Roth IRA questions

[Bimmerbill]

OK, I've been learning a lot reading this forum.  So, thanks everyone!

I have a question about Roth IRAs.  I've read here several times that it is advantageous to max out the Roth IRA. 

Currently I put 16% into my 401k plan (the TSP).  My employer matches 6%. 

How can I calculate if it would be worthwhile to max out a Roth for myself and my wife, then put the rest into 401k?

Won't I miss out on the tax defferal of the 401?

 

[laurence]

Well, here's my take on why you hear the drumbeat on Roths. It's a bet, the 401k gives you tax defferal now, where a Roth gives you no tax benefit now, but gives you tax benefit at the time of withdrawal. When you withdraw from a 401k or traditional IRA, you will be taxed as normal income. That Roth will not be taxed. Considering tax rates are pretty much at historic lows, and will probably only go up (Congress just raised the debt ceiling to $10 trillion-somebody is paying that), people are betting that paying taxes now (roth) is cheaper than paying later (401k). Plus, a 401k can often be full of bad choices for funds. You may find the expense ratios too high, or be unable to properly diversify your portfolio.

You definitely should take advantage of your employer's free money, though. I think:

Match 6% in 401k

Max Roths

All additional back in 401k

Is a good order of operations. Hope that helps!

 

[ats5g]

Hi Bill,

You still get tax deferral with a Roth IRA, it's just that you get deferral of after tax returns, whereas with the 401(k) you get deferral of pre-tax returns. A rather "back-of-the-envelope" way to do it is to say that you could either invest:

1. $X in the TSP, or

2. $X * (1 - marginal tax rate) in the Roth IRA

Then at the end of say 20 years with 6% return you'd have amounts of:

1. $X*((1.06)^20))*(1-marginal tax rate at withdrawal) in TSP, or

2. $X*(1 - marginal tax rate now)*((1.06)^20)) in Roth IRA

As you can see [hopefully  ] if your marginal tax rates are the same now as in retirement, you'll end up with the same amount of after-tax money. If you think you'll be in a lower tax rate in retirement, maxing out the 401(k) after the match might be better. If you think you'll be in a higher tax rate in retirement, maxing out the Roth IRA after the match might be better.

Note that withdrawals of principal from Roth IRAs do not have restrictions, while withdrawals from TSP most likely does. So, if you plan to retire before you can withdraw from TSP, by contributing to Roth IRAs, you will avoid the whole SEPP thingee.

Also note that the TSP may have more restrictive withdrawal options than a Roth IRA, but these restrictions can generally be avoided by rolling over to an IRA after separation. But then you run into the whole SEPP issue again.

My wife and I are contributing to her TSP up to the match, and then plan on maxing out our Roths before contributing more to her TSP.

- Alec

 

[Telly]

Another advantage of a ROTH is that income that you take out of it does not count in the calculations of the SS $32K rule (for married filing jointly) in taxation of SS benefits. Just about every other source of income, including pensions, figures in for possible taxation of benefits.

 

[Texas Proud]

Since you did not include your tax level... let me throw out something that is important, but buried in the posts above..

If you are in the 28% bracket prior to your 401(k), you should not put in so much it takes you into the 15% bracket... I have a friend who was doing this on a few percent of her income.... it is much better to only put in enough to get you to the bottom of 28% and the rest after ROTH in a taxable account with cap gains and dividend tax benefits..

So, 401(k) for full match,

Roth until full,

401(k) until you get to the bottom of the tax rate you are 'in'..

rest savings..

 

[just_hatched]

Also, 401(k)s have Required Minimum Distribution (RMDs) you have to take when you reach, uh, 72?

With Roth IRAs, theoritically you can leave it growing and even pass it on to your heirs if you don't need it.
Tax free! (I think.)

But who wants to do that? Spend it!

 

[Martha]

With Roth IRAs, theoritically you can leave it growing and even pass it on to your heirs if you don't need it.
Tax free! (I think.)

A nice discussion of what tax implications of a Roth IRA when you die is here: http://www.fairmark.com/rothira/inherit.htm

Although nothing will avoid the estate tax (if you have a taxable estate) the Roth is much better from an income tax standpoint for your heirs.

 

[LOL!]

If you are in the 28% bracket prior to your 401(k), you should not put in so much it takes you into the 15% bracket...

...
401(k) until you get to the bottom of the tax rate you are 'in'..

Why?

