Roth 401k vs. standard 401k

[moof]

Our company 401k let's me choose between either a Roth 401k, or a regular 401k.  I did some digging, and frankly I don't see the point of the Roth 401k option.  Am I missing something?

Regular 401k:  Pre-tax money, harder to pull out, taxed on the back end.  I will likely be in the 15% federal tax bracket upon withdrawal (with a good chunk taxed taxed at less than that), state taxes will depend on where I live.  The absolute worst case is I pay a 10% penalty for early withdrawal, putting the net loss to federal taxes at about 25% (though a lot would still only be subject to the 10% penalty).  So I see an upper tax rate ceiling on money done this route approaching ~34% if I stay in Oregon and do everything wrong in how I withdraw it.  More likely this money will get taxed more like 10-20%, maybe less depending on how I spread out my regular Roth and taxable account money during the gap before 59.5 and use the 72(t) strategy as the meat of my money.

Roth 401k:  Post-tax money, easier to pull a lot of it back out for early retirement.  Currently I am in the 25% federal bracket, and 9% state bracket.  So money through this route would effectively be fully pre-taxed at 34%, which is then lost forever.

As best I can tell the only real advantage of the Roth option is if I plan to retire to a state with higher state income taxes than the one you earn your money in, or if you expect the federal tax rates to go up significantly in the future.  So why the heck is this option around?  Has anyone else found a use of this bizarre mashup option?

The only argument I have found is that the Roth version squirrels away more buying power (18k of post-tax instead of 18k of pre-tax), so if you are undisciplined and are likely to squander the larger take home pay you end up with with a Roth 401k you end up better off in retirement.  But I shovel everything that is not bolted down into additional savings so that does not apply to this community.

[tonysemail]

yeah, agreed.  this makes sense in the first X years after college, while wages are lowest.
once you hit the higher tax brackets, it's much more favorable to defer the taxes now and optimize the withdrawal later

[markstache]

I think you have the measure of it. If you had less income or lived in a lower tax state, the Roth might have advantages for you, but you have run the numbers and see the best option. The other thing to think about is if you want to bet on tax rates increasing or decreasing over the long term (either at a federal level or by you moving to a lower tax state). Increasing rates generally favor the Roth, decreasing rates the traditional.

[Jack]

The answer for normal people saving only a small percentage of their income is "it depends on the tax rate." But for Mustachians, traditional is effectively always better because your very high savings rate implies that your income while working is going to be much higher than your income after FIRE.

(The "worst" case scenario when it doesn't apply is when you have runaway investment compounding and either inflate your lifestyle or are forced to take Required Minimum Distributions that increase your retirement income into a higher tax bracket... but are you really gonna complain about that?!)

But I shovel everything that is not bolted down into additional savings so that does not apply to this community.

You should invest in a Crescent wrench and take care of that problem too!

; )

[moof]

Thanks guys, glad I am not missing something.

I like the crescent wrench idea, or at least a dolly.  I need to sell some of the crap in my garage...

Next year should be even better than this one.  This year I had to replace a roof, pay off the last used car, and get a bunch of siding work done (sorry, not nearly as handy as MMM) and I still managed to save about 30%.  Basically next year I should be able to save an new car's worth more than this year and be up past 50%.  My goal is to have at least half what I need for my ~12 year gap till 59.5 in Roth base contributions and taxable funds so I can do the SEPP thing at the minimum allowable calculation and still be sure I will make it.

[Spork]

(The "worst" case scenario when it doesn't apply is when you have runaway investment compounding and either inflate your lifestyle or are forced to take Required Minimum Distributions that increase your retirement income into a higher tax bracket... but are you really gonna complain about that?!)

So... I had a Roth 401k for a while.  I wish I had had the opportunity to have had one longer.  I guess I represent Jack's worst case scenario.

I did all my pre-FIRE planning with the idea that I would get no inheritance.  I did that because (1) I wanted to be conservative and (2) I wanted to feel like I did it on my own.

Enter: the inherited IRA.  This here is your worst case scenario.  Sure, it's a first world problem.  I get that.  But the way inherited RMDs work, there is a distinct possibility that your own traditional IRA RMDs and your inherited IRA RMDs are on course to collide with a pretty gigantic tax implication. 

Long story short: if the chances you'll inherit a significant IRA are out there, you might do better paying tax now and putting it in the Roth 401k.

[shuffler]

I did some digging, and frankly I don't see the point of the Roth 401k option.  Am I missing something?

