Monday, February 17, 2014

Traditional 401k vs. Roth 401k

Over at Bogleheads we came across the following discussion: Traditional 401k vs. Roth 401k

Traditional 401k vs. Roth 401kby bigez17 » Sun Feb 16, 2014 11:44 am

I am interested in perspective regarding the pros and cons of whether to invest in traditional or Roth 401k.


If we start with the fact that we do not know what the tax rates will be when the money is taken out (no one has crystal ball) then we cannot compare to current rates, expelling the rate argument. It matters, but is all speculation.


I would also dismiss the argument of whether or not the Roth will continue to receive favorable congressional treatment, again speculation.


That brings me to the only differences I conclude we can compare:


1) with a Roth 401k we can escape any tax on principal and earnings withdrawn
2) we can pass on to heirs a more valuable inheritance
3) we can roll over to Roth IRA and avoid 70 1/2 required minimum distribution
4) by putting max amount in ($17,500 or $23,000) Roth, the whole amount is available vs. the ultimately taxable same amount which means less overall dollars to be available after taxes
5) we will spend more to fund Roth given the need to pay taxes now and not receive a tax break now


It is #4 that puts the decision over the top and thinking the Roth is the way to go.


I would appreciate your insights.
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Re: Traditional 401k vs. Roth 401kby freebeer » Sun Feb 16, 2014 11:46 am

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Re: Traditional 401k vs. Roth 401kby livesoft » Sun Feb 16, 2014 11:51 am

I guess I will try to throw a wrench into this.


It is not a "traditional 401(k) vs Roth 401(k)" decision. It is a "Traditional 401(k) + taxable investments vs Roth 401(k)" decision.


Does a traditional 401(k) give you tax breaks that will make your taxable investments tax-free?
Can you withdraw your taxable investments tax-free and that way make your traditional 401(k) withdrawals tax-free as well?
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Traditional 401k vs. Roth 401kby DSInvestor » Sun Feb 16, 2014 12:00 pm

Contributions to Traditional 401k give you a tax deduction at your marginal bracket. Taxation of withdrawals from Traditional 401k can vary greatly depending on the composition of your income in retirement. For example if you have a generous defined benefit pension that consumes your 0% and low tax brackets, your 401k withdrawals will be taxed at a higher rate than if you do not have pension. Without a pension, the 401k withdrawals are taxed at 0% first to consume deductions and exemptions and then creep up the tax brackets. As long as the tax code provides for deductions and exemptions, there will be a 0% tax bracket even if tax rates may be higher. Run some numbers with taxcaster to see what the tax cost for 20k, 40K, 60K, 80K of IRA/401k withdrawal would be with no other income.


I did not have a defined benefit pension. I maxed out Traditional 401k, Roth IRA, and also invested in taxable accounts. The Traditional IRA contributions gave me a tax break in 25-33% Fed tax bracket and 6-8% state. My tax savings allowed me to invest more in taxable accounts and have more take home pay to accelerate mortgage payments, student loans, house/car purchase etc. After I stopped working, I tapped assets in taxable accounts and that was so tax efficient that I was able to convert Traditional assets to Roth for little or no tax cost. Roth 401k contributions would not have been the way to go in my situation. I'm very happy to get a tax deduction at 40% and convert at 0-10%. YMMV.
Last edited by DSInvestor on Sun Feb 16, 2014 12:13 pm, edited 1 time in total.
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Re: Traditional 401k vs. Roth 401kby retiredjg » Sun Feb 16, 2014 12:13 pm

bigez17 wrote:If we start with the fact that we do not know what the tax rates will be when the money is taken out (no one has crystal ball) then we cannot compare to current rates, expelling the rate argument. It matters, but is all speculation.


I'd argue it is not all speculation. Yes, there is some speculation involved about what future taxes will look like, but I believe it is pretty clear that most people are in a lower bracket or the same bracket in retirement.



It is #4 that puts the decision over the top and thinking the Roth is the way to go.


It is #4 where you have made your error.



4) by putting max amount in ($17,500 or $23,000) Roth, the whole amount is available vs. the ultimately taxable same amount which means less overall dollars to be available after taxes


If the tax rate is the same going into Roth 401k as it would be coming out of traditional 401k, you end up with the same amount of money, to the penny.


