Wednesday, February 12, 2014

Traditional 401k vs Roth 401k

Over at Bogleheads we came across the following discussion: 

Math with Wine is Hard: Traditional 401k vs Roth 401k

36 posts • Page 1 of 1

Math with Wine is Hard: Traditional 401k vs Roth 401kby 

BanditKing » Mon Feb 10, 2014 5:18 pm

This year, my employer started offering a ROTH 401k option in addition to the traditional tax-deferred option. I'm currently (almost) 43 and solidly in the 25% bracket with about 6.5% state taxes and I expect to be in that same tax bracket when I retire. Initially, it seemed to make sense to just continue with maxing out my traditional 401k.

However, over a bottle of wine this weekend, I got to wondering if maybe it doesn't make more sense to put $17.5 of tax-free monies aside instead. I started to try to crunch some numbers and that's when my brain broke. I tried again when the wine was no longer a factor and didn't make much headway there either.

What's the best way to approach this analysis from a simplicity standpont? Or am I missing some obvious choice?

I also max my ROTH (via backdoor) as well, if it matters for this discussion.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Mon Feb 10, 2014 6:04 pm

Do you expect a sizable pension? How many years between retiring and collecting pension/Social Security? What matters is marginal rate when contributing and average rate when withdrawing. Do you currently get tax credits/deductions that phase-out with income, like the child tax credit?
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby telemark » Mon Feb 10, 2014 6:08 pm

BanditKing wrote:What's the best way to approach this analysis from a simplicity standpont? Or am I missing some obvious choice?


Suppose you take $500 out of your pay check, in any tax bracket, put it in a Roth, and earn a straight 5% return for the next twenty years. That gives you

$500 * (1.05 ^ 20), or $1326.65, tax free

Now suppose you take $500 out of your pay check in a 25% tax bracket and put it in a traditional 401K with the same (very hypothetical) return. Then you have

$666.67 * (1.05 ^ 20), or $1768.87, all subject to taxation as income

If you're still in a 25% tax bracket when you take the money out, you end up with $1768.87 * 0.75, or $1326.65, same as you got with the Roth. Where people usually go wrong is by comparing the amount that hits the 401K instead of the amount that comes out of the pay check.

If you're frustrated with the contribution limits and wish you could contribute more, the Roth is a way to get that effect.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby BanditKing » Mon Feb 10, 2014 6:12 pm

Ok, that's sorta where my brain was going when I started this exercise, that in effect going the Roth route was a way to effectively put more money into tax-advantaged space given the same $17.5k cap. It just kinda fell apart when I started running the numbers and then my head imploded.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby The Wizard » Mon Feb 10, 2014 6:19 pm

It's good to put enough in traditional 401k to fill up the low income brackets in retirement, 10% and 15% presently. Hard to predict brackets XX years in advance, I know. But do it anyway.
Then start putting more in Roth and/or taxable in your later years...
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby Iorek » Mon Feb 10, 2014 6:21 pm

Agree with Telemark-- the best argument for doing Roth 401k is if you want to sock away more because $17.5k of Roth is more than $17.5k of traditional. Personally I like to do the traditional and then use the money saved for a backdoor Roth IRA, which gives you money in both types of accounts.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby BanditKing » Mon Feb 10, 2014 6:28 pm

Iorek wrote:Personally I like to do the traditional and then use the money saved for a backdoor Roth IRA, which gives you money in both types of accounts.


I've already maxed my backdoor ROTH as well, and at this point am investing in taxable, so anything to put more into advantaged space is a good thing I'd think.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby DSInvestor » Mon Feb 10, 2014 6:32 pm

Will you have a pension? If not, you may be in a lower bracket in retirement. I maxed out Traditional 401k, Roth IRA. The traditional 401k contributions gave me more take home pay than Roth 401k and I used the higher pay to a) save for home downpayment / pay extra on mortgage b) invest in taxable account etc.

