Roth 401k or 401k? - lots of calculations done. sanity check
by terrycwu » Wed Mar 19, 2014 1:15 am
Hey guys! I'm new to the forum and would really appreciate some advice on whether I should contribute completely to the Roth 401k, the 401k, or both.
I will have enough funds to contribute max of both the 401k AND IRA limit. (For 2014 = 17500+5500 = 23000)
I've inputed the salary data on an excel spreadsheet and came up with close estimates of what my federal taxes and state taxes would be, and thought i'd post here to see if my logic is flawed or maybe i'm missing something.
I'm currently in the 25% income bracket with a 9.3% california income bracket.
Assuming a yearly return rate of a conservative 5%, compounding 40 years, and a retirement bracket of 25% (assuming living in non-income tax state).
TRADITIONAL
Traditional Pre-tax value (40 years later) Tax(25%) Post tax value
23000 154209 - 38552 115657
7352 (cash flow from saved taxes) 49293 - 10485 38808
154465
Roth Post tax val tax
23000 154209 0 Traditional - Roth = 154465-154209 = 256
My logic is that, since maxing out the traditional 401k+IRA will save me 7352 (after 2014 tax bracket calculations, I still make less than the TIRA phase out limit) in tax compared to if I put all that 23k into Roth 401k + Roth IRA. That extra cash flow is therefore able to go into a taxable account in Vanguard/Fidelity, and as a result, I thought I should include that as investments earning a 5% interest each year too as opportunity cost. When I do take that taxable amount out, only Gains-Principle is taxed, at the assumed retirement bracket of 25%.
From the calculations it looks like the 2 options are pretty even, which made me lean towards going Traditional, simply because it provides more liquidity. Purchasing property is not out of the picture for me down the road, so perhaps saving up that liquid investment for downpayment is the way to go?
On the other hand, I don't know whether I'll be living in a non-income tax state when I retire, so that retirement bracket could be higher than 25%. Uncertainty analysis tells me that a 26% tax bracket will flip the decision towards Roth side, and at 30%, for the next 5 years I should be going Roth too given predicted salary raise. The higher the rate of return, the more I should go towards Traditional too, and I think the average rate of return would likely >5%.
Am I missing out on anything? Is my logic flawed in any way? Seems to me that traditional is clearly the better option in this case due to its liquidity.
Appreciate any feedback.
Thanks!
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by Johm221122 » Thu Mar 20, 2014 3:15 am
Welcome to forum
I would lean towards traditional
John
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by celia » Thu Mar 20, 2014 5:31 am
Terry, From your post, I can assume you are in your 20's (since you don't plan on retiring for 40 years and this appears to be your first contribution). You are also in a field where you are making good money since you are able to save this much each year at such a young age and because you are already in the 25% federal bracket. I also assume that your salary will increase as you get more experience in your field, thus pushing you into higher tax brackets in your working years. It is smart of you to save this much at this time, if you can afford it.
The usual recommendation is to put money into Roths or convert to Roths when you are in lower tax brackets. You might not ever be in lower brackets unless you become unemployed or take time off from your career. You seem to have a saver's mentality so far (and probably no spouse or kids) but you may not stay this way for 40 years. As your taxable savings grow, you will get dividends or interest that will be taxed on top of your other income (which is rising, remember). When you retire, you may not be in the 25% tax bracket, especially if you are eligible for a pension and social security. At age 70, you will have to take distributions from your traditional IRA and they will be taxed on top of your other income at that time.
OK, I'm projecting far into the future for you, but this is what I see if you are already in the 25% tax bracket. (To verify it, calculate your tax liability for an entire year using tax software, then add $100 to your wages to see if your federal and state liability really increase by 25% and 9.3%)
If my assumptions are correct, I think you should take the Roth route since your tax rate after you retire can easily be over 25% in your circumstances. If I am way off on my assumptions, let me know what you expect instead.
