Saturday, January 18, 2014

Priority of Investment Roth 401 vs (T) ( Traditional) 401k

 Over at Bogleheads we read the following discussion:

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Postby nickjo88 » Thu Jan 16, 2014 2:04 pm
My wife and I are having a discussion in regards to which account we should fund of her employer sponsored plans.
I am maxing out my 401k. She has the option of a 401k w/ 5% match and Roth 401. I have the feeling we should be maxing her 401 and she would like to contribute to her Roth. We have been unable to convince the other to switch their point of view. She is currenlty putting 25% into each account (total 50%) in attempt to split the max.

I am currenlty doing contract work which may end when we start a family. I would assume a decrease of roughly 40% in gross pay.
I also thught it would be nice to do a backdoor after both 401k are maxed, But I feel my vangourd (t)ira (58K) is an obstacle if I have to pay 28% tax on it.

Does anyone have any good points in either direction?

Current situation:
Tax Rate 28% (227K gross)
Age 30
Retirement Accounts:
His VG (t)ira: 58k
His Employer 401k : 24K
His VG (r)IRA 3,400
Brokerage: 1,800

Her Employer 401k: 28K
Her Employer (r)401: 4k
Her VG (r)ira: 3400

Total: 124k

223k Mortgage
59K Student Loan
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Re: Priority of Invenstment Roth 401 vs (T) 401k

Postby mnvalue » Thu Jan 16, 2014 3:19 pm
If you're in the 28% bracket, the traditional (non-Roth) is the probably way to go. The Roth thing of "don't pay taxes ever again" sounds sexy, but remember that you have to pay taxes now. So a Roth makes sense if you have some rational basis for thinking 28% (your current marginal rate) is less than (or equal to) the rate you'll pay in retirement. Remember that when you pay the taxes now, it's at your marginal (think: "top") rate, but when you withdraw the money, some of it fills the lower (read: "cheaper") brackets first. So even if you expected your marginal rate to be 28% in retirement, pre-tax is still better.

If you do switch the Roth 401k contributions to traditional, keep in mind that for the same $17,500 nominal dollars, that's a reduction in the overall contribution rate. This is because you're paying taxes on top of the Roth portion. So if she's contributing $8,750 to the Roth, she needs to contribute more than $8,750 if she switches to traditional. Since she can't do that in the 401k (as she's already hitting the max), she'll have to contribute to her Roth IRA, possibly via the "backdoor Roth" method, depending on your combined income level. By my math, that $8,750 she's putting into the Roth is worth $12,153 pre-tax [$8750÷(1−.28)]; subtracting the $8,750 pre-tax (traditional 401k) contributions she'd replace it with, the difference is $3,403 pre-tax or $2,450 after tax [$3403×(1−.28)]. So she needs to increase her Roth IRA contributions by $2,450 to keep the same overall contribution level. If she's already contributing the max to the Roth IRA as well, then you need to contribute more to your IRA to make up that difference (again, possibly the backdoor Roth mechanism). NOTE WELL: If either of you wants to do a "backdoor Roth", you'll need to get your T IRA out of the way by rolling it into your 401k.

If this reaches the point where you're both maxing 401ks and Roth IRAs, then the question is: "Is it better to contribute more dollars via the Roth 401k or invest in a taxable account?" That can go either way and may depend on age. The wiki article on tax-adjusted allocation suggests a rule of thumb of discounting taxable by 25% early in your career and 15% later to estimate the effect of capital gains and dividends taxation rules. Since that's less than your marginal rate, taxable investing may make more sense. It also offers you the flexibility to re-purpose those monies for non-retirement use. However, psychologically, the accessibility of that money can equally be a curse, plus the "forced savings" pre-committment strategy of Roth 401k contributions from payroll may mean that more money actually gets invested.