In the early years of retirement, there may be opportunities to convert Traditional assets to Roth IRA for little or no tax. Roth 401k contributions would not have been as good for me.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby bsteiner » Mon Feb 10, 2014 6:50 pm

As you point out, a $17,500 contribution to a Roth 401(k) is effectively greater than a $17,500 contribution to a traditional 401(k). At a constant tax rate, you would contribute $17,500 to the Roth. If you (or your beneficiaries) will be in a lower tax bracket upon retirement (or after death), you have to weigh the benefit of effectively getting more money into the 401(k) sooner versus the benefit of the lower tax rate if you convert or take distributions later. The Roth will likely win for younger people who expect that the tax rate upon a subsequent conversion or distribution will be the same, or a little bit lower, than their current tax bracket, but the traditional will likely win for older people who expect that the tax rate upon a subsequent conversion or distribution will likely be more than a little bit lower than their current tax bracket.

The analysis is similar to that of whether to do a Roth conversion now or to wait until later to convert or take distributions.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby Cherokee8215 » Mon Feb 10, 2014 7:01 pm

I don't know your employer's setup, but at mine, they only match dollars in the traditional 401k and not the Roth. Something to consider. Personally, I put up to the maximum match in the traditional and put the rest in the Roth.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby lrak » Mon Feb 10, 2014 8:36 pm

Usually the match goes into traditional, but they will still match your contributions even if they go in as Roth dollars.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby retiredjg » Mon Feb 10, 2014 8:50 pm

Why do you think you'll still be in the 25% bracket in retirement? If you have a pension, you might be right. If you don't have a pension, you might want to look at it closer.

Even if you are in the 25% bracket in retirement, the "pay 25% now is the same as pay 25% later" argument only works if you have enough other income later to fill the lower brackets. If you don't, some of the "pay 25% later" money could actually be taxed at less than 25%.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby telemark » Tue Feb 11, 2014 2:29 am

The match always goes into traditional, because the IRS requires that. If you're struggling to contribute anything at all, contributing to traditional is best because it lets you capture more of the match (the O.P. is presumably not in this position). Once you've captured all of the match, it gets complicated, and you're basically making guesses about future tax rates.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Tue Feb 11, 2014 8:57 am

telemark wrote:
BanditKing wrote:What's the best way to approach this analysis from a simplicity standpont? Or am I missing some obvious choice?


Suppose you take $500 out of your pay check, in any tax bracket, put it in a Roth, and earn a straight 5% return for the next twenty years. That gives you

$500 * (1.05 ^ 20), or $1326.65, tax free

Now suppose you take $500 out of your pay check in a 25% tax bracket and put it in a traditional 401K with the same (very hypothetical) return. Then you have

$666.67 * (1.05 ^ 20), or $1768.87, all subject to taxation as income

If you're still in a 25% tax bracket when you take the money out, you end up with $1768.87 * 0.75, or $1326.65, same as you got with the Roth. Where people usually go wrong is by comparing the amount that hits the 401K instead of the amount that comes out of the pay check.

If you're frustrated with the contribution limits and wish you could contribute more, the Roth is a way to get that effect.


This is only valid if there is another source of income filling all the lower tax brackets, such that all the funds you withdraw from your traditional account are taxed at 25%.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby Flashes1 » Tue Feb 11, 2014 9:16 am

We're right at the bottom of the 33% tax bracket.....which subjects us to the dreaded AMT. The traditional 401k contribution has been a great way to reduce our income tax liability given we can't deduct for property taxes and some other deductions. Therefore, I haven't been doing the Roth 401k; however, I'm beginning to get concerned about future tax obligations of the IRA Required Minimum Distributions. I estimated our combined 401k's will total at least $1.5MM at age 70.......and I'll have a $24,000/year pension----and I'm 7 years older than my wife (who'll have the bigger 401k). I'm concerned about the impact of setting aside at least 25% of my IRA withdrawls for Taxes. That really bites!  

