Author Topic: Allocation to roth IRAs and taxable accounts  (Read 7031 times)

J2

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Allocation to roth IRAs and taxable accounts
« on: July 09, 2016, 12:15:29 PM »
I recently read Go Curry Cracker's article on why he favors taxable accounts over roth IRA after maxing out 401k space (http://www.gocurrycracker.com/roth-sucks/). 

I recently read through a discussion on this (http://forum.mrmoneymustache.com/taxes/go-curry-cracker-roth-vs-taxable/), but I am still uncertain what to do personally and was hoping I could get some advice.  I fall into a situation where the income of my wife and I is too high to qualify for a traditional IRA deduction.  We are both 30 years old and hope to be financially independent in about 10-15 years.

Here is what I'm working with:
Annual gross household income: $132,600
Total annual savings: $64,200 (includes employer matches)

For starters, I know to do the following:
401k contributions: max out at $36,000
HSA contributions: max out at $6,600

That brings us to $42,600, leaving $21,600 for savings. At this point, should my wife and I max out our roth IRAs before hitting the taxable account or should we just plow it all into taxable?  We currently invest $900 every month into a taxable account at Vanguard and put about $900/month into roth IRAs. 

So far we have about ~60k in assets, with about $7k in taxable.

Paul der Krake

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Re: Allocation to roth IRAs and taxable accounts
« Reply #1 on: July 09, 2016, 12:25:26 PM »
Actually, if you do max out both 401(k)s and the family HSA, your AGI drops to under 90k a year, and you get to fully deduct your $11,000 for two traditional IRAs.

The AGI limit for traditional IRA deduction for married filing jointly in 2016 is 98k, so even with a raise you would have a buffer.

https://www.irs.gov/retirement-plans/plan-participant-employee/2016-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work


seattlecyclone

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Re: Allocation to roth IRAs and taxable accounts
« Reply #2 on: July 09, 2016, 12:58:03 PM »
I agree with the Go Curry Cracker article about traditional vs. Roth, but I disagree with him about Roth vs. taxable. Under current tax law, people with lower incomes pay equal federal tax under both options (namely, $0). However there may still be state taxes to consider. Also the 0% capital gains rate is a fairly recent invention, having only existed since 2008. There's no guarantee it will last for your entire retirement.

The one downside to Roth accounts is that the growth is subject to rather high taxes if it is withdrawn prior to age 60. However my feeling on that is that if you get yourself into a position where you're less than 60 years old and the only money you have left to draw from is Roth earnings, you probably didn't save enough to last your entire retirement even if it was in a taxable account.

J2

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Re: Allocation to roth IRAs and taxable accounts
« Reply #3 on: July 09, 2016, 02:11:48 PM »
Wow, thank you so much, I totally forgot that income limits for traditional IRA contributions are based on your income after 401k and HSA contributions!  So in our case, our AGI would be:
 132,600 - 36,000(401k) - 6600 (HSA) = $90000

Is that right?  If only I realized this before making some contributions to roth IRAs already this year!  Better late than never I suppose.

Regarding state income taxes, we did pay about 6.8% on AGI, and the AGI would include income from dividends in a taxable account, right? In high tax states, it would seem sensible then to contribute to roth IRAs before taxable if you can't contribute to a traditional.

seattlecyclone

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Re: Allocation to roth IRAs and taxable accounts
« Reply #4 on: July 09, 2016, 02:35:52 PM »
Regarding state income taxes, we did pay about 6.8% on AGI, and the AGI would include income from dividends in a taxable account, right? In high tax states, it would seem sensible then to contribute to roth IRAs before taxable if you can't contribute to a traditional.

Every state has different laws, but I would generally expect your taxable account dividends to generate some state tax liability if you live in a state with income tax.

If you do get to the point where you can't make deductible traditional IRA contributions due to income restrictions, it's likely your tax bracket is high enough that you would owe some federal tax on dividends every year until you retire. Yet another reason to prefer Roth over taxable!

MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #5 on: July 11, 2016, 07:43:20 PM »
One more reason to prefer Roth over taxable: once you start taking SS, Roth withdrawals won't affect your SS taxation, but capital gains and dividends may.

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Re: Allocation to roth IRAs and taxable accounts
« Reply #6 on: July 11, 2016, 08:16:07 PM »
Another thing I forgot to mention: capital gains count as income for the purpose of calculating your Obamacare subsidies even if they are in a bracket where they are taxed at 0%. Roth withdrawals do not. Therefore you may find that this income has a de facto non-zero tax rate as the subsidy phases out, even if the nominal tax rate on it is zero.

terran

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Re: Allocation to roth IRAs and taxable accounts
« Reply #7 on: July 12, 2016, 05:41:34 AM »
Two things:

6600 (HSA)

The HSA limit for a family plan this year is $6750

If only I realized this before making some contributions to roth IRAs already this year!  Better late than never I suppose.

