Roth 401k vs Traditional

[HnE]

My employer will offer roth 401k in 2006.   Is the roth or traditional plan a better deal.  Present tax bracket is estimated at 33 per cent with at least 20 years before any distributions taken.  Thanks.

 

[LOL!]

If you're at 33% marginal (I hope that is Federal, State, Local, FICA, etc) I cannot imagine one being in that bracket when retired. That's because you will probably be using capital gains for income and not wages. Furthermore, reducing your income now has other advantages such as keeping you away from the AMT and allowing other possible deductions.

I'd go with the traditional 401(k) and not the Roth.

The Roth 401k appears to me to be a gimmick with very few people actually benefitting from it.

 

[New Thinking]

I would go with the Roth..Most people do a comparison assuming the same tax rate applies both when working and in retirement. The value of the Roth is that it does not cause the taxation of Social Security benefits. Even if rates don't go up in the future, many individuals are going to pay a marginal rate of 50% or more just at a federal level on their IRA withdrawals (401k assets rolled to IRA) because they are causing the taxation of SS.

Go with the Roth now and lock in..My guess is that rates must go up to pay for Medicare, SS, and Medicaid as boomers retire. Its too difficult politically to cut the benefits and raising taxes may be the only option.

 

[maddythebeagle]

I would vote on the traditional since your tax bracket is so high now.

 

[Cut-Throat]

Isn't the Roth's gains totally exempt from Federal Taxes while the traditional All gains are taxed when withdrawn.
Another reason to consider the Roth.


It's a tough call, and the Tax advantage now is a bird in the hand.

 

[HnE]

Thanks for all the input.   I feel like there are too many unknowns to make a good decision.  I am still trying to work through it.  I think the Roth will not require minimum distributions?? which may be a plus.  The present deduction for the traditional is truly a "bird in the hand."

 

[Martha]

The further you are from retirement, the more likely I would lean towards the ROTH option, even with the high tax bracket. But then again, the bird in the hand. . .

 

[wabmester]

Just a few minor points nobody has mentioned:

1) If your employer offers a match on the 401(k), then go with the 401(k).   No brainer.

2) If you want to save more than $4000/year, go with the 401(k).

3) If you're in the 33% tax bracket, I think that means you're not elligible for a Roth.   Go with the 401(k). 

 

[Martha]

Just a few minor points nobody has mentioned:

1) If your employer offers a match on the 401(k), then go with the 401(k). No brainer.

2) If you want to save more than $4000/year, go with the 401(k).

3) If you're in the 33% tax bracket, I think that means you're not elligible for a Roth. Go with the 401(k).

I think he was talking about a Roth 401k, which does not have the eligibilty limits and contribution limits of a Roth IRA.

 

[wabmester]

I think he was talking about a Roth 401k, which does not have the eligibilty limits and contribution limits of a Roth IRA.

Oh. Nevermind. 

 

[Gone4Good]

I feel like there are too many unknowns to make a good decision. 

No need to decide - you can do both.  I view the primary difference between the Roth and the traditional 401(k) as an arbitrage between current and future tax rates.  Because we don't know what the future rates will be, there is no harm in hedging your bets.  Either way things go, some of your money will have made the right choice.  

 

[LOL!]

I'm surprised that there is any discussion of this at all when the money that Aronnax would put into the Roth 401k would be taxed at 33% at the outset. I think that is just too high a tax rate to overcome.

Let's say you wish to put in $15,000 in 2006 into the Roth 401k. That means you need to have $22,500 to start with, pay an additional $7425 in income tax. Sure you have the money lying around because after all you are in the 33% marginal tax bracket. But it's still a big chunk of change. I don't know how the Roth401k works for sure, but if you are paying the tax ahead of time does that mean your AGI goes up by $22,500? That increase in AGI could affect other deductions and have AMT considerations.

But if you put $15,000 in 2006 into a traditional 401(k), your AGI doesn't even show that $15K ... in effect your AGI will be $37,500 lower than with the Roth401k. That's gotta save some bucks there. Then later in retirement, when you start withdrawing from your 401(k) or its IRA antecedent, don't forget that you will definitely have that money in a lower tax bracket. After all, the first $16,000 or so of your money is tax-free (source Scott Burns web site).

You could write that tax rates are the same or tax rates will be higher. That just doesn't matter because you will not have as high an AGI in retirement. Why? Because you won't need to withdraw so much from your retirement plans to pay for social security taxes, to pay for contributions to the 401(k), to pay for other after-tax savings, to pay your mortgage which probably won't exist then, etc. Furthermore your withdrawals from the after-tax portion of your retirement savings may just be taxed at the long term capital gains tax rate and that's most likely gonna be lower than 33%.