Unsure what to do, but gut is telling me to stick with the Traditional IRA?
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Tue Feb 11, 2014 9:25 am

Flashes1 wrote:We're right at the bottom of the 33% tax bracket.....which subjects us to the dreaded AMT. The traditional 401k contribution has been a great way to reduce our income tax liability given we can't deduct for property taxes and some other deductions. Therefore, I haven't been doing the Roth 401k; however, I'm beginning to get concerned about future tax obligations of the IRA Required Minimum Distributions. I estimated our combined 401k's will total at least $1.5MM at age 70.......and I'll have a $24,000/year pension----and I'm 7 years older than my wife (who'll have the bigger 401k). I'm concerned about the impact of setting aside at least 25% of my IRA withdrawls for Taxes. That really bites!  

Unsure what to do, but gut is telling me to stick with the Traditional IRA?


Have you been doing Roth IRA's? Will you have a gap between retiring and collecting the pension and Social Security? If you are maxing out tax advantaged space (and hence investing in taxable space) and will have other substantial taxable income in retirement, like pensions and Social Security, there is an advantage to going the Roth route, at least partially. But I don't know if it is enough to overcome the gap between the 33% and 25% brackets. You would have to do some careful analysis. It might be a dice roll either way.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby JamesSFO » Tue Feb 11, 2014 9:29 am

Cherokee8215 wrote:I don't know your employer's setup, but at mine, they only match dollars in the traditional 401k and not the Roth. Something to consider. Personally, I put up to the maximum match in the traditional and put the rest in the Roth.


I think you are misunderstanding this, the MATCH itself will always be traditional IRRESPECTIVE of your contribution type.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby freddie » Tue Feb 11, 2014 10:20 am

17k in a roth is worth more than 17k in a traditional but it is worth about the same as 17k in a traditional and 5k in taxable account. Depending on your exact situation one or the other might be better but the difference tend to be minor. The advantage of the Roth in a lot of cases is to avoid RMDs and takes on SS more than to help with taxes but this is very income/situation dependent.


BanditKing wrote:
Iorek wrote:Personally I like to do the traditional and then use the money saved for a backdoor Roth IRA, which gives you money in both types of accounts.


I've already maxed my backdoor ROTH as well, and at this point am investing in taxable, so anything to put more into advantaged space is a good thing I'd think.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rustymutt » Tue Feb 11, 2014 10:28 am

If in retirement, you expect to earn more than you currently do, then the Roth is an ideal tool for lowering taxes. If on the other hand, you'd expect to be making less, and don't believe taxes a problem, then stick to what you do now. It's all about projecting the future into a thought and planning ahead.
I would go with the Roth in a heartbeat myself. Pay me now, or pay me later. You need to determine that yourself.
At the Very Least, Work Hard, Do Your Best, Know the Truth and the Facts and Always Be Honest!
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby Dandy » Tue Feb 11, 2014 10:36 am

I didn't have the opportunity to use a Roth 401k until the year before retirement. So I am blessed with a very large IRA (after converting my 401k).
When I project my RMD at age 70 it starts off with a very reasonable amount but jumps up rather quickly and will push me to a higher tax bracket than I anticipated till I die. I am blessed with a pension and plan to take SS at age 70.

I am doing some Roth conversions now while I am in a lower tax bracket. I'm hoping that will keep me in that bracket longer when the RMD. So if I had more Roth contributions in my working days I would have given up some tax deductions then but might be in a better place later in retirement. Also, who knows what the tax rates will be 20 or so years from now?

I had a do over I would probably split the contributions between Roth and Traditional 401k and put equities in the Roth and fixed income in the 401k.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Tue Feb 11, 2014 10:50 am

Dandy wrote:I had a do over I would probably split the contributions between Roth and Traditional 401k and put equities in the Roth and fixed income in the 401k.


It is easier to rebalance if one has both equities and fixed income in the same account.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby sunnyday » Tue Feb 11, 2014 10:58 am

I personally like to save on taxes now and would go the traditional 401k + $5,500 in taxable route. A lot could happen between now and your retirement. This would give more flexibility and save you money if you retire in a lower tax bracket. If or when you build up a massive nest egg (~$2million) or RMDs become a concern, I would then consider a Roth


rkhusky wrote:
Dandy wrote:I had a do over I would probably split the contributions between Roth and Traditional 401k and put equities in the Roth and fixed income in the 401k.


