Am I missing something easy here?

[bots2019]

Currently I'm trying to determine whether to participate in a Roth 401 or 401k with my wife's employer. From what I understand conventional wisdom is that you should consider whether your future tax rate will be higher or lower than your present tax rate (if they're equal then the two options are equivalent).

However, I ran a few figures and it appears that the Roth option may be preferable (even if the current and future tax rates are equal)... Here's the scenario:

Current federal rate: 33%
Assumed future rate: 33%
Assumed investment return: 8%
timeframe - 20 years
Investment amount for both options = $1,000 (to keep it simple)
Gross required income = $1,493 ($1,493 x .67 = $1,000)

Option 1 - pay tax on $1,493 and invest remaining $1,000 in Roth

Option 2 - contribute $1,000 to 401k, pay tax on remaining $493 and invest after tax amount of $330 in after-tax accounts

After 20 years at 8% return:

Option 1 - Roth balance of $4,661 = tax free

Option 2 - 401k balance of $4,661, pay 33% tax=$3,123, after tax investment of $330 is now worth $1,296, pay gains taxes of 20% on $966 gain => total after tax value of $4,419

So... it appears that if my tax rate remains the same then the Roth may be a better option. I've ignored any dividends in the after-tax account, but those would have a pretty minor impact...

Am I missing something here? This seems to defy conventional wisdom

 

[mickeyd]

My thinking about Roth taxation has always been, since I have no idea what my future tax bracket will be (who does?), I will participate in a Roth IRA rather than a traditional IRA and be happy that I will never have to pay tax on that growth in my Roth. It makes me smile.

 

[mathjak107]

My thinking about Roth taxation has always been, since I have no idea what my future tax bracket will be (who does?), I will participate in a Roth IRA rather than a traditional IRA and be happy that I will never have to pay tax on that growth in my Roth. It makes me smile.

my feeling is since i know my tax status now while working , and i cant ever imagine being in a higher tax bracket when im not getting a pay check compared to getting one now ill take every tax deferred plan i can put money in. if i was trying to out guess future tax rates, which by the way have been dropping steadily for over 20 years ill do my planning based on what is rather than a speculation of what ever may be and go with im paying higher taxes now..

no roth for me at this point

 

[mathjak107]

Currently I'm trying to determine whether to participate in a Roth 401 or 401k with my wife's employer. From what I understand conventional wisdom is that you should consider whether your future tax rate will be higher or lower than your present tax rate (if they're equal then the two options are equivalent).

However, I ran a few figures and it appears that the Roth option may be preferable (even if the current and future tax rates are equal)... Here's the scenario:

Current federal rate: 33%
Assumed future rate: 33%
Assumed investment return: 8%
timeframe - 20 years
Investment amount for both options = $1,000 (to keep it simple)
Gross required income = $1,493 ($1,493 x .67 = $1,000)

Option 1 - pay tax on $1,493 and invest remaining $1,000 in Roth

Option 2 - contribute $1,000 to 401k, pay tax on remaining $493 and invest after tax amount of $330 in after-tax accounts

After 20 years at 8% return:

Option 1 - Roth balance of $4,661 = tax free

Option 2 - 401k balance of $4,661, pay 33% tax=$3,123, after tax investment of $330 is now worth $1,296, pay gains taxes of 20% on $966 gain => total after tax value of $4,419

So... it appears that if my tax rate remains the same then the Roth may be a better option. I've ignored any dividends in the after-tax account, but those would have a pretty minor impact...

Am I missing something here? This seems to defy conventional wisdom

if you invest the after tax money properly in stock funds taxes if you are in the 15% bracket are 5% soon to go to zero and if your higher the taxes are only 15% not 20

 

[Texas Proud]

I am with Mathjac....

I can not see my tax bracket being any higher than it is today.... even if the dems change the tax code etc... I just will not be making anywhere near what I make now....

But, the other thinking is that ROTH is better than regular if all else is the same as you have so much more options in withdrawl (or not to withdrawl as the case may be...)....

So I put all I can in the regular 401 and will do conversions to ROTH over the years if I get a chance...

I also am planning on removing a lot of money in my companies stock with the ? whatever they call it when you do not pay on the gain if you distribute actual shares instead of cash..

 

[mathjak107]

with the ability to pull 35,000 a year from my retirement accounts and pay as little as 1500 bucks why would i want to pay almost 26% to the federal gov and almost 10% to the state and city by giving up my tax defered contributions now. . id have to be nuts

 

[LOL!]