Recharacterizing from Roth to Traditional (or the reverse) isn't hard. Just call up your custodian and they'll be able to help, then you need to add a statement to your taxes explaining what you did.

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #8 on: July 14, 2016, 08:02:37 AM »
Don't touch Roth. With your high income keep in mind that traditional retirement account contributions save you tax at the top marginal rate which I believe is 25% for you. At the time you want to withdraw money, it is taxed "bottom up" at your EFFECTIVE tax rate which will probably be 10-15% depending on how much you pull out.

MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #9 on: July 14, 2016, 08:16:42 AM »
With your high income keep in mind that traditional retirement account contributions save you tax at the top marginal rate which I believe is 25% for you.
Yes, you save at your current marginal savings rate.

Quote
At the time you want to withdraw money, it is taxed "bottom up" at your EFFECTIVE tax rate which will probably be 10-15% depending on how much you pull out.
If only this were so.  It is not.  Any traditional money contributed now will be taxed on withdrawal at the marginal rate on top of any pension, SS, and previously made traditional contributions.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth.  You have to compare marginal now vs. marginal later.  "Effective" is irrelevant.

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #10 on: July 14, 2016, 08:31:47 AM »
With your high income keep in mind that traditional retirement account contributions save you tax at the top marginal rate which I believe is 25% for you.
Yes, you save at your current marginal savings rate.

Quote
At the time you want to withdraw money, it is taxed "bottom up" at your EFFECTIVE tax rate which will probably be 10-15% depending on how much you pull out.
If only this were so.  It is not.  Any traditional money contributed now will be taxed on withdrawal at the marginal rate on top of any pension, SS, and previously made traditional contributions.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth.  You have to compare marginal now vs. marginal later.  "Effective" is irrelevant.

...right. So for most of us who are early retirees, we will not be collecting SS or pensions at the time we begin withdrawing from the 401k. The distributions are taxed as ordinary income. Not sure what you mean by "previously made traditional contributions"

http://www.bankrate.com/finance/taxes/how-are-401k-withdrawals-taxed.aspx
« Last Edit: July 14, 2016, 08:39:35 AM by armueller2001 »

MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #11 on: July 14, 2016, 08:43:33 AM »
[f only this were so.  It is not.  Any traditional money contributed now will be taxed on withdrawal at the marginal rate on top of any pension, SS, and previously made traditional contributions.
See https://www.bogleheads.org/wiki/Traditional_versus_Roth.  You have to compare marginal now vs. marginal later.  "Effective" is irrelevant.
...right. So for most of us who are early retirees, we will not be collecting SS or pensions at the time we begin withdrawing from the 401k. The distributions are taxed as ordinary income. Not sure what you mean by "previously made traditional contributions"

It is the "previously made traditional contributions" that make it necessary to compare marginal now vs. marginal later.  As the bogleheads wiki states,
Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions
Does that make sense?

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #12 on: July 14, 2016, 08:54:52 AM »
Does that make sense?

I must be missing something. Is there a numerical example you could provide? I'd appreciate it.

johnny847

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Re: Allocation to roth IRAs and taxable accounts
« Reply #13 on: July 14, 2016, 09:09:56 AM »
Does that make sense?

I must be missing something. Is there a numerical example you could provide? I'd appreciate it.

It goes something along the lines of

Suppose you have 500k already in your traditional IRA, and that its your only assets for retirement. By the 4% rule you can withdraw 20k a year from it.
Any extra contributions to your tIRA would result in withdrawals that are taken after first withdrawing your 20k a year. So let's say you put in another 10k. That's another 400 you can withdraw per year. But you were already go in to withdraw 20k a year because you already have 500k in the account. That extra 400 a year you can withdraw is now taxed at a marginal rate of 15% (assuming you're single).

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #14 on: July 14, 2016, 09:10:52 AM »
Does that make sense?

I must be missing something. Is there a numerical example you could provide? I'd appreciate it.