If all your assets are in Roth status, you could actually end up with less money in the end because you need some income in retirement to fill up the lower tax brackets. If you don't fill the lower tax brackets with money that has not yet been taxed (SS, pension, withdrawals from traditional IRA/401k/403b), you will be taking it all from Roth which might have been taxed quite heavily on the front end.
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Re: Traditional 401k vs. Roth 401kby Calm Man » Sun Feb 16, 2014 3:20 pm

OP, without realizing it you have given responders no real choice except to disagree with your assumptions. Because you start out by throwing out 2 of the major arguments against this as speculation and therefore not worth considering. In fact, it is the unexpected or less expected events that can have the most profound influences on situations. So unless you come to terms with that, I do not think you will find any of the input useful.
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Re: Traditional 401k vs. Roth 401kby billfromct » Sun Feb 16, 2014 4:17 pm

I would use (for myself or if I was advising my kids) the following guide lines based on age & marginal tax rate


-under 30, Roth 401K (all tax brackets because you have 35-40 years of tax free compounding & ultimate tax free withdrawal)
-30 to 40, Roth 401K if 25% & lower tax bracket (you still have 25-35 years of tax free compounding & ultimate tax free withdrawal), Traditional 401K if 28% tax bracket & higher
-40 & older, Traditional 401K


bill
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Re: Traditional 401k vs. Roth 401kby fungus_amungus » Sun Feb 16, 2014 4:34 pm

For me the decision was mostly pension related. My wife will receive a pension that will fill the lower tax brackets by itself and push us into 15% without an extra dime. We will also likely receive a significant windfall at some point. We are currently in the 15% bracket so it makes sense for me to go ahead and pay the tax man and go Roth
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Re: Traditional 401k vs. Roth 401kby retiredjg » Sun Feb 16, 2014 4:48 pm

fungus_amungus wrote:For me the decision was mostly pension related. My wife will receive a pension that will fill the lower tax brackets by itself and push us into 15% without an extra dime. We will also likely receive a significant windfall at some point. We are currently in the 15% bracket so it makes sense for me to go ahead and pay the tax man and go Roth


You have 2 independent factors that argue FOR using Roth now.


  • First is the pension which will fill much of your lower brackets.
Second is getting money into Roth at only 15%.
Even if/when you move into the 25% bracket, you might want to continue to put some money into Roth 401k, in my opinion. But I would use some traditional as well so you'll have money in retirement to finish filling the 15% bracket. Yes, I know it won't be exactly the same then, but you get the idea.
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Re: Traditional 401k vs. Roth 401kby fungus_amungus » Sun Feb 16, 2014 5:45 pm

retiredjg wrote:
fungus_amungus wrote:For me the decision was mostly pension related. My wife will receive a pension that will fill the lower tax brackets by itself and push us into 15% without an extra dime. We will also likely receive a significant windfall at some point. We are currently in the 15% bracket so it makes sense for me to go ahead and pay the tax man and go Roth


You have 2 independent factors that argue FOR using Roth now.


  • First is the pension which will fill much of your lower brackets.
Second is getting money into Roth at only 15%.
Even if/when you move into the 25% bracket, you might want to continue to put some money into Roth 401k, in my opinion. But I would use some traditional as well so you'll have money in retirement to finish filling the 15% bracket. Yes, I know it won't be exactly the same then, but you get the idea.



I don't want to hijack the topic but I did have a question here.


Because I have a taxable account and plan to take advantage of tax gain harvesting given my 15% tax bracket and thus no federal capital gains tax, I'm guessing it would benefit me to scale my Roth contributions to traditional to stay in the 15% bracket given increases in income over time right?


For instance in 2013 numbers, I would start going traditional when our combined gross income exceeds 72500 + 12200 standard deduction + 3900 exemption (me) + 3900 exemption (wife) + 3900 exemption (daughter) + 1000 child tax credit = $97400 in order to maintain this capital gains federal exemption right? Or have I missed something with regards to how the federal brackets are calculated?


Edit: By the way, thanks to livesoft for making me aware of tax gain harvesting yesterday. It's going to be tricky because I live in Tennessee have to keep capital gains and dividends under $2500 before getting taxed, but I do have a bit of wiggle room anyway.
Last edited by fungus_amungus on Sun Feb 16, 2014 6:01 pm, edited 1 time in total.
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Re: Traditional 401k vs. Roth 401kby grabiner » Sun Feb 16, 2014 5:51 pm

livesoft wrote:I guess I will try to throw a wrench into this.


It is not a "traditional 401(k) vs Roth 401(k)" decision. It is a "Traditional 401(k) + taxable investments vs Roth 401(k)" decision.



And with that situation, the Roth 401(k) is better if your marginal tax rate is the same as it will be in retirement, but still worse if your marginal tax rate is significantly higher. (Note "marginal tax rate", not "tax bracket"; if you are in the phase-out of the child tax credit, your tax bracket is 25% but the child tax credit phases out at 5%, giving you a total marginal rate of 30%.)

If your marginal rate is only 25%, the Roth is likely to be better, as you will likely either retire in the 25% bracket, or in the 15% bracket with the phase-in of taxable Social Security giving you a 27.75% marginal tax rate. (Still better would be to convert to a traditional 401(k) at 25% deduction, and then convert some of it to a Roth at 15% before you start taking Social Security; this would apply if you expect to retire before taking Social Security and won't be filling up the 15% bracket with 401(k) withdrawals in those years.) David Grabiner

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