 

[Ed_The_Gypsy]

Hi, Bill,

I vote so:
a) 401K to the limit of the company's matching.
b) then, as much as you can into Roths.

Roths are a gift from God. Tax-free, forever! (or until Congress taketh away, but until then, the best game in town). Also, flexible withdrawal. I don't worry about the inheritance thing, but some might. In my experience, kids squander inheritances (myself included). Instead, contribute to their Roths and tell them not to touch it until 55 upon pain of death. (Maybe that will work.)

My dos pesos.

Ed

 

[just_hatched]

Tax-free, forever! (or until Congress taketh away,

I think that would be a raw deal if the government decided to change the rules.

I know they can do anything they want, but if so, I hope they give us a chance to
move the money somewhere beneficial. Of course, the IRS will have all of these
stipulations based on income, net worth, moon phase...

 

[Ed_The_Gypsy]

Congress can do anything they want.

The fact remains that, today, the Roth is the best deal you can get from da gummint. (And are EVER going to get. Max them NOW!)

 

[Bimmerbill]

Thanks for the info. I guess I am having trouble trying to predict what my tax bracket will be in retirement.

Also, someone mentioned not using 401k to reduce my tax bracket as much as possible. Why is that?

 

[laurence]

I think what Texas Proud is getting at that you aren't getting much incentive from the government once you drop to the 15% tax bracket, meanwhile, on the back end you'll be paying taxes like regular income on the 401k when you withdraw, and you are unlikely to see lower than 15%, and possibly higher. Do your own DD and run the numbers, but you may be better off just putting the money in an "after tax" account with Vanguard at that point. I haven't run the numbers for myself, because at this point we only have enough income to max the Roth and the company match for the 401k, we sock the rest onto our 2nd, since the rates are shooting up (we have an equity line of credit - stupid but the amount is small so we should have it wrapped up soon).

 

[Texas Proud]

Thanks for the info.  I guess I am having trouble trying to predict what my tax bracket will be in retirement. 

Also, someone mentioned not using 401k to reduce my tax bracket as much as possible.  Why is that? 

Yes, what Laurence said...

If you sock away savings that you would only pay 15% tax on today, and more than likely pay 28% on in the future, it is not a good thing.. remember, 100% of distributions from an 401(k) is taxable as ordinary income (except for the one instance of company stock).. so, it is better in the long run to pay the tax now, invest in stocks that will produce capital gains which are taxed at lower rates, earn dividends which are taxed at lower rates than to pay full taxes on everything later in life...

Of course, if you do not plan on getting enough assets to earn you money to get into the next higher tax bracket when you retire.. and you are sure that the gvmt will not raise the 15% rate... then of course put the money in now...

 

[Bimmerbill]

Yes, I am in the 15% bracket, due to my mortgage deductions and state property taxes.

 

[yakers]

Bimmerbill,

Just what Lawrence said in his first reply, get the TSP match, then the Roth, then the rest of the TSP, then taxable investing. You can overcomplicate the process. The TSP is a good place to invest it has index funds, low fees and a good bond/stable market fund (the G Fund).
I am CSRS so no match in my TSP; I go for the full TSP and Roth and then some taxable stocks. My priority is actually the Roth as I do not get any matching contributions in the TSP/401k. My wife ws (she retired last week) a teacher and we maxed her 403b, which is not a very good program like the TSP but it kept our taxabel income down so we could still use the Roths.

 

[Texas Proud]

Yes, I am in the 15% bracket, due to my mortgage deductions and state property taxes. 

If you are IN the 15% bracket... I would only put in money to get all the match your company will make... nothing more... then fill up the ROTH..  rest in ordinary savings...

But, this is me... you might still have the craving to put more aside...

One big caveat... if you can not hang on to money that is in an ordinary account, then put it in your 401(k) as you will have a bit more trouble spending it from there..

 

[ats5g]

Hey Bill,

I tried to create a spreadsheet that's fairly easy to understand for one to figure out whether it's better to contribute past the match in the 401(k) or into a taxable account. Here it is if you want to play around [just change the #'s in blue]:

401kvsTaxable

[Note: I "borrowed" the taxable stock calculations from a free spreadsheet that William Reichenstein used to have on his website. doesn't look like it's there anymore  ]

I'd appreciate any comments.

Thanks,

- Alec

 

[LOL!]

Yes, what Laurence said...

If you sock away savings that you would only pay 15% tax on today, and more than likely pay 28% on in the future, it is not a good thing..  remember, 100% of distributions from an 401(k) is taxable as ordinary income (except for the one instance of company stock).. 