My company offers both.  My salary is enough that I would never contribute to the Roth at the expense of contributions to the traditional.

However, I do still use the Roth 401k, and am very glad it exists.

I employ the backdoor Roth 401k technique (sometimes called "Mega backdoor roth").  I contribute post-tax dollars to my 401k, and initially they receive no preferential tax-treatment at all.  But then I do an in-service conversion of those after-tax contributions into the Roth account, and they do get the tax-deferred treatment at that point.

This way I'm able to contribute the standard $18k to my traditional 401k, plus an additional $20k (my particular plan's limit) indirectly to the Roth 401k.

Some plans allow for the after-tax contributions to be rolled-over into an external (i.e. outside of the company's 401k plan) IRA account.  My company's plan doesn't allow that, but it does allow this in-service conversion to the Roth 401k.  Which is why I'm glad the Roth 401k account exists, even if I'd never directly contribute to it.

[Undecided]

I did some digging, and frankly I don't see the point of the Roth 401k option.  Am I missing something?

My company offers both.  My salary is enough that I would never contribute to the Roth at the expense of contributions to the traditional.

However, I do still use the Roth 401k, and am very glad it exists.

I employ the backdoor Roth 401k technique (sometimes called "Mega backdoor roth").  I contribute post-tax dollars to my 401k, and initially they receive no preferential tax-treatment at all.  But then I do an in-service conversion of those after-tax contributions into the Roth account, and they do get the tax-deferred treatment at that point.

This way I'm able to contribute the standard $18k to my traditional 401k, plus an additional $20k (my particular plan's limit) indirectly to the Roth 401k.

Some plans allow for the after-tax contributions to be rolled-over into an external (i.e. outside of the company's 401k plan) IRA account.  My company's plan doesn't allow that, but it does allow this in-service conversion to the Roth 401k.  Which is why I'm glad the Roth 401k account exists, even if I'd never directly contribute to it.

At first I thought you misunderstood the Roth 401(k) vs. the after-tax traditional 401(k), but I was wrong; but still, I'm not sure the ability to do an in-service conversion from after-tax to Roth 401(k) is relevant to the OP's question about contributions; the OP doesn't mention having an after-tax 401(k) option; is that a given?

[shuffler]

I'm not sure the ability to do an in-service conversion from after-tax to Roth 401(k) is relevant to the OP's question about contributions

Sure it's relevant.
OP was asking "why does the Roth 401k option exist" and "has anyone found a use for it" (paraphrased).  I was attempting to give reasons for both those questions.
It could be that it exists to receive rollovers, and I've used my own that way.

It's also relevant to the "contributions" question, because the ability to do a backdoor Roth 401k means you can (effectively) do both and don't have to choose between them.  Go ahead and contribute the "full" $18k as traditional, because you can still do another $20k (in my case, at least) as Roth.

the OP doesn't mention having an after-tax 401(k) option; is that a given?

No, I don't think it's a given.  But maybe OP will go look it up in his specific plan, and have a somewhat more tax-advantaged place to put the savings that we know they're doing beyond the normal 18k contribution limit.

[Undecided]

Thanks, Shuffler, all good points. I don't have the in-plan conversion option---I wonder if there's a reason weighing against it. I have had the in-service rollover-to-IRA option and after-tax contributions for four years, so have been able to do much the same thing, but it is relatively cumbersome.

[MDM]

(The "worst" case scenario when it doesn't apply is when you have runaway investment compounding and either inflate your lifestyle or are forced to take Required Minimum Distributions that increase your retirement income into a higher tax bracket... but are you really gonna complain about that?!)

So... I had a Roth 401k for a while.  I wish I had had the opportunity to have had one longer.  I guess I represent Jack's worst case scenario.
I did all my pre-FIRE planning with the idea that I would get no inheritance.  I did that because (1) I wanted to be conservative and (2) I wanted to feel like I did it on my own.
Enter: the inherited IRA.  This here is your worst case scenario.  Sure, it's a first world problem.  I get that.  But the way inherited RMDs work, there is a distinct possibility that your own traditional IRA RMDs and your inherited IRA RMDs are on course to collide with a pretty gigantic tax implication. 
Long story short: if the chances you'll inherit a significant IRA are out there, you might do better paying tax now and putting it in the Roth 401k.

All good points and reasons why a Roth (either 401k or IRA) might be preferable.

Two additional considerations: pensions and social security payments. 

In short, for those who will have significant "other" income, the Roth option can be preferable.  For those who won't, traditional will likely be better.  See also Traditional versus Roth - Bogleheads.