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ROTH 401k vs 401k
Old 02-04-2013, 09:04 PM   #1
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ROTH 401k vs 401k

Thought this discussion may be worth its own thread. What is the consensus on ROTH401k vs 401k. I understand there are a lot of variables, but the most common analysis is current tax rate vs anticipated future tax rate at time of retirement. If you anticipate a higher tax rate at retirement then use ROTH - if you anticipate lower tax rate at retirement then use tax deferred 401k. It seems that there are several assumptions baked into this analysis that may not always be accurate. Most importantly, most analysis assumes a fixed amount available to contribute. That is, if you contribute to a ROTH401k you will reduce the amount of the contribution by the amount of the tax that must be paid on the dollars. This might be true for some but others will choose to pay the tax and keep their contribution amount the same. This increases the contribution and takes the present vs future tax rate issue out of the equation.

My situation

Age - 36
Income - 145,000
401k Contribution - 17,000
Employer Contribution - 23,000
Retirement Age - 59.5

Seems to me that contributing my max to the ROTH401k may be a good move - although it will cost me more out of pocket today in taxes. This is contrary to what most analysis would conclude since my tax rate will likely be lower in retirement.

Perhaps I am stating the obvious but I have asked advisors in the past and they always focus on anticipated tax rates which I think may miss the point for many investors. Or maybe I have been missing the obvious point all along...
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Old 02-04-2013, 09:08 PM   #2
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Quote:
Originally Posted by mark3rs View Post
Thought this discussion may be worth its own thread. What is the consensus on ROTH401k vs 401k. I understand there are a lot of variables, but the most common analysis is current tax rate vs anticipated future tax rate at time of retirement. If you anticipate a higher tax rate at retirement then use ROTH - if you anticipate lower tax rate at retirement then use tax deferred 401k. It seems that there are several assumptions baked into this analysis that may not always be accurate. Most importantly, most analysis assumes a fixed amount available to contribute. That is, if you contribute to a ROTH401k you will reduce the amount of the contribution by the amount of the tax that must be paid on the dollars. This might be true for some but others will choose to pay the tax and keep their contribution amount the same. This increases the contribution and takes the present vs future tax rate issue out of the equation.

My situation

Age - 36
Income - 145,000
401k Contribution - 17,000
Employer Contribution - 23,000
Retirement Age - 59.5

Seems to me that contributing my max to the ROTH401k may be a good move - although it will cost me more out of pocket today in taxes. This is contrary to what most analysis would conclude since my tax rate will likely be lower in retirement.

Perhaps I am stating the obvious but I have asked advisors in the past and they always focus on anticipated tax rates which I think may miss the point for many investors. Or maybe I have been missing the obvious point all along...

I fully fund the Roth 401K (but then again, I am not a huge money earner yet..). Although people always talk about tax rates now vs the future, I get a lot of peace with the Roth, knowing my tax liability is final.
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Old 02-04-2013, 09:11 PM   #3
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Do the math: if your tax rate is the same now as when you withdraw, the after-tax value of a t401k and r401k are identical.

Some might mistakenly try to use an r401k to avoid RMDs, but unlike rIRAs, an r401k has RMDs just like a t401k.
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Old 02-04-2013, 09:23 PM   #4
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Your employer contribution is 23,000 WOW.

My contribution last year was 17,000 and I think employer contribution was 2,500(50% on the first 6%).

We have an After-Tax 401K and I max out on that too at 10% since I can take the contribution money out anytime I want.
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Old 02-04-2013, 09:25 PM   #5
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GrayHare - are they really the same under my modified assumption (that I will pay taxes in addition to my contribution)?

If I put 17k in a t401k and 17k in a r401k the balances may be the same at retirement but r401k is tax free dollars so it actually has more value than t401k dollars that I will actually receive $0.80 on the dollar (or less).