With a 401(k) you save taxes at your marginal income tax rate NOW. Later when you start withdrawing, your first income tax bracket is 0%. So you don't pay taxes now on ALL the money, and you don't pay taxes later on SOME of the money.

Now you couldbe in a low tax bracket now. Then the Roth 401(k) would make sense. But if you haven't noticed 33% is not a low tax bracket.

To be fair, if you have low income in retirement (really low), then your SS benefits are not taxed. But if you have moderate income, then SS is taxed and this can make your marginal rate go above 40%. The trick here is to retire early and delay SS benefits. Use the intervening years while not receiving SS benefits to convert retirement money to a Roth IRA while you are in a low tax bracket.

Maybe you should run a poll to see if you can find somebody who pays more taxes in retirement than while working?

 

[bots2019]

The earlier scenario doesn't completely reflect my situation... I DO plan on being in a lower tax bracket in retirement (especially since I plan on retiring WAY before NRA. However, my question was more theoretical... if my calculations are correct it seems to imply that IF you're in the same tax bracket you might actually be better off using the ROTH. Thanks for the thoughts...

 

[mathjak107]

The earlier scenario doesn't completely reflect my situation... I DO plan on being in a lower tax bracket in retirement (especially since I plan on retiring WAY before NRA. However, my question was more theoretical... if my calculations are correct it seems to imply that IF you're in the same tax bracket you might actually be better off using the ROTH. Thanks for the thoughts...

your calculations werent correct because you had the capital gains rate wrong on investments you should have in your taxable account.

 

[Cut-Throat]

My rule has been to always defer taxes, you may never have to pay them. Laws change. When you pay the taxes the money is gone forever.

 

[mathjak107]

My rule has been to always defer taxes, you may never have to pay them. Laws change. When you pay the taxes the money is gone forever.

my sentiments exacly. boy im scared we have been agreeing to much lately! ha ha

 

[Cut-Throat]

my sentiments exacly. boy im scared we have been agreeing to much lately! ha ha

Why? - You're not a Republican are you?

 

[mathjak107]

Why? - You're not a Republican are you?

nah i stopped voting after richard nixon.

 

[bots2019]

your calculations werent correct because you had the capital gains rate wrong on investments you should have in your taxable account.

Capital gains tax - Wikipedia, the free encyclopedia

from that page--> "After 2010, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket)."

I don't think it's wrong (unless wiki's out of date). Even if it's 15% instead of 20% the 401k route is worth less ($4,480) than the Roth

 

[ESRBob]

For those who think they may never pay higher taxes than they pay whhile they are working, it's worth running some scenarios regarding Mandatory Withdrawals from an IRA. A reasonably successful IRA can grow to a pretty big number by the time you're 70 and the required minimum distributions (RMDs) can be big. Combine that with your SS payments plus whatever other taxable earnings you're making on your portfolio and you could have much more income than you need or want, and all taxable at top rates. (Stick RMD Calculator into Google and take your pick). Results have always been pretty scary to me, and they get worse as you (and your IRA) grow -- if you are living to age 90, you're really getting hosed on RMDs.

I still say soaking up whatever 10% or 15% bracket you have left over with Roth conversions is a no-brainer, though one probably not availalbe while you're working full time.

For those who are working or who are in higher brackets, maybe just fund the traditional IRA/401k for now and wait until you stop career work to think about the Roth. But you'll have whatever the years until age 70 1/2 to make the conversions-- managing your taxable income to keep it low enough to do the conversions? Still the sooner you can convert the better, since the numbers get bigger inside the IRA the longer you wait.

 

[Cut-Throat]

For those who think they may never pay higher taxes than they pay whhile they are working, it's worth running some scenarios regarding Mandatory Withdrawals from an IRA. A reasonably successful IRA can grow to a pretty big number by the time you're 70 and the required minimum distributions (RMDs) can be big. Combine that with your SS payments plus whatever other taxable earnings you're making on your portfolio and you could have much more income than you need or want, and all taxable at top rates. (Stick RMD Calculator into Google and take your pick). Results have always been pretty scary to me, and they get worse as you (and your IRA) grow -- if you are living to age 90, you're really getting hosed on RMDs.

I still say soaking up whatever 10% or 15% bracket you have left over with Roth conversions is a no-brainer, though one probably not availalbe while you're working full time.