Also, don't forget to also save 6 months pay in an emergency fund that you can tap when needed.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by Bob's not my name » Thu Mar 20, 2014 6:56 am
You're making a "saturated case" argument, meaning that you're assuming you'll always be able to completely fill your available tax-advantaged space. Is that realistic? You say you're under the deductible TIRA phaseout, which starts at $60,000 MAGI. If you're sheltering none of your income from taxes, then your MAGI is pretty close to your gross income, maybe exactly your gross income if no pre-tax insurance premiums are withheld from your pay (because, for example, you're still riding free on your parents' health insurance, thanks to the ACA). $60,000 of gross income, completely unprotected from taxes (Roth choice), would yield a pretty hefty tax bill. And then there's SS and Medicare (regardless of your Roth/traditional choice). And then you're saying you can still afford to put $23,000 into Roth accounts. It seems to me this will leave you with less than $1,500/month to live on ... in California. Maybe you're doing that now, but for how many years can you maintain such a low cost of living? It would take you years to save up for a car, never mind a house.
The saturated case argument falls apart if you can't indefinitely max out your tax-advantaged space, even after you're married and have $46,000 of space available. That's because you've assumed the saved taxes in the traditional scenario must be invested in a taxable account for the next forty years. What if they're invested in taxable space only for one year, because next year you effectively move them into your 401k? (What this really means is you draw down your taxable account for living expenses or a car or a house while still maxing your 401k.)
Alternatively, let's assume you can continue this horrific savings rate for eternity. People who save half their income are very likely to retire early. Early retirement gives you years or decades with zero income, which allows you to convert your traditional accounts to Roth at very low tax rates, even 0%.
Finally, voluntarily paying painfully high taxes now (about a third), means you're betting you will never in the next half century be unemployed (voluntarily or involuntarily), return to school full-time, be disabled, get married, have kids, die leaving dependents, or move to a lower tax state (no state has a significantly higher tax rate than California, and most give huge tax breaks to wealthy retirees).
I recommend traditional. Once you've accumulated so much money in tax-advantaged space that you face the unspeakable horrors of wealth, large RMDs after 70, and possibly being in the 25% bracket from 70 until you enter a nursing home (which is fully deductible and will throw you back into the 0% federal bracket), then you can switch to Roth.
Actually I recommend traditional 401k and Roth IRA, since that hedges your bets and keeps your slate clean in the unfortunate event your income more than doubles and you must do a back door Roth.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by rkhusky » Thu Mar 20, 2014 1:57 pm
Do you expect a large pension? Do you expect to remain in the 25% bracket through your career? Do you expect to retire early and/or defer SS to age 70? The rate of return on your investments applies to both Roth or Traditional, so it doesn't play much of a role in the decision of which to use.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by terrycwu » Thu Mar 20, 2014 2:19 pm
Wow I am so glad I found this forum.
Thanks for the very constructive advices!! I've already learned so much just from reading other people's posts on here.
@celia
Yes I"m in my early 20s and recently just graduated college. No spouse, no kids, and likely not getting married in the next 10+ years. I am also fortunately to not have debt, and a lot of expenses (food, transportation, rent) are covered through work. Looking at historical data on average raises and promotions, I'm projecting to be hitting the 28% bracket in 3 years, which makes me think that if there is a time for me to ever do Roth, it'll be right now.
I suppose the main factor becomes, what my predicted retirement bracket would be... ?
What sort of retirement income do people generally receive? So far I can only think of taxable accounts, TIRA, 401k, social security (is that taxable?)
Is having so much taxable retirement fund that it goes above the current 25% realistic?
@NotBob
I made the saturated case scenario at least for the next few years because there's enough savings stashed away for me at this point (fortunately through parental funding), that I could comfortably live with a slightly negative cash flow for the next few years, which makes leveraging complete tax advantage a little bit more realistic. I'm definitely not planning on maxing out that limit every year. I'm optimistically assuming that at some point I"ll realize that the retirement fund is large enough and then I"ll only contribute up to company match. Your point regarding early retirement makes a lot of sense. It's clearly hard to predict the future, but early retirement is definitely possible, so going from traditional -> Roth at 0% tax rate does make sense. Could you go the other way around and go Roth -> Traditional?