Your analysis is the same analysis I always hear but I think it is making some big assumptions.
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Old 02-04-2013, 09:32 PM   #6
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Well, I figured it to be understood we're talking about total net worth of your retirement plus non-retirement accounts. Specifically, since you pay tax (from non-retirement accounts) on an r401k now, you are left with less to invest and grow in those accounts. The end result is your total after-tax net worth is identical either way.
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Old 02-04-2013, 09:40 PM   #7
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Fidelity had a nice calculator that did this comparison. The Roth account has the after tax value advantage, so if tax rates are equal in and out the Roth is preferred. However, I don't think that was enough to give it the advantage if retirement taxes are a bracket lower. Also keep in mind that taxes into the Roth while you are working are essentially at your highest marginal rate. Some of your t401k withdrawal comes through the 10% and 15% tax brackets in retirement, in the absence of other income. So the average tax rate out may be significantly smaller than the nominal tax bracket you're in.
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Old 02-04-2013, 09:45 PM   #8
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The tax calculations are not quite as simple as described. Your contributions are tax deductible at your current marginal rate. For many people this is your peak earning years, so it is also your highest likely rate.

On distribution, the tax depends on what other income you have. If you are mostly counting on retirement accounts, then you fill up all the lower brackets before you reach the higher marginal rates. If your marginal rate is the same in retirement as in your contributing years, you still get withdrawals at the lower brackets before you reach the same marginal rate.

It is complicated because it also depends on what other income sources you have.
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Old 02-04-2013, 09:52 PM   #9
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A Roth 401(k) is great for folks in high tax brackets who will work until age 70.5 and have large pensions. So I doubt anybody on this forum qualifies for that. If these folks retire, they will definitiely be in high tax brackets because their pensions and social security benefits will fill up all the lower tax brackets.

The Traditional 401(k) is great for folks who will retire early or don't have pensions. These folks will be in lower tax brackets or at least have much of their 401(k)/IRA withdrawals consumed by the 0% tax bracket. Futhermore, they will be able to do conversions of the 401(k)/IRA money to a Roth IRA while in a low tax bracket.

So I don't know if the online calculators take all of this into account, but it is not just your tax bracket today and your tax bracket in retirement because in retirement you get some money at 0%, some cap gains at 0%, qualified dividends at another rate, long-term cap gains at another rate, some low tax brackets, until you get to your marginal income tax bracket.

That means with traditional 401(k) you save money at your marginal rate while in retirement you may get it tax-free, at your effective-rate (lower than marginal), etc.

Take a look at this: Wiki article link: Traditional versus Roth including the external links therein.

And to add to the woes, one's marginal income tax rate is often not the real rate. For example, we are in the 25% marginal income tax bracket based on taxable income, but in reality our real marginal rate is 38% due to loss of tax credits. If we have $1,000 more in taxable income, we pay $380 more in federal income tax. For us, the traditional 401(k) is a no-brainer.
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Old 02-04-2013, 09:53 PM   #10
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Originally Posted by GrayHare View Post
Do the math: if your tax rate is the same now as when you withdraw, the after-tax value of a t401k and r401k are identical.

Some might mistakenly try to use an r401k to avoid RMDs, but unlike rIRAs, an r401k has RMDs just like a t401k.
But if Roth 401k distributions are tax-free (like a Roth IRA), why do RMDs matter other than it cuts short tax-free compounding?
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Old 02-04-2013, 09:53 PM   #11
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Since the tax matter is very complex, like many people I split between traditional and Roth so as to provide more withdrawal options, ones that can be adjusted to some extent based on tax laws in effect at the time of withdrawal.
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Old 02-04-2013, 09:54 PM   #12
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GrayHare - your assumption is the very assumption that I think many people miss. My modification of that assumption is that I currently spend the money I would pay in tax as result of the r401k on eating out and other non-essentials. By contributing to the r401k I take otherwise disposable income and use it to pay the taxes. If instead I saved the money I spend eating out or if I reduced my r401k contribution by the amount of the taxes I think your analysis is correct.