It goes something along the lines of

Suppose you have 500k already in your traditional IRA, and that its your only assets for retirement. By the 4% rule you can withdraw 20k a year from it.
Any extra contributions to your tIRA would result in withdrawals that are taken after first withdrawing your 20k a year. So let's say you put in another 10k. That's another 400 you can withdraw per year. But you were already go in to withdraw 20k a year because you already have 500k in the account. That extra 400 a year you can withdraw is now taxed at a marginal rate of 15% (assuming you're single).

Got it. But who the hell is simultaneously withdrawing and contributing to their IRA/401k?

johnny847

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Re: Allocation to roth IRAs and taxable accounts
« Reply #15 on: July 14, 2016, 09:26:33 AM »
Does that make sense?

I must be missing something. Is there a numerical example you could provide? I'd appreciate it.

It goes something along the lines of

Suppose you have 500k already in your traditional IRA, and that its your only assets for retirement. By the 4% rule you can withdraw 20k a year from it.
Any extra contributions to your tIRA would result in withdrawals that are taken after first withdrawing your 20k a year. So let's say you put in another 10k. That's another 400 you can withdraw per year. But you were already go in to withdraw 20k a year because you already have 500k in the account. That extra 400 a year you can withdraw is now taxed at a marginal rate of 15% (assuming you're single).

Got it. But who the hell is simultaneously withdrawing and contributing to their IRA/401k?

I'd imagine very few people.

I didn't mean in this example that someone simultaenously withdraws and contributes. I meant because of the $500k, you can withdraw 20k a year when you retire. And by adding another 10k, you can withdraw another $400 per year when you retire.

Sure there's nothing stopping you from withdrawing earlier than that, but my assumption was that this hypothetical person wouldn't.

MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #16 on: July 14, 2016, 09:30:44 AM »
Got it. But who the hell is simultaneously withdrawing and contributing to their IRA/401k?
Nobody.  But that's not what johnny847's example implied.

The contribution occurs now.  The withdrawal occurs later. 

The contribution saves the marginal savings rate now.  The withdrawal pays the marginal tax rate later.

Roth = Original amount * (1 - marginal_tax_rate_now) * Growth
Traditional = Original amount * Growth * (1 - marginal_tax_rate_later)

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #17 on: July 14, 2016, 09:39:39 AM »
Got it. But who the hell is simultaneously withdrawing and contributing to their IRA/401k?
Nobody.  But that's not what johnny847's example implied.

The contribution occurs now.  The withdrawal occurs later. 

The contribution saves the marginal savings rate now.  The withdrawal pays the marginal tax rate later.

Roth = Original amount * (1 - marginal_tax_rate_now) * Growth
Traditional = Original amount * Growth * (1 - marginal_tax_rate_later)

So let me get this straight. If I stop working and begin pulling out $50K from my IRA annually, I will be taxed on the marginal rate (15%) and not on the effective rate? (13.1% because the first 18,450 is at 10%)


ender

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Re: Allocation to roth IRAs and taxable accounts
« Reply #18 on: July 14, 2016, 09:56:55 AM »
Got it. But who the hell is simultaneously withdrawing and contributing to their IRA/401k?
Nobody.  But that's not what johnny847's example implied.

The contribution occurs now.  The withdrawal occurs later. 

The contribution saves the marginal savings rate now.  The withdrawal pays the marginal tax rate later.

Roth = Original amount * (1 - marginal_tax_rate_now) * Growth
Traditional = Original amount * Growth * (1 - marginal_tax_rate_later)

So let me get this straight. If I stop working and begin pulling out $50K from my IRA annually, I will be taxed on the marginal rate (15%) and not on the effective rate? (13.1% because the first 18,450 is at 10%)

When you withdraw from your IRA, that income becomes your actual income - meaning, if you withdraw $50k it's the equivalent of making $50k in salary for this calculation (there are other factors).

You are using the married brackets, so the way it would work for federal taxes assuming no other sources of income or deductions:

  • First 12600 + 8000, nothing (exemption/standard deduction), total: $22600
  • Next $18450, 10%, total withdrawal: $41,050, taxes: $1845
  • Next $8950, 15%, total withdrawal: $50,000, taxes: $3187


This results in an effective rate of about 6.3% for your federal income taxes, for a married couple withdrawing $50k from an IRA. State/city taxes also will apply.

A key observation is the marginal rates you put the money in at is almost certainly higher than 6.2%.


MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #19 on: July 14, 2016, 10:26:11 AM »
So let me get this straight. If I stop working and begin pulling out $50K from my IRA annually, I will be taxed on the marginal rate (15%) and not on the effective rate? (13.1% because the first 18,450 is at 10%)
This results in an effective rate of about 6.3% for your federal income taxes, for a married couple withdrawing $50k from an IRA. State/city taxes also will apply.