I'm also not paying any FICA taxes for at least 2 years due to my visa status. As a result I can't take the standard deduction and must itemize. I suppose this would lean towards favouring Roth for those 2 years. You make a great point about liquid savings.. By taking full tax advantage, I'm giving up on liquid savings which significantly lowers my disposable income for a car or housing.
Thanks again guys!
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by Bob's not my name » Thu Mar 20, 2014 2:25 pm
terrycwu wrote:Could you go the other way around and go Roth -> Traditional?
Yes. See:
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by catspaw » Thu Mar 20, 2014 3:02 pm
Are you assuming all of the traditional IRA balance will be taxed at 25% in retirement? If so, it is much messier than that.
Things to consider:
1) The 10% and 15% brackets - If you are living on less than the cutoff for the 25% bracket, none of your Traditional withdrawals will be taxed at 25%.
2) RMDs - Currently, you have to take out about 3.6% at age 70.5 per year of all traditional IRAs/401k (with the exception of your 401k if you are still working for that company). The % you must withdraw each year goes up based on your life expectancy. This can push you up to a higher tax bracket later in retirement if you have sizable traditional IRA/401k assets. Note, this would be less true if when you retire the average life expectancy is 120.
3) SS - a variable amount of your SS benefits will be taxed based on your income for the year
4) Can you gain any additional tax credits/deductions by contributing this year to traditional. If so, your marginal tax rate is higher than 34% (fed+state)
5) Don't forget to add in the taxes you pay each year for the taxable savings
6) If you retire early, you will have several years to convert to Roth's with little tax impact.
One of the financial genius on this board figured out, maxing out all of your Roth's was better than Traditional 401k/IRA + taxable as long as your tax rate in retirement was less than 7% higher than your current tax rate. With your assumptions of current marginal tax rate of 34% and retirement tax rate of 25%, the traditional would be the way to go. I.E. your retirement tax rate is less than 34%+7%, therefore, traditional is better.
However, all of the tax laws you are using to plan the optimal amounts in a traditional vs Roth will change over the next 40 years. Personally, I try to max out a traditional 401k, Roth IRA then save the rest in taxable. But no one knows what will turn out to be the best.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by broadreach » Thu Mar 20, 2014 4:30 pm
Don't overlook the impact of state taxes. You are paying a lot in state income taxes now with few avenues of reducing state taxes. A traditional 401K is one way to reduce state income taxes by reducing your W2 wages. Many states have lower state income tax rates and a handful have no state income tax. Your personal situation could change a lot in 40 years and you may well retire somewhere other than CA, NY or NJ. You can always convert some to Roth after retiring before mandatory RMDs (70 1/2) and social security (can be deferred until age 70) push you into a higher bracket.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by rkhusky » Thu Mar 20, 2014 5:00 pm
Here are a couple of examples:
Withdraw $100K from a Traditional 401K with no pension or SS or other income, standard deductions, married filing jointly: average tax cost - 12%.
Withdraw $60K from a Traditional 401K with $40K of SS and no pension or other income, standard deductions, married filing jointly: average tax cost on the 401K withdrawal portion - 17%.
If you are paying 25% now and expect to be in similar situations in retirement, traditional is better than Roth. Of course, the current situation is no guarantee of a future situation.
You can play with TaxCaster to do similar calculations for simple returns.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by celia » Thu Mar 20, 2014 9:29 pm
catspaw wrote:However, all of the tax laws you are using to plan the optimal amounts in a traditional vs Roth will change over the next 40 years.
Most of the state tax rates will also change in the next 40 years.
One way to "hedge your bets" is to diversify your holdings: put some in traditional and some in Roth.
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Re: Roth 401k or 401k? - lots of calculations done. sanity c
by Bob's not my name » Fri Mar 21, 2014 5:36 am
broadreach wrote:Many states have lower state income tax rates and a handful have no state income tax. Your personal situation could change a lot in 40 years and you may well retire somewhere other than CA, NY or NJ.
New York tax is lower than California unless you live in NYC. Furthermore, taxpayers over 59.5 get to exclude $20K of IRA income. Note that young age -- allows for a decade of conversions before RMDs start.
I believe only Oregon and Washington DC rival California for a high tax rate and no special breaks for IRA withdrawals.
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