I agree that marginal tax rates and the progressive nature of our IRC make the analysis more complex - but I wonder if it still isn't more beneficial to pay the tax now and effectively increase the amount of tax free dollars at retirement.
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Old 02-04-2013, 09:57 PM   #13
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But if Roth 401k distributions are tax-free (like a Roth IRA), why do RMDs matter other than it cuts short tax-free compounding?
For estate planning, RMDs reduce the value of the "stretch" that guys like Ed Slott frequently talk about.
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Old 02-04-2013, 10:53 PM   #14
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When I was younger, most years we were in the 15% bracket and everyone said our tax rate would be lower in retirement. So we maxed out the deferred accounts. We have been in the 25% bracket for quite awhile since then. I retired in 2009. DW is retiring this year. We both have pensions. We will have just a couple years that we can squeak in under the top of the 15% bracket. After that SS will put us back in the 25% bracket. RMDs will later push us into the 28% bracket. AMT could even be an issue. We should have put a little less into the deferred accounts and more into the Roths. Everyone's situation is different but assuming you will be in a lower tax bracket in retirement may be wrong. One other thing to consider is that If retiring before age 59.5 you may have problems getting money out of the deferred plans. I know this can be gotten around with 72t withdrawals but they do require some thought and could take away a bit of flexibility in the overall plan. My advice would be to put money into both deferred and Roth accounts. How much in which one is the really tough question.
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Old 02-05-2013, 12:22 AM   #15
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I used to max out my Roth 401k. Not having it as an option anymore makes the decision easier. But, as I touched the 28% tax bracket last year, I would definitely dial that back if the decision was in front of me, especially with hind sight.

I've done the math here showing an advantage to roth vs trad if maxing out. In 20's 401k vs roth 401k

Finally, one may wish to consider a little "diversity." In other words, some combination is probably healthy considering the uncertainty ahead.
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Old 02-05-2013, 06:38 AM   #16
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Something to consider also is the state taxation - Illinois doesn't tax income from retirement accounts, so 401k=>withdrawal doesn't pay ANY Illinois income tax, but R401k pays on the front end. 5% difference.
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Old 02-05-2013, 08:44 AM   #17
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Something to consider also is the state taxation - Illinois doesn't tax income from retirement accounts, so 401k=>withdrawal doesn't pay ANY Illinois income tax, but R401k pays on the front end. 5% difference.
It might be better to say 'Illinois doesn't tax income from retirement accounts... YET'.

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Old 02-05-2013, 09:08 AM   #18
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My employer is just now offering a Roth 403b. My understanding is that aftering retiring, I can convert it to a Roth IRA and avoid the RMDs on it. I think it is important to look at several other issues related to the tax deferred vs tax exempt issue. Although many people assume that their tax rate will be lower in retirement, you have to consider the entire expected retirement period.

If you are married, you have to consider what the tax situation will be like for your spouse after you are gone. In our case, we are planning that I may be a widow for 30 years after my DH passes. If we have large RMDs, I will not only be paying taxes on the RMDs, but will also be forced to pay taxes on 85% of my SS as well. In addition, take a good hard look at the tax rates for singles vs married filing joint. During the beginning of retirement when my DH is with me, we can file as married, joint, with lots of exemptions and no RMDs yet. After he passes, I will be at the much higher single status with no dependents left. If I pay the taxes now, it is at 25%. If I pay later, I could be at 28% or higher and also have to pay on SS.

I have come to the conclusion that I need to have more flexibility to draw from the different buckets to keep taxes down. Ideally, we would like to minimize my DHs tax deferred accounts and plan on converting some of his tax deferred to Roths after retirement but before he starts to collect SS. We call it our "golden window". We will be in a unique tax situation: filing married joint, with house mortgage, dependents, college expenses, and no SS or RMDs yet.


I am also in IL and am not counting on them to not tax retirement income in the future. But I agree that it is a consideration.
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Old 02-05-2013, 10:28 AM   #19
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I like that the tax free dollar is worth more than a tax deferred dollar, so I view the Roth 401(k) as a way to make larger tax preferred contributions. Since the match is always pre-tax I still get tax diversity in the event I want to do selected conversions down the line. My employer only offered Roth in 2010, so I also have a sizeable pre-tax balance from prior savings.

But I am an admitted roth zealot, so know my biases. My current composition after some IRA conversions is about 52% Roth, 48% Traditional, with the Roth side growing a bit faster based on contributions.
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Old 02-05-2013, 10:36 AM   #20
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I think Roth 401k's can be great for early retirement. If you are going to retire before 55 look at it like this. When you retire you can roll the 401k money into iras. The money the company matches in your 401k is always tax deferered so that money can go into a traditional IRA. The roth money you contributed is after tax and can be rolled into a roth ira. You can access 100% of the roth contribution money tax and penalty free right away. Then after 59 1/2 you can access the roth earnings tax and penalty free. Finally you can tap the traditional money after 59 1/2 just paying taxes on that. For me this allows me to invest money after tax. It will earn intrest tax free and I have pre tax money invested for me from the match. This gives me 3 different kinds of retirement funds in one account.
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