For those who are working or who are in higher brackets, maybe just fund the traditional IRA/401k for now and wait until you stop career work to think about the Roth. But you'll have whatever the years until age 70 1/2 to make the conversions-- managing your taxable income to keep it low enough to do the conversions? Still the sooner you can convert the better, since the numbers get bigger inside the IRA the longer you wait.

That is another reason to delay SS to age 70. Start taking the money out of your IRA at age 62 and draw it down while taxes are lower. When the RMD kicks in the SS payment will be larger and the RMD will be smaller.

 

[theoldwizard]

Currently I'm trying to determine whether to participate in a Roth 401 or 401k with my wife's employer.

You are working way too hard at this ! As MickeyD said "No taxes makes me smile !"

The only thing better would be, take the conventional 401k and open a separate Roth IRA. I did about 5 years ago. I wish I had done it when Roth's first came out !

 

[LOL!]

...
To be fair, if you have low income in retirement (really low), then your SS benefits are not taxed. But if you have moderate income, then SS is taxed and this can make your marginal rate go above 40%. The trick here is to retire early and delay SS benefits. Use the intervening years while not receiving SS benefits to convert retirement money to a Roth IRA while you are in a low tax bracket.

Check out Scott Burns column today on taxation of SS bennies. It don't look good at all.

 

[mathjak107]

since it looks like ss will end up being taxed anyway from what scott says , my vote is dont give the gov a penny in tax money before its due and defer all you can .

 

[ferco]

Just an abstract thought.....do we all REALLY believe the gov-ment, is going to keep its word and let all that Roth money be taking out tax free. Since the US will still have huge ongoing debt from the war and future obligations for medicare and SS. As the social program needs expand for the boomers that money will have to come from somewhere. Overall will any of this make a difference....we are still all guaranteed to get screwed (ie., the middle class).

 

[mathjak107]

Just an abstract thought.....do we all REALLY believe the gov-ment, is going to keep its word and let all that Roth money be taking out tax free. Since the US will still have huge ongoing debt from the war and future obligations for medicare and SS. As the social program needs expand for the boomers that money will have to come from somewhere. Overall will any of this make a difference....we are still all guaranteed to get screwed (ie., the middle class).

already roths get screwed as tax brackets increase by 3% a year letting more and more income fall under a lower rate that you should maybe have taken a current tax deduction fot instead.

 

[Texas Proud]

Just an abstract thought.....do we all REALLY believe the gov-ment, is going to keep its word and let all that Roth money be taking out tax free. Since the US will still have huge ongoing debt from the war and future obligations for medicare and SS. As the social program needs expand for the boomers that money will have to come from somewhere. Overall will any of this make a difference....we are still all guaranteed to get screwed (ie., the middle class).

Ahhh.... yes, I do think that they will not tax all that money...


Now... there is a possibility that there will be a VAT tax, but I don't think that they would get rid of the income tax even if they went that way... so that does not count unless they get rid of the income tax system.... but then you have to ask.... do you think they will allow all that UNTAXED 401 and IRA money not get taxed if they don't spend it

 

[Independent]

Currently I'm trying to determine whether to participate in a Roth 401 or 401k with my wife's employer. From what I understand conventional wisdom is that you should consider whether your future tax rate will be higher or lower than your present tax rate (if they're equal then the two options are equivalent).

However, I ran a few figures and it appears that the Roth option may be preferable (even if the current and future tax rates are equal)... Here's the scenario:

Current federal rate: 33%
Assumed future rate: 33%
Assumed investment return: 8%
timeframe - 20 years
Investment amount for both options = $1,000 (to keep it simple)
Gross required income = $1,493 ($1,493 x .67 = $1,000)

Option 1 - pay tax on $1,493 and invest remaining $1,000 in Roth

Option 2 - contribute $1,000 to 401k, pay tax on remaining $493 and invest after tax amount of $330 in after-tax accounts

After 20 years at 8% return:

Option 1 - Roth balance of $4,661 = tax free

Option 2 - 401k balance of $4,661, pay 33% tax=$3,123, after tax investment of $330 is now worth $1,296, pay gains taxes of 20% on $966 gain => total after tax value of $4,419

So... it appears that if my tax rate remains the same then the Roth may be a better option. I've ignored any dividends in the after-tax account, but those would have a pretty minor impact...

Am I missing something here? This seems to defy conventional wisdom

I would do the analysis a little differently -- I see three options.

Assume that you have $1,493 of before-tax income that you are willing to commit to retirement savings this year. You have three ways of using it: Roth, Traditional tax deferred, Taxable.