It is easier to rebalance if one has both equities and fixed income in the same account.


The point of the equities in the Roth is that the equities should grow faster, thus saving on future taxes. Rebalancing is just a simple spreadsheet calculation so it's well worth the tax savings IMO.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby sscritic » Tue Feb 11, 2014 11:09 am

BanditKing wrote:I expect to be in that same tax bracket when I retire.

Just checking: you are single and don't expect to get married.

[Married people get divorced and have spouses die, which changes their tax brackets. Single people sometimes marry, which changes their tax brackets.]
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Tue Feb 11, 2014 12:35 pm

sunnyday wrote:The point of the equities in the Roth is that the equities should grow faster, thus saving on future taxes. Rebalancing is just a simple spreadsheet calculation so it's well worth the tax savings IMO.


If you had all equities in Roth and all fixed income in a regular 401K, would you not rebalance? If you would, how would you accomplish it?
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby DSInvestor » Tue Feb 11, 2014 1:33 pm

rkhusky wrote:If you had all equities in Roth and all fixed income in a regular 401K, would you not rebalance? If you would, how would you accomplish it?
Rebalancing is easy in this scenario. If you need more bonds that your bond filled Traditional 401(k), you buy bonds in the Roth IRA which can be done with new money or by exchanging stocks for bonds in the Roth IRA. Conversely, if you need more stocks than your stock filled Roth IRA, you use new money to buy stocks in the 401k or exchange bonds for stocks in the 401k. There's no rule that says you can't have stocks in 401k or bonds in Roth IRA.

My taxable account is 100% stocks. My IRA holds bonds first, then stocks if there is room. I just try to fill my AA in the most tax efficient manner. As long as I have stocks and bonds in any one account, I can rebalance the entire portfolio by taking action in that one account. Should my IRA space be completely filled with bonds, I would rebalance with new money for by exchanging stocks for bonds or bonds for stocks in the appropriate accounts.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby sunnyday » Tue Feb 11, 2014 1:51 pm

rkhusky wrote:
sunnyday wrote:The point of the equities in the Roth is that the equities should grow faster, thus saving on future taxes. Rebalancing is just a simple spreadsheet calculation so it's well worth the tax savings IMO.


If you had all equities in Roth and all fixed income in a regular 401K, would you not rebalance? If you would, how would you accomplish it?


AA takes priority over tax efficiency so I would rebalance.

For tax-efficiency reasons it doesnt make sense to have bonds in Roth while having equity in traditional.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby sscritic » Tue Feb 11, 2014 1:57 pm

In thinking about taxes in retirement, don't forget IRMAA.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby smalldata » Tue Feb 11, 2014 3:30 pm

TFB has an excellent set of posts on this:
Even if you're in the same tax bracket now as in retirement, the traditional 401k may still be advantageous.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby markcoop » Tue Feb 11, 2014 3:41 pm

When my employer started offering a ROTH 401K a few years, I initially did it to be able to put more money into tax-advantaged space. But then I realized that I lost money because I was losing the child tax credit. I then switched back.

One other point. Unlike a ROTH IRA, a ROTH 401K may be subject to a RMD.
Mark
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby Dandy » Tue Feb 11, 2014 3:59 pm

It is easier to rebalance if one has both equities and fixed income in the same account

True. You can put a small % of fixed in the Roth and/or adjust future contributions. If equities need trimming you can sell some Roth equities for some fixed income. My main point was to have the major growth in Roth and less in IRA to limit RMD s later in retirement and most likely increase your tax free withdrawals from your Roth if needed.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby simpsonlang » Tue Feb 11, 2014 4:21 pm

