but if everything is identical then the after-tax returns from a Roth 401k will be the same as the after-tax returns from a traditional 401k.

 

[jeffmete]

Shawn, Thanks for the explanation. I was missing the point that you would put less into a Roth due to the original tax liability!

 

[Gone4Good]

Shawn, Thanks for the explanation. I was missing the point that you would put less into a Roth due to the original tax liability!

There's no rule that says you have to though. As long as you have the cash, you can pay the tax liability and still max out the account.

 

[ronocnikral]

what has been unclear to me is if instead of Shawn's example, one has enough to max out the roth 401k and roth ira.

e.g. assume the same 25% tax rate and roth 401k and ira contributions of $21,500 ($16,500 for 401k and $5000 for ira). @ the 25% tax rate, one would have to earn $28,666.67 (21,500/(1-0.25)) for a difference of $7166.67 (all of which could be invested after tax if one elected trad 401k and trad IRA. So, take the 25% taxes out of the difference, that leaves the "traditional" investor $5375 to put into taxable accounts (or day trade).

so, if you're all in on the roth accounts, you invest $21,500 @ 8% annual growth for 30 years and you have $216,347.12.

If you're trad you invest $21,500 @ 8% for 30 years less 25% tax and you'll have $162,260.34. Plus, your taxable accounts of $5375 @ the same return for 30 years gives $54,086.78. Less the 15% capital gains (let's assume no dividend tax payments along the way) leaves one with $45,973.76. So, a total of $208,234.11

so, if my math is correct, which it may not be, if you have to invest the difference in taxable accounts, there are some advantages to a roth if you will be in the same tax bracket when you retire (which is all the debate). Of course, the value of such things as going the trad route and having slightly less than 25% of your portfolio liquid for a relatively small difference is not accounted for.

 

[Gone4Good]

so, if my math is correct, which it may not be, if you have to invest the difference in taxable accounts, there are some advantages to a roth if you will be in the same tax bracket when you retire (which is all the debate).

Correct.

 

[LOL!]

Long-term capital gains are taxed at 0% for folks in a low enough tax bracket, so you may wish to put that in your planning.

 

[ronocnikral]

true, at least for 2011 and 2012 for those in 15% tax bracket and below, LT capital gains is 0%. can also be a benefit for those with roth funds and taxable accounts who plan to retire on higher incomes....