Option 1: I agree with your math for the Roth. You use $493 to pay taxes, save the rest in the Roth, and end up with $4,661 of spendable, after-tax money.

Option 2: Put the whole $1,493 into a traditional 401k. You pay no taxes today. The $1,493 grows to $6,959 in 20 years. Pay taxes at 33% and end up with $4,661 in spendable, after-tax money.

Option 3: Use $493 to pay taxes on the $1,493. Put all the remaining $1,000 into a taxable account. If you can get it to grow at 8% without paying any taxes along the way (e.g. no dividends), you will have $4,662 in 20 years. The 20% cap gains tax on the $3,662 of gains is $834, so you end up with $3,828.

My Option 1 and Option 2 end up with the same spendable money. This is a general result - if the tax rates, investment returns, and beginning before-tax dollars are the same, the Roth and Traditional will always give the same value.

My Option 3 is worse. I think this is also a general result. It seems that Option 3 has to be worse than Option 2 if the capital gains rate is any numbers bigger than 0%.

So, the way I'm doing it, I would say that your "Option 2" is a combination of my "Option 2 and Option 3". In my mind, you are comparing a Roth to a combination of something that is equal to the Roth plus something that is worse than the Roth, hence your Option 2 gave the lower value.

One important assumption in my approach is that you can really "fit" the whole $1,493 into your 401k max contribution limit. Since you picked the $1,000 for convenience, it's possible that your real situation is different. When Roths first became available for IRA, I believe that the IRA contribution limit was $2,000. People who found that $2,000 limit too restrictive were better off with the Roth because they could put the whole (after-tax) $2,000 into the tax free account. That is, they might be willing to "commit $3,000 of before tax money to retirement savings". If they went the Roth route, they got $2,000 of after-tax dollars into the Roth. If they went the traditional route, they had to do the split that's in your Option 2.

It's possible that you are maxing out on your 401k, so you are in this type of a situation today. Maybe this is why you constructed the example as 100% Roth vs. a combination of traditional plus taxable.

 

[bots2019]

I would do the analysis a little differently -- I see three options.

Assume that you have $1,493 of before-tax income that you are willing to commit to retirement savings this year. You have three ways of using it: Roth, Traditional tax deferred, Taxable.

Option 1: I agree with your math for the Roth. You use $493 to pay taxes, save the rest in the Roth, and end up with $4,661 of spendable, after-tax money.

Option 2: Put the whole $1,493 into a traditional 401k. You pay no taxes today. The $1,493 grows to $6,959 in 20 years. Pay taxes at 33% and end up with $4,661 in spendable, after-tax money.

Option 3: Use $493 to pay taxes on the $1,493. Put all the remaining $1,000 into a taxable account. If you can get it to grow at 8% without paying any taxes along the way (e.g. no dividends), you will have $4,662 in 20 years. The 20% cap gains tax on the $3,662 of gains is $834, so you end up with $3,828.

My Option 1 and Option 2 end up with the same spendable money. This is a general result - if the tax rates, investment returns, and beginning before-tax dollars are the same, the Roth and Traditional will always give the same value.

My Option 3 is worse. I think this is also a general result. It seems that Option 3 has to be worse than Option 2 if the capital gains rate is any numbers bigger than 0%.

So, the way I'm doing it, I would say that your "Option 2" is a combination of my "Option 2 and Option 3". In my mind, you are comparing a Roth to a combination of something that is equal to the Roth plus something that is worse than the Roth, hence your Option 2 gave the lower value.

One important assumption in my approach is that you can really "fit" the whole $1,493 into your 401k max contribution limit. Since you picked the $1,000 for convenience, it's possible that your real situation is different. When Roths first became available for IRA, I believe that the IRA contribution limit was $2,000. People who found that $2,000 limit too restrictive were better off with the Roth because they could put the whole (after-tax) $2,000 into the tax free account. That is, they might be willing to "commit $3,000 of before tax money to retirement savings". If they went the Roth route, they got $2,000 of after-tax dollars into the Roth. If they went the traditional route, they had to do the split that's in your Option 2.

It's possible that you are maxing out on your 401k, so you are in this type of a situation today. Maybe this is why you constructed the example as 100% Roth vs. a combination of traditional plus taxable.

Good analysis... you're right I'm really comparing maxing out each account (thus the hybrid approach)... it seems to me that IF the taxes are equal now and later THEN the roth is best... however, in reality, it seems that I'll likely be in a lower bracket in the future and should probably go with the 401k. Thanks for the good thoughts!