I disagree with the above statement.  There is your marginal tax bracket and there is your overall tax rate.   Lots of folks seem to confuse all this tax stuff and thus make incorrect decisions.

An example: a two-earner family with 2 kids, W2 wages of over $200K, investment income of over $10K, a small mortgage, no state income tax, itemized deductions would pay about $30K in Federal income taxes.  That's about 15% overall.  BTW, they are not eligible for Roth IRAs anyways.

If one of the wage earners retires and income drops to $100K, then Federal income taxes drop to about $5K or an overall rate of 5% or so.

If both retire, then the first income tax bracket is 0% (not 15%).  Thus, if the couple withdraws from a 401(k) or a rollover IRA, it could be that a significant amount is withdrawn tax-free.

Therefore, when you put it in the 401(k) it was not taxed and when you take it out it is also possibly not taxed.

Thus, "and more than likely pay 28% on in the future" is pure conjecture.  It may be right for some folks, but for others it is certainly not true.

 

[just_hatched]

remember, 100% of distributions from an 401(k) is taxable as ordinary income (except for the one instance of company stock)..

What are the tax implications of holding company stock in a 401(k)?

Do I need to track over the course of 40 years each purchase to calculate the capital gains and cost basis for tax purposes when I eventually withdraw them from the 401(k)?

What about re-balancing the company stock into other 401(k) funds before retirement? Is there a reason not to do that, tax-wise and recordkeeping-wise, I mean?

(sorry, slightly off topic versus Roth.)

 

[gindie]

just_hatched,

You might be able to take advantage of a special tax treatment for company stock called Net Unrealized Appreciation (NUA).  It is a method where, if you transfer all the ESOP stock to a taxable account (not first converting them to cash) then:

1) At the time of the ESOP distribution, you'll owe ordinary income tax ONLY on the original cost of the shares.  I've been told that most companies will keep track of this basis for you.

2) Then, when the shares are ultimately sold,
    a) you'll owe long-term capital gains taxes on the difference between the original cost of the shares and the price at the time of the distribution (this is the NUA).
    b) you'll owe either long-term or short term capital gains on the amount of appreciation since the distribution, depending on how long you held the shares after the distribution.

The above strategy is subject to rules (age, etc.).  But it is something to look into before automatically rolling into an IRA where everything is subject to ordinary income tax.

 

[Bimmerbill]

I appreciate all the comments. I gotta say, tho, that I am more confused than ever!

A buddy at work gave me some articles on Roth vs Traditional and I will read them.

I expect to be in the 15% bracket for my career, and probably in retirement too. Not sure tho!

 

[mathjak107]

as i said in a previous article if you structure your investments properly keeping equities in your taxable account and bonds and cash in your ira or 401k you can withdraw 20,000 a year tax free from your retirement money and another 15,000 from it at 10%...thats 35,000 a year with a 1500.00 tax bill on money never taxed ...

 

[azanon]

Currently I put 16% into my 401k plan (the TSP).  My employer matches 6%.

You get 5% from your employer, not 6%. 

How can I calculate if it would be worthwhile to max out a Roth for myself and my wife, then put the rest into 401k?

The TSP is not a vanilla traditional IRA.  It has two extra advantages over a typical one.  First, after 20 years of service, and minimum age of 50, you are eligible for an early out which means you can have access to this money penalty free if you were to take it.  At 30 years of service, minimum age of 55, you can do a full retirement and also have access to this money penalty free.    A typical traditional IRA requires you to wait until 59 1/2.     Forget 72(t);  think complicated withdrawals with specific limitations on how it can be done (something about equal distributions).

The second special advantage of TSP is, for all practical purposes, index funds with no expenses at all.    Ok its like 0.02% or something nominal.    Show me any fund company that will offer you that (i'll save you the time and just let you know, you wont find one).

A third special advantage is that the federal government will give you the option to annutized part or all of it at likely a competitive rate. Some people like to do a partial annuity just to have one more steady stream of income. Yes, that's an unpopular thing to do here, but that doesn't mean it isnt done very often. People here will also tell you its a good idea to retire in your 30s, so use this as proof to take the things said here with a grain of salt.

Roth's usually win the Roth vs traditional battle.   But against a TSP, its a much harder choice as to which to max first per what i said above.

 

[Bimmerbill]

Yep, 5%, thanks for the correction. 1% automatically, 3% dollar for dollar, and the next 2% at 50 cents on the dollar.