So as long as your are not taxed at 33% in retirement, you come out way ahead. The taxes on Social Security could amount to quite a bit (source Scott Burns), but I imagine you are going to have to pay those anyways unless your retirement life-style ratchets you way down in the income column.

In short, it's pretty much a no-brainer for folks in the 33% marginal income tax bracket to NOT use a Roth 401(k), but to use a traditional 401(k) instead.

 

[Martha]

I understand what you are saying LOL, but the upside to the Roth 401k is that withdrawls will be entirely tax free, so if you are younger, you have a lot of years for that money to grow, and then never have to pay taxes on the withdrawls.

If it were me, who pays AMT and is close to retirement, I would put it all in the traditional 401k. But if I were 20 years from retirement I would give serious thought to putting at least some of the money in the Roth 401k.

 

[LOL!]

Although you would never pay tax on the withdrawals, you still pay tax. Also it seems to me that a -18% tax rate (15% - 33%) is better than 33% - 0% tax rate.

My MIL hated paying taxes in retirement even though her tax rate was virtually 0%. She had tax-free municipal bonds even though her tax bracket was so low, that she would have come out ahead after paying the taxes on the corporate bond dividends. She made an emotional decision, not a rational one.

 

[maddythebeagle]

I think also, that you can NOT mix and match on the 401k. You have to either pick one or the other (roth or traditional).

Also, you mentioned Scott Burns. I heard him recently say that he likes Roth's because he sees some folks saving TOO much and taking out deferred money at higher rates. I suspect that isnt as big a problem for FIRE types, though... and more for slaves with high savings rates working late in life...for whatever reason....

 

[Martha]

I think also, that you can NOT mix and match on the 401k. You have to either pick one or the other (roth or traditional).

Also, you mentioned Scott Burns. I heard him recently say that he likes Roth's because he sees some folks saving TOO much and taking out deferred money at higher rates. I suspect that isnt as big a problem for FIRE types, though... and more for slaves with high savings rates working late in life...for whatever reason....

Your 401(k) plan at work can allow both regular contributions and Roth contributions. They just have to be accounted for separately. http://www.roth401k.com/proposedregs.htm

From the IRS:" Under section 402A, beginning in 2006, a plan may permit an employee who makes elective contributions under a qualified cash or deferred arrangement to designate some or all of those contributions as Roth contributions."

 

[maddythebeagle]

You are right martha. The plan has to allow it though and I think that is what I confused from my reading about these.

 

[HnE]

Thanks again for all the help.   The following article is somewhat helpful. 
https://institutional2.vanguard.com/iip/pdf/CRR_Roth_401k.pdf  I found a calculator to compare the two options at the following site, http://www.lkravitz.com/roth/ .  The link worked earlier but now it seems password protected.  Thanks!

 

[LOL!]

Aronnax, thanks very much for the link to the Vanguard analysis.  It's telling on page 30 that they think (if I read it right) that contributing to a Roth401(k) even if taxed at 38% is better than contributing to a regular 401(k) pre-tax and withdrawing at a 33% rate in retirement.

We are big-time LBYM'ers, so we expect to be able to live on about 50% of our pre-retirement income.  That means that with withdrawals from after-tax plans first and paying cap gains taxes at first, that we should be in a much lower tax bracket than we are now. 

It was not clear to me if the Vanguard analysis covered our situation at all. For example, our AGI is in the 33% range, but we have qualified dividends and cap gains that put us up there. The reality is that the qualified dividends and cap gains are taxed at 15% leaving our highest marginal bracket is 28%. Our overall tax rate is about 16%.

Anyone else digest the Vanguard analysis?
I'll have to keep my eye on this.

 

[Gone4Good]

Anyone else digest the Vanguard analysis?

I scanned it and it deserves a closer look, but don't get too crazy with the analysis. The Vanguard analysis takes into account deduction and exemption phaseouts, current tax brackets, etc. The only thing we know for certain is that all these tax rules are going to change - possibly multiple times. The further one is away from retirement, the more dramatic the changes will probably be.

For someone 10 or more years away from 401(k) or Roth withdrawals, I would suggest keeping it really simple. If you are in one of the top tax brackets now, go with the 401(k). If you are in one of the lowest brackets now, go with the Roth. If you are in the middle, try to do both.

 

[bamsphd]

I see two advantages to the Roth 401k that I have not seen mentioned above.

1) You can effectively contribute more money to the Roth 401k than
     to a traditional 401k.  Though this only matters if you have hit
     the federal limit on your annual contributions.
     If you do hit the limit, then your Roth contribution is effectively
     larger by whatever marginal tax rate exists when the money
     is eventually withdrawn.

2) If you plan to leave any money to relatives, you are better off
     leaving money in a Roth account than in a "traditional" account.
     That stretches out the tax free compounding to the max.