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Roth 401k in 25% bracket?
Old 12-20-2011, 05:51 PM   #1
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Roth 401k in 25% bracket?

It appears I will be in the 25% federal income tax bracket next year. The vast majority of my retirement type savings are in traditional IRAs/401ks. Is it worth starting to divert some of the money into a Roth 401k? I have always taken the approach taht I would rather have the tax deduction up front, but I am starting to wonder if I should diversify.
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Old 12-20-2011, 06:27 PM   #2
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I hedge my bets and invest in a 403b, Roth IRA, and Traditional IRA. 403b is maxed every year, then I alternate yearly between either filling the Roth or Trad. IRA.
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Old 12-20-2011, 06:31 PM   #3
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I doubt that a Roth 401(k) makes sense even in the 25% tax bracket. You should already have Roth IRAs which is probably enough.

The whole thing about Roth 401(k) versus traditional 401(k) is what will your taxes be like in retirement? You would pay your marginal rate now on Roth 401(k) contributions or 25%, but in retirement you will very likely pay less than the full 25% because some of your withdrawals (or conversions to Roth) will be taxed at lower brackets. That is, your effective rate is much much less than your marginal rate.

This will also be true if you intend to retire early. If you do your conversions at a 25% rate, then you will not have hurt yourself by not having the Roth 401(k) where you paid 25% ahead of time. If you do your conversions at a lower rate, then you come out ahead.

Roth 401(k)s seem best for folks in very high brackets who will work at high income until they die.

I am kind of against Roth 401(k)s myself. The folks in the lowest tax brackets cannot afford to contribute much to their 401(k) (trad or Roth), so they don't benefit. What they can contribute for retirement could go into a Roth IRA. Folks who are not working until they die just get confused by Roth 401(k) vs traditional 401(k) and often make an uninformed choice that they wouldn't have to make if there was no Roth 401(k). The uber-wealthy make out like bandits though.
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Old 12-20-2011, 06:46 PM   #4
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Do you think you'll be in 15% bracket in retirement? If so, I would say stick with traditional 401k and dump what you save on taxes ($4125 plus whatever state taxes you avoid) into a tax efficient investment in your taxable account.

My crystal ball says marginal rates for today's 15% bracket won't go above 25% in the future.

One complication on the analysis is the impact of obamacare health insurance tax credits and how they phase out as your income rises. I think that adds another 12% or so to your marginal tax rate (if you plan on using the obamacare health insurance pools). So that makes it about a wash if you are in 15% in retirement plus 10-12% or so in foregone tax credits.

I'm in 15% bracket now and plan on being in 15% FIT bracket or lower in ER, but given the obamacare effective marginal tax rate, I doubt I'll be below 12% even if I owe zero federal income tax. I am personally doing Roth IRAs instead of traditional IRA (for tax diversity to allow income stream crafting) plus traditional 401ks and 457s.
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Old 12-20-2011, 09:15 PM   #5
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If you will RE and have a few years with $0 income and enough in taxable accounts to cover living expenses and extra taxes you may come out better by contributing to the regular 401k and converting later. (Presuming 25% is higher than normal and not a sudden dip.) Might be beneficial to boost the taxable account instead of Roth even. In my case that results in more retirement funds available.

On the other hand, I have done just what you are thinking of, in the past. I think it's a pretty small inefficiency, and may turn out to be a good move if IRA tax rates move up significantly. The Roth does help keep taxes down in retirement, so diversification is nice. The only real question for me was Roth now or Roth conversion a few years later. In my case, later is probably only another year away for me, so maybe the tax uncertainty is not super high.
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Old 12-20-2011, 09:49 PM   #6
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I just ran the calculator at Optimal Retirement Calculator and Retirement Decision Support System to see the effect of all this. Then I doubled checked with Intuit Taxcaster the taxes it suggested I would pay from age 55 to 70 doing all the 401(k) to Roth conversions. Bascially i-orp said I would pay ZERO taxes and this was confirmed by Taxcaster despite annual expenses of 6-figures. Even in later years, ORP said my mariginal tax rate was barely 15%.

Anyways, 0% is a lot lower than 25%, don't you think?
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Old 12-20-2011, 09:54 PM   #7
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I am mostly traditional 401k for the deduction and any savings beyond that in taxable. I figure I will have a few years of low nominal income to convert to Roth with a lower effective tax rate than I have now. But I'm starting to wonder if it may be more complicated than that when figuring in kids' college as well. Parents financial contributions count taxable savings heavily, but not 401k or IRA. If I use only Roth 401k I will pay tax now instead of savings in taxable. That may allow us to qualify for more loans for education, or even grants. Why should the type of account in which I save retirement funds matter for parental contribution calculations? But they do.
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Old 12-20-2011, 10:36 PM   #8
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Quote:
Originally Posted by brewer12345 View Post
It appears I will be in the 25% federal income tax bracket next year. The vast majority of my retirement type savings are in traditional IRAs/401ks. Is it worth starting to divert some of the money into a Roth 401k? I have always taken the approach taht I would rather have the tax deduction up front, but I am starting to wonder if I should diversify.
If you think you'll be in the 25% bracket (or higher) in retirement and you already have a lot in your traditional IRAs/401Ks, I think it might be a good idea to shunt some into a Roth IRA. Nobody knows what the tax code is going to look like in 20-40 years, so having some in each type of account lets you modify your withdrawals to benefit from changes (or at least get burned less severely).
I've got $$ in a T-IRA and in a Roth IRA.
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