So if your today's dollars SSI retirement benefit is 40k per year and your RMD pushes you into the 80% taxation of benefits then contributing more towards a roth, to push your RMDs down, is worth it even if the taxes on a federal level appear to be a loss. Trying to figure out how much is a loss is the trick. So if your able to deduct a huge amount from a high enough tax bracket then roth might not be worth it even with the SSI taxation. Aside from Esplanner I'm not sure of any software that can really figure this out. I know when I switch Trad to Roth in Esplanner for my situation it always shows Roth being the winner but that is my situation. Though I don't plan on 100% on everything being Roth so I'm not one way or the other so as time goes by if my RMDs look lower than I predict then I'll do more traditional.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby telemark » Tue Feb 11, 2014 4:29 pm

rkhusky wrote:
telemark wrote:If you're still in a 25% tax bracket when you take the money out, you end up with $1768.87 * 0.75, or $1326.65, same as you got with the Roth. Where people usually go wrong is by comparing the amount that hits the 401K instead of the amount that comes out of the pay check.

If you're frustrated with the contribution limits and wish you could contribute more, the Roth is a way to get that effect.


This is only valid if there is another source of income filling all the lower tax brackets, such that all the funds you withdraw from your traditional account are taxed at 25%.


Good point, I was oversimplifying. I think this can also apply on the contributions side: if your income is just above the boundary for a tax bracket, some of your tax deferral may be at different rates.

Short form: it's all about tax rates, when you contribute and when you withdraw.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby rkhusky » Tue Feb 11, 2014 5:17 pm

sscritic wrote:In thinking about taxes in retirement, don't forget IRMAA.


Great. Another income-based tax.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby lrak » Tue Feb 11, 2014 9:16 pm

markcoop wrote:Unlike a ROTH IRA, a ROTH 401K may be subject to a RMD.


Right now you can roll the Roth 401k to a Roth IRA at 70.4 and then there is no RMD. I don't expect that to change.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby sscritic » Tue Feb 11, 2014 10:14 pm

BanditKing wrote:I'm currently (almost) 43 and solidly in the 25% bracket

Assuming you are exactly in the middle, you make $54,726, $62,051, $87,026, or $109,451. Keep your taxable income as it is and change filing status by retirement, and you might not be in the 25% bracket anymore. Some of these numbers are in the 15% bracket and some are in the 28% bracket.
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Re: Math with Wine is Hard: Traditional 401k vs Roth 401kby dharrythomas » Tue Feb 11, 2014 10:32 pm

First, let me admit that I didn't do all the math.

I've got two pensions. One will start at 59.25 and the other probably at 62. They plus SS should bring in initially about what I make now (that will increase 20-25% at age 65-67). Could go earlier or later than 62, but that appears to be the sweet spot for a FERS pension if you spent enough time in the private sector so that you don't qualify for a pension plus retiree health care short of 60.

We've maxed out IRAs most years from when the limit was $2,000 although for a number of those years, DW didn't work and she never had a retirement account. I invested at least enough to get the match when I had an account available. We raised two kids, through college & weddings with minimal student loans. We've paid off the house and owe no money (other than repaying a buyout that will come out of the pension). We've maxed Roth IRAs since they started.

I anticipate that we'll have over $500K in our traditional accounts by the time I retire. We're putting everything into Roth accounts at this point. 15% in the TSP and a little into Roth IRAs. I think this is Enough, so I'm not going to further stress DW to continue saving over $30K a year so we can say we maxed it out. And that doesn't factor in the small taxable account or the inheritance I anticipate.

Roth: 1) I like knowing what's mine! 2) Roth is a better account to leave to the kids. Unless something goes badly wrong we won't need to take the Roth money out. 3) No MRDs, I do have to transfer the Roth TSP to an IRA. 4) My father was a CPA, he had several clients who whined a great deal about about having to take money out of various plans and pay taxes. We'll be paying enough taxes in retirement! The only thing going into traditional at this point is the match!

My situation is not the norm and my decision was more feel than calculation so it may not be the maximizer, but it satisfies us. Make your own decisions based on your own unique set of circumstances. Then accept that whatever decision you make will probably not be the BEST based on how history actually develops. You pay your money, you take your chances.

So far, I've managed to muddle through OK.

Good Luck!

Harry
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