You need to distinguish between "sunk costs" (or "water under the bridge" or whatever phrase you choose for traditional IRA contributions you made in past years) vs. the choices you can still make in this and subsequent years.

Taking this example, we assume that if you stop working now you can pull $50K/yr from your IRA.  That's fine, it is what it is.  The taxes you pay on that $50K/yr, however, have no effect whatsoever on what you ought to to for this year's contribution. 

That's because the withdrawal taxes you will pay on the results of this year's contribution will be the taxes on the amount above $50K you can withdraw due to this year's contribution.

cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #20 on: July 14, 2016, 12:43:22 PM »
So let me get this straight. If I stop working and begin pulling out $50K from my IRA annually, I will be taxed on the marginal rate (15%) and not on the effective rate? (13.1% because the first 18,450 is at 10%)
This results in an effective rate of about 6.3% for your federal income taxes, for a married couple withdrawing $50k from an IRA. State/city taxes also will apply.

You need to distinguish between "sunk costs" (or "water under the bridge" or whatever phrase you choose for traditional IRA contributions you made in past years) vs. the choices you can still make in this and subsequent years.

Taking this example, we assume that if you stop working now you can pull $50K/yr from your IRA.  That's fine, it is what it is.  The taxes you pay on that $50K/yr, however, have no effect whatsoever on what you ought to to for this year's contribution. 

That's because the withdrawal taxes you will pay on the results of this year's contribution will be the taxes on the amount above $50K you can withdraw due to this year's contribution.

I fail to see how this invalidates the statement that 401K distributions are taxed on a "bottom-up" basis. You're just adding more to the (potential) top if you add more during your contribution phase.

MDM

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Re: Allocation to roth IRAs and taxable accounts
« Reply #21 on: July 14, 2016, 02:34:03 PM »
I fail to see how this invalidates the statement that 401K distributions are taxed on a "bottom-up" basis. You're just adding more to the (potential) top if you add more during your contribution phase.
The important point - from the perspective of deciding whether to use Roth or traditional for a given contribution - is the bolded sentence.  The amount you added to the (potential) top is taxed at your marginal, not effective, rate.

Yes, a traditional distribution is included in income that is taxed according to US tax law, with all its brackets, credits, phaseouts, etc.  When you fill out form 1040 in a given year, your income for that year is indeed taxed on a "bottom-up" basis.

If you had to make a one-time, effective for the rest of your working career, choice on traditional vs. Roth, then using the "effective" withdrawal tax rate (and the "effective" cumulative contribution rate) for analyzing that choice would be appropriate.

Fortunately, tax law allows you to switch your choice from year to year.  For that matter, you can split each year dollar by dollar, but assuming a yearly choice is good enough.

What statement(s) in https://www.bogleheads.org/wiki/Traditional_versus_Roth#Marginal_tax_rates do you disagree with?


cheapass

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Re: Allocation to roth IRAs and taxable accounts
« Reply #22 on: July 14, 2016, 02:59:36 PM »
What statement(s) in https://www.bogleheads.org/wiki/Traditional_versus_Roth#Marginal_tax_rates do you disagree with?

A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom"

Withdrawls do come from the bottom. You can choose to pull out 30K, or 50K, or 200K per year. You'll be taxed accordingly, bottom to top just like ordinary income.

seattlecyclone

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Re: Allocation to roth IRAs and taxable accounts
« Reply #23 on: July 14, 2016, 03:16:26 PM »
What statement(s) in https://www.bogleheads.org/wiki/Traditional_versus_Roth#Marginal_tax_rates do you disagree with?

A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom"

Withdrawls do come from the bottom. You can choose to pull out 30K, or 50K, or 200K per year. You'll be taxed accordingly, bottom to top just like ordinary income.

Yes, you start withdrawing in lower brackets and work your way up. It's the same as salary income in this regard.

What's also the same is that if you're already in the 15% bracket, the next dollar you withdraw will be taxed at 15% even if your previous dollars were only taxed at an average of 5%. By that token, it's not right to say "I expect to have a 5% average tax rate in retirement, so the next dollar I contribute to an IRA will be taxed at 5%."

No. You've already contributed some number of dollars to an IRA, which you expect to grow to a certain level by the time you retire. You're already planning to take out 4% (or whatever) of that amount. The lower tax brackets might already be spoken for with the money you have in your traditional IRA right now. If you add more money to the pot, you'll be increasing the amount you can withdraw each year. You need to look at what tax you would pay on this additional amount: a marginal rate.