If it were me, I'd definitely max Roth IRAs before contributing to a Roth 401k. The tax treatment is the same, the investment options will certainly be no worse in the IRA and likely will be better, and it gives you some flexibility as you could withdraw those contributions penalty-free in an extreme emergency. (The fact that you can't put the funds back will help temper the urge to spend it frivolously.) But, if I was in your shoes, I probably wouldn't bother if I had a bad 401k, as I wouldn't want to roll my traditional IRA into it. So, if your 401k is good, roll your traditional into it and use Roth IRAs instead of the Roth 401k, at least, even if you don't go all pre-tax. If your 401k is bad, make no changes.
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Re: Priority of Invenstment Roth 401 vs (T) 401k

Postby livesoft » Thu Jan 16, 2014 3:48 pm
She can always convert her traditional 401(k) to a Roth IRA in retirement while in a lower tax bracket. If that doesn't convince her I don't know what will. Basically, she can have her cake and eat it, too.

I am glad Roth IRAs didn't exist when we were younger. They seem like a big scam for most people. Yes, there is a small subset of folks who benefit from Roth, but those folks don't pay income taxes anyways.

I always recommend:
401(k) for both to max
Roth IRAs afterwards
maybe 529 plan

and throw in HSA somewhere, too. Probably before 401(k) since one needs health care dollars.

If pay is about to decrease 40% and you are only in the 28% bracket now, you should certainly be below 28% when pay drops.
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Re: Priority of Invenstment Roth 401 vs (T) 401k

Postby nickjo88 » Thu Jan 16, 2014 4:16 pm
Thank You for the replies.
If we both max 401K, our income is still above the limit for Roth IRA's. By roth IRA, do you mean through backdoor method?

Our 401k's are both through ING, from what I have reviewed and I do need to go into further research, the funds are not that great.
I am comparing these to vangaurd, and the fees seem to be much more. I have been a little hesistant rolling the vangaurd over becasue of the ING options.
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Re: Priority of Invenstment Roth 401 vs (T) 401k

Postby Chadnudj » Thu Jan 16, 2014 4:32 pm
I think in your particular situation, there is a benefit to having your wife do a Roth 401(k) -- namely tax diversification.

You're already maxing out your traditional 401k (and have a traditional IRA), so you're doing well in terms of having money that will be taxed in retirement (potentially at a lower rate). By doing a Roth 401k with your wife's contributions, you're giving yourself wiggle room by creating tax-free at withdrawal sources. A good example is if you were just approaching a higher tax bracket -- if you needed X amount of money for expenses, but that would just put you in a higher tax bracket in retirement, you could withdraw the amount below the tax bracket from traditional sources while taking the little extra over the tax bracket from the Roth 401k.

There is a big caveat here, though -- you could potentially significantly lower your taxable income NOW if you both contribute more/the max to TRADITIONAL 401ks....this might then get you below the Roth contribution limit, or else allow you to take other tax deductions (thinking losses on rental properties, student loan interest) that aren't available above certain income levels.

Really, though, either/both ways are going to have benefits and really depends what your goals are, both long term in retirement and short-term.
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Re: Priority of Invenstment Roth 401 vs (T) 401k

Postby Quickfoot » Thu Jan 16, 2014 4:34 pm
We are also in the 28% tax bracket and our priority is tax deferred first, then Roth. We do not expect to be in a higher relative tax bracket in retirement and possibly could achieve a lower tax rate. We have 2 custody battles going on at the same time but next year we'll max both traditional 401k's, our HSA, and a dependent care FSA and any remaining money will either go in a Roth and then taxable.
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Re: Priority of Investment Roth 401 vs (T) 401k

Postby LadyGeek » Thu Jan 16, 2014 6:08 pm
This thread is now in the Investing - Help with Personal Investments forum.
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Re: Priority of Investment Roth 401 vs (T) 401k

Postby bdpb » Fri Jan 17, 2014 3:03 am
At these tax rates (you didn't mention the state tax), contribute the deductible max to both 401k.

Then contribute back-door Roth for her.

Is it possible to roll your IRA into your 401k? If so, back-door Roth for you.

Then pay down debt. Again, you didn't mention your mortgage rate or school debt rate.

Then invest in taxable account.
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