401k vs. Roth IRA & other savings

[MrTux]

I have been doing research on what to save and why. I have found out that many people recommend that you first put money in your company's 401k until they stop matching it. Then you max out your Roth IRA contribution, followed by returning to your company's 401k to max its limit out.

If you do not plan on staying with a company for the length of time that it takes for the matched money that they put in to become yours, should you still invest this way?

Thanks in Advance for the Info!!!

- Mr. Tux

 

[ziggy29]

I'd say so. Circumstances change, and if you eventually find yourself there long enough to vest in the company match, you'll kick yourself for not doing so.

 

[W2R]

I agree with Ziggy. Also you need to be sure that you have an adequate emergency fund built up. Due to the recent economic problems, an emergency fund equal to at least a year's expenses or more might be a good idea.

 

[MrTux]

Thanks for the information.

Now I just need to determine what % to contribute.

 

[LOL!]

I disagree with the premise that was listed by MrTux of contributing to a Roth before maxing out one's 401(k). What you should do depends on your marginal income tax bracket now and your effective tax rate for the money when you withdraw it.

For folks in the marginal income tax brackets above 15%, they should probably avoid the Roth IRA and max out their 401(k) contributions first unless they will be getting a hefty pension as well. For folks below the 155 marginal income tax bracket, then the order that MrTux wrote makes sense: capture the match, then Roth, then go back and max out the 401(k).

The reasons have been shown over and over in this forum: Most retirees without a pension pay little to no income taxes. So your money going into the 401(k) is tax-free going in and practically tax-free coming out. While the Roth is tax-free coming out, it was taxed at your highest rate going in.

 

[bank5]

I disagree with the premise that was listed by MrTux of contributing to a Roth before maxing out one's 401(k). What you should do depends on your marginal income tax bracket now and your effective tax rate for the money when you withdraw it.

For folks in the marginal income tax brackets above 15%, they should probably avoid the Roth IRA and max out their 401(k) contributions first unless they will be getting a hefty pension as well. For folks below the 155 marginal income tax bracket, then the order that MrTux wrote makes sense: capture the match, then Roth, then go back and max out the 401(k).

The reasons have been shown over and over in this forum: Most retirees without a pension pay little to no income taxes. So your money going into the 401(k) is tax-free going in and practically tax-free coming out. While the Roth is tax-free coming out, it was taxed at your highest rate going in.

LOL! I agree but I'm a little confused about how you mentioned the pension. Say I retire and take $40k each year from my 401k. Would I be taxed more if I had a $20k pension and took $20k from my 401k?

State taxes are another thing to consider too. Especially if you work in a state with high income taxes but plan to retire to a state with low or no income taxes.

To prioritize, I would:
1. Get company match from 401k
2. Pay off highest interest debt (> 5%)
3. Max 401k
4. Max Roth IRA (I'd move this up to #2 if you need a bigger E-fund, or #3 if you are in the 15% or less tax bracket)
5. Pay off mortgage (~4 - 5% after taxes)
6. Pay off student loans that are under 3%

 

[LOL!]

Your pension will fill up the lower income tax brackets of 0%, 10% ... and possibly cause your social security benefits to be taxed more. So yes, your 401(k) would be taxed more.

You would pay no more tax on that $40K of income whether it was $40K of 401(k) withdrawals or $20K of pension and $20K of 401(k) withdrawals. But the overall taxes on the money you put into the 401(k) as it is taken out would be lower without a pension.

 

[ziggy29]

You would pay no more tax on that $40K of income whether it was $40K of 401(k) withdrawals or $20K of pension and $20K of 401(k) withdrawals.

Not always. Some states have favorable tax status for certain types of pension income.

 

[RetireBy90]

One item that seems lost in the pay me now or later discussion is the cost of risk. You know what your tax rate is today, but don't know what taxes will do in the future. Esp for someone looking more than 10 years down the road. This unknown is a risk, and you should either be compensated for the risk (higher return) or decline the risk.

For me, I'm sending 15% to my 401K (reduced to 201K now) and of that 6% is to a roth 401K. I have been increasing the % to the roth 1% a year and plan to move more in comming couple years. I gotta think that taxes are going up as time goes along.

 

[LOL!]

One item that seems lost in the pay me now or later discussion is the cost of risk. You know what your tax rate is today, but don't know what taxes will do in the future. Esp for someone looking more than 10 years down the road. This unknown is a risk, and you should either be compensated for the risk (higher return) or decline the risk.

For me, I'm sending 15% to my 401K (reduced to 201K now) and of that 6% is to a roth 401K. I have been increasing the % to the roth 1% a year and plan to move more in comming couple years. I gotta think that taxes are going up as time goes along.

The risk that there will not be a 0% tax bracket is essentially zero. The government would have to do away with exemptions and the standard deduction first before one would pay less money on a traditional than on a Roth. It would also mean that poor folk are taxed just as much as wealthy folks and the end of our progressive tax system.

Do not confuse a higher marginal income tax rate with a lower overall effective tax rate.

 

[RetireBy90]

It seems that I didn't explain my point well. If you plan to have lower taxable income, including all sources, pension, social security, IRA, savings and 401K, then you could argue that in retirement your taxes would be less.

However, if you plan to have retirement income that is close to your pre-retirement income then paying taxes today (using a Roth) would be a better deal. I have my son (early 20s) setup with a Roth IRA today even at his low effective rate of today.

My point is that you would almost always be better off paying taxes today than to risk unknown tax rates in the future.

If I could get a piece of the action betting overall, marginal, or any measure of taxes going to 0% maybe I wouldn't need a retirement account.

 

[LOL!]

Sorry, you still don't get it. Any money you put in your traditional 401(k) today saves you taxes at your marginal income tax rate. Let's say you are in the 25% tax bracket, so you save 25% of that money in taxes.

Later when you are retired, you can still have the same income. You can withdraw the same income from your 401(k). But, the first several thousand dollars will be tax-free, then next is taxed at 10%, and the next at 15%, until eventually you may get back up to 25%. You probably won't get to 25% because you will not be paying FICA and some other things. Thus your taxes will definitely be LESS for the same income.

You are right that tax rates can go up, but those lower tax brackets which some of your retirement withdrawals will be tax-free and taxed at a low rate will still be there.

Essentially you made the same mistake that a blogger made that is being discussed in this thread: http://www.early-retirement.org/forums/f28/decent-article-on-median-us-household-44915.html

 

[HornedToad10]

Sorry, you still don't get it. Any money you put in your traditional 401(k) today saves you taxes at your marginal income tax rate. Let's say you are in the 25% tax bracket, so you save 25% of that money in taxes.

Later when you are retired, you can still have the same income. You can withdraw the same income from your 401(k). But, the first several thousand dollars will be tax-free, then next is taxed at 10%, and the next at 15%, until eventually you may get back up to 25%. You probably won't get to 25% because you will not be paying FICA and some other things. Thus your taxes will definitely be LESS for the same income.

You are right that tax rates can go up, but those lower tax brackets which some of your retirement withdrawals will be tax-free and taxed at a low rate will still be there.

Essentially you made the same mistake that a blogger made that is being discussed in this thread: http://www.early-retirement.org/forums/f28/decent-article-on-median-us-household-44915.html

Here's a couple interesting articles that demonstrate the above point of 401k saving you on your marginal rate. I would definitely do Roth for 15% or lower rates and then 25% is debatable depending on income/plans. That said, I do 401k->Roth-> back to 401k as originally suggested.

1st: http://thefinancebuff.com/2008/03/case-against-roth-401k.html

2nd: http://thefinancebuff.com/2008/05/roth-401k-for-people-who-contribute-max.html