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Re: Allocation to roth IRAs and taxable accounts
« Reply #24 on: July 14, 2016, 03:55:14 PM »
You'll be taxed accordingly, bottom to top just like ordinary income.
That statement is true - we agree.

That statement is also irrelevant to the "traditional vs. Roth" question - can you see why that is true?

Here is a specific example.  Assume you
 - are a single person paying 15% marginal rate now.
 - have saved and invested well, and if you never make another contribution your traditional accounts will contain $1,250,000 at retirement. 
 - will withdraw 4% ($50K for a $1250K balance) per year, and that will be your only income.

Under those conditions your withdrawal tax rates are
  Effective = 10.8%
  Marginal = 25.0%

You decide to keep working and contributing to your retirement accounts (thus the nest egg will be larger than $1250K), and get to choose whether to put this year's $18K into traditional or Roth.  Do you
1) put it into traditional because 10.8% is less than 15%, or
2) put it into Roth because 25% is greater than 15%?

For your sake, given the assumptions, I hope you would choose option #2 because that will give you more spendable income in retirement.  This is the point we are trying to illustrate - is it clear, or clear as mud?

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Re: Allocation to roth IRAs and taxable accounts
« Reply #25 on: July 14, 2016, 05:03:23 PM »
You'll be taxed accordingly, bottom to top just like ordinary income.
That statement is true - we agree.

That statement is also irrelevant to the "traditional vs. Roth" question - can you see why that is true?

Here is a specific example.  Assume you
 - are a single person paying 15% marginal rate now.
 - have saved and invested well, and if you never make another contribution your traditional accounts will contain $1,250,000 at retirement. 
 - will withdraw 4% ($50K for a $1250K balance) per year, and that will be your only income.

Under those conditions your withdrawal tax rates are
  Effective = 10.8%
  Marginal = 25.0%

You decide to keep working and contributing to your retirement accounts (thus the nest egg will be larger than $1250K), and get to choose whether to put this year's $18K into traditional or Roth.  Do you
1) put it into traditional because 10.8% is less than 15%, or
2) put it into Roth because 25% is greater than 15%?

For your sake, given the assumptions, I hope you would choose option #2 because that will give you more spendable income in retirement.  This is the point we are trying to illustrate - is it clear, or clear as mud?

Got it, I was being dense. Thank you for explaining!

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Re: Allocation to roth IRAs and taxable accounts
« Reply #26 on: July 14, 2016, 05:38:40 PM »
Got it, I was being dense. Thank you for explaining!

No problem.  The "marginal vs. effective" approach seems so reasonable at first glance that this topic comes up often.

See Traditional 401k versus Roth 401k - Bogleheads.org for one of the longer, more recent discussions.  Also Roth vs Traditional 401K - Bogleheads.org from eight years ago.

You are much less dense than some of the posters in those threads. :)

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Re: Allocation to roth IRAs and taxable accounts
« Reply #27 on: July 14, 2016, 06:14:40 PM »
If you had to make a one-time, effective for the rest of your working career, choice on traditional vs. Roth, then using the "effective" withdrawal tax rate (and the "effective" cumulative contribution rate) for analyzing that choice would be appropriate.

Fortunately, tax law allows you to switch your choice from year to year.  For that matter, you can split each year dollar by dollar, but assuming a yearly choice is good enough.

This is a good point (considering existing balances) and one I'm glad you made.

It is also important to recognize that your marginal rate can change per year even for the same income and that the decision is a "new" decision. When we have kids, I suspect we will put some Roth money in because our marginal rate will be lower. Or higher, as my income might go way up.

One additional consideration is the timing of withdrawals. If you plan on retiring at 40, this planning gets even more complicated. Assuming the same tax code, you can at 40:

  • Do Roth conversions
  • Withdraw from your traditional 401k (and pay a penalty
  • Withdraw Roth IRA principle
  • Withdraw Roth conversions after 5 years

this requires planning in addition to your 59.5+ retirement years when IRAs are available normally. A lot of other factors start influencing these decisions, such as "do I want to use Roth principle as ER funding?" or "will I have RMDs from inherited IRAs?" or "do I have a pension income?" or "how will I fund ER?" to name a few.

For me, given that I expect my income to be zero from ER by the time I am 50 the likelihood of me being able to convert some traditional IRA to Roth for free is much better than if I was planning a purely normal retirement at age 65. The net effect on this conversation is that the "what % of portfolio do I need to be Roth vs traditional given withdrawal %" question gets... much less straightforward fairly quickly.