Roth Question

[ATC KH]

Was looking for some feedback and/or advice on Roth vs traditional investing for retirement. As it stands now, I am 100% Roth and max out both the 401k at 16500 and IRA at 5000. There seems to be good arguments for both sides; however, to truly determine which one is the better choice you would need information which is not obtainable. Namely, you would need to know what your portfolio would be worth during retirement and what the tax code would be. This might be somewhat predictable, although not certain, for someone very close to retirement, but for someone at 27 (my age) largely an unknown. Despite the fact that I am single and in the 25% federal tax bracket and the 5.75% state bracket, I still feel that choosing the Roth option is the best choice. Here are my best reasons:

1.) While it would be nice to pay less tax now, I don't feel that paying taxes on my contributions hinders my quality of life. Who knows what retirement may hold? This is more of an emotional reason.

2.) The Roth 401k can be rolled over to a Roth IRA thereby not requiring RMDs. Mandatory distributions during a period of steep portfolio decline could have a profound effect on how long the portfolio could last. In effect, RMDs could force you to sell low. Here is my example and anyone correct me if I am wrong.

Kevin is 72 and the IRS determines his RMD from his portfolio worth on December 31, 2053. This RMD is significantly higher than Kevin determines he needs to withdraw in order to meet yearly living expenses. The market declines drastically leaving Kevin with a 20% loss in his well allocated portfolio. The RMD, calculated from portfolio worth 20% higher, forces Kevin to sell at a loss and to further add insult to injury he must pay taxes on the distributions. Even if Kevin takes the bulk of the RMD and reinvests it, he still has less capital to invest at the lower prices and that capital will no longer grow tax deferred. Avoiding the RMD seems to be a significant advantage for the Roth IRA.

3.) I have nine years total service between the active duty Air Force and the Air National Guard. I plan to stay in for at least twenty years so I will have a small pension beginning at 60 (actually slightly before that due to rule changes affecting how deployments get factored in). More than likely within the next couple of years I will probably seek employment with the FAA which will also add another pension although in my early fifties due to the air traffic controller retirement system. Being conservative, I would estimate the combined worth of these pensions in today's dollars would be around $50,000/yr and they are both COLAd. The pensions are taxed. If, and likely when, I go into the FAA I hope the Roth TSP. I do have some money in the TSP from the my active duty days as well as plan to contribute a little more on each deployment so as to put away more money for retirement than the combined $21,500 a year I do now.


I do have a couple of question though, particularly for those knowledgeable with tax rules and regulations.

Even if the tax structure remains the same and you withdraw the same amount in retirement per year as you earned working per year, you will pay less tax in retirement due to the effective tax rate being lower in retirement. How come the amount of taxes paid on an equal amount of income would not be the same in both retirement and during working years? Just to reemphasize, we are assuming the tax structure remains exact the same pre and post retirement. If this is true, it certainly is one of the strongest arguments for traditional over Roth in terms of tax efficiency. I still would feel that Roth is a better choice for me due mostly to anticipated pensions.

In terms of state income taxes, are you taxed again on Roth withdrawals? My understanding is you are.

Lastly, I suppose you could always split contributions between traditional and Roth. Anyone have any arguments in favor of making contributions to traditional rather than Roth that I'm missing.

Note: I'm also going to post this on the bogleheads site to maximize responses. Thanks in advance to all who reply.

 

[lemming]

Just want to say I think you are really lucky your company adopted the Roth 401(k). I would for sure want any employer contribution match & discretionary put into the Roth..

THat free of tax forever component is really sweet.

Still if you have enough to fully fund the retirement plan could you put part in the traditional plan. Your tax bracket is high enough that the tax savings now would be noticeable and there will be transition years before age 70 where you can be in a lower then normal tax bracket when you withdraw the traditional funds.

 

[ATC KH]

Unfortunately, the employer contributions grow tax deferred rather than tax free. It would sure be nice though if the employer contributions were neither taxed on the front end or back end. I agree that tax savings would be noticeable if I were to contribute to traditional retirement vehicles, but I don't feel hindered by the tax now. Of major concern is the RMD and how that could effect me during retirement. I could easily see the RMD becoming increasingly greater than how much I would need to live on year to year. I would rather not be forced to withdraw money from its tax shelter if I didn't need it. Despite the arguments for either traditional or Roth, I still feel the most important thing is just saving for retirement in a properly allocated portfolio. I just see the Roth as having the greater potential in my situation.

 

[LOL!]

If your tax rate in retirement is less than during contribution years, then traditional IRA is better. Your tax rate in retirement could be much less if
(a) You retire early
(b) You have no pension,
(c) You delay SS benefits,
(d) You have substantial taxable investments, or
(e) You move to an income-tax-free state.

This allows you to convert from traditional IRA/401(k) to Roth while paying expenses out of taxable at a low tax rate.

I think you wrote that you would have a pension and you don't have much taxable investments. However, you could retire before you start your pension and it's too early to know how your taxable investing will play out.

Based on what you posted, I don't think one can make a strong case for either the Roth 401(k) or the traditional 401(k), so you really can't go wrong.

 

[ATC KH]

True, with such a long time frame there are too many "ifs" that would need to be accounted. Of course, the two variables which would help me out greatest, knowing future taxes and the worth of a future portfolio, are impossible to know a few decades in advance. I suppose it is my assumptions which lead me to the conclusion that a Roth is the better choice in my position. For example, counting on a pension that will likely cover a significant portion of my yearly expenses and healthcare is large one assumption. This leads me to the conclusion that I would typically need to withdraw little from my portfolio to meet living needs. Therefore, I should hopefully have a sizeable portfolio which RMDs would then have a huge negative affect on future growth, as I would likely be forced to withdraw increasingly larger amounts than I otherwise would need. Converting from traditional to Roth in retirement may still prove tax inefficient given the potential portfolio size. Obviously a lot of assumptions and really the only truly poor decision would be to not save for retirement.

 

[seabourne]

I would suggest investing at least some into the trad 401(k) to allow you to manage your tax burden in future years. You can withdraw and pay taxes up to a breakpoint (say everything you can draw at 15% tax or less) and fund the rest from Roth accounts. This will allow you to minimize the overall tax burden. In some ways it is similar to divirsification in investments, but it allows you to better manage taxes in the future and to be more flexible in light of unpredictable future tax laws.