Author Topic: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA  (Read 5407 times)

Cheddar Bob

  • 5 O'Clock Shadow
  • *
  • Posts: 20
My employer offers both traditional 401k and Roth 401k.  It's through Vanguard, which is awesome, and I'm able to maximize my contributions.  However, I had been under the impression that "maximizing" meant contributing $18,000 to the traditional 401k and $5,500 for the Roth 401k.  I just realized that the $18,000 limit is for BOTH traditional and Roth, so I'm now wondering what mix of traditional and Roth I should pursue.

I had thought that the benefit of a 401k was that you could contribute pre-tax earnings.  So I'm wondering if it's even worth it to use $5,500 of my $18,000 limit on Roth, which are post-tax earnings.  Wouldn't I be better off contributing $18,000 solely to traditional 401k and then contributing $5,500 to a Roth IRA? 

lpep

  • Bristles
  • ***
  • Posts: 286
  • Location: Hanoi, VN
    • My MMM journal
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #1 on: April 26, 2015, 08:46:58 PM »
First: 401k max is $18000. IRA max is $5500. Roth or traditional doesn't matter. I think you get that but just so it's clear :)

Mad Fientist has a good post on this topic: http://www.madfientist.com/traditional-ira-vs-roth-ira/

Basically, because Roth anything is post-tax money and traditional is pre-tax, you can invest more and thus get more return from a traditional 401k/IRA. So you're right on that. The issue is then avoiding paying a buttload of taxes on your future withdrawals. Your options:

1. Use a traditional 401k and IRA. When you quit your job, roll your t. 401k into your t-IRA. You wouldn't want to convert a traditional 401k into Roth IRA because you would pay taxes on all that money in the year you quit your job and roll it over. Mad Fientist argues you should use traditional everything during your working years since you can convert a traditional IRA to a Roth IRA in early retirement, little by little as the years pass, by staying within the standard tax deductions, since t-IRA deductions count as standard income. You could pay little to no taxes this way and get the best of both worlds. You could also pay about the same or more tax depending on where you get income during RE, since this money is being converted to a Roth for later use in most cases, and you can't always predict the future accurately. Some people think the government might change the rules eventually and tax growth on Roth IRAs/401ks, and this method also requires keeping a close watch on everything year by year after RE. So: trade-offs.

2. Use Roth everything. After tax, simpler. MF says this keeps growth lower, but if you're in a lower tax bracket now than you think you might be after FIRE for some reason, it could be a good idea.

3. Mix things up to hedge your bets! Usually, if you buy into the MF way of thinking, there's a clear path for you each year depending on your salary and tax bracket, but it really depends on what you're comfortable with and what your future plans are (as well as your current and future tax brackets).

There are also mandatory withdrawals once you hit 70, I think, with t-IRAS, and those don't exist for Roth. So your future self might thank you for using a Roth, but again, the Roth conversion is an option.

Note that Roth conversion is different from the Roth pipeline, which is a way to access Roth IRA funds without paying the 10% penalty before turning 59.5 years old.

Good luck Cheddar Bob, and please, someone correct me if I got something wrong - it's a complicated topic.

« Last Edit: April 26, 2015, 08:50:42 PM by lpep »

MDM

  • Walrus Stache
  • *******
  • Posts: 9609
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #2 on: April 26, 2015, 10:41:00 PM »
there's a clear path for you each year depending on your salary and tax bracket, but it really depends on what you're comfortable with and what your future plans are (as well as your current and future tax brackets).
^This.

Anyone who says the right path is obvious - and provides simple "Do X" advice - is making assumptions.  If you fit the assumptions, then follow the advice - except sometimes the assumptions aren't clearly stated.  To make an informed choice, you need to predict the future.  Easy, right?  Well, at least make an informed guess about your financial future.  Specifically, what overall tax rate will you pay on your tax-deferred withdrawals later, compared with the marginal tax rate you save by investing now.

See also http://www.gocurrycracker.com/roth-sucks/ and http://forum.mrmoneymustache.com/ask-a-mustachian/tax-bracket-question/ for some pictures showing the difference between marginal and overall tax rates.

Gocurrycracker makes the assumption that you will have little to no income other than withdrawing from your tax deferred account.  If so, then his conclusion that "Roth sucks" is correct.  But if you do have significant other income (e.g., pension, SS, 457, etc.) then it may not be as clear cut.

I think in most cases traditional will be better, but it's up to you to evaluate your own.

seattlecyclone

  • Magnum Stache
  • ******
  • Posts: 4982
  • Age: 34
  • Location: Seattle, WA
    • My blog
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #3 on: April 27, 2015, 08:44:17 AM »
Specifically, what overall tax rate will you pay on your tax-deferred withdrawals later, compared with the marginal tax rate you save by investing now.

I've seen this guideline a few times (comparing overall tax rate at retirement to marginal tax rate now), but I don't really understand the reasoning behind it. It seems that you should be able to take your current tax-deferred account balance as well as any other potential retirement income sources, and extrapolate what your taxable income in retirement might be if you stopped all of your pre-tax contributions and went with Roth from now on.

Given that you already have some sort of baseline for what your tax bracket might be if you don't contribute to a traditional 401(k) anymore, by adding more money to the traditional account you're adding marginal dollars to your taxable income at retirement, and should therefore consider what your marginal tax rate will be at that time. The overall tax rate doesn't seem like a useful metric because you already might be planning to use up the lowest bracket or two, and the marginal dollar is what would matter more. You're just trading marginal taxes now for marginal taxes later. Am I missing something here?

ShoulderThingThatGoesUp

  • Magnum Stache
  • ******
  • Posts: 3057
  • Location: Emmaus, PA
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #4 on: April 27, 2015, 09:02:42 AM »
My employer offers both traditional 401k and Roth 401k.  It's through Vanguard, which is awesome, and I'm able to maximize my contributions.  However, I had been under the impression that "maximizing" meant contributing $18,000 to the traditional 401k and $5,500 for the Roth 401k.

It does, at least that's the assumption I've been operating on. Can you point to a reference that says otherwise?

Eric

  • Magnum Stache
  • ******
  • Posts: 4061
  • Location: On my bike
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #5 on: April 27, 2015, 10:09:42 AM »
My employer offers both traditional 401k and Roth 401k.  It's through Vanguard, which is awesome, and I'm able to maximize my contributions.  However, I had been under the impression that "maximizing" meant contributing $18,000 to the traditional 401k and $5,500 for the Roth 401k.

It does, at least that's the assumption I've been operating on. Can you point to a reference that says otherwise?

I think you misread.  Both items referenced above are 401k contributions.  It's correct if the second one is an IRA instead, but that's not what's written.

MDM

  • Walrus Stache
  • *******
  • Posts: 9609
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #6 on: April 27, 2015, 12:31:18 PM »
I've seen this guideline a few times (comparing overall tax rate at retirement to marginal tax rate now), but I don't really understand the reasoning behind it. It seems that you should be able to take your current tax-deferred account balance as well as any other potential retirement income sources, and extrapolate what your taxable income in retirement might be if you stopped all of your pre-tax contributions and went with Roth from now on.

Given that you already have some sort of baseline for what your tax bracket might be if you don't contribute to a traditional 401(k) anymore, by adding more money to the traditional account you're adding marginal dollars to your taxable income at retirement, and should therefore consider what your marginal tax rate will be at that time. The overall tax rate doesn't seem like a useful metric because you already might be planning to use up the lowest bracket or two, and the marginal dollar is what would matter more. You're just trading marginal taxes now for marginal taxes later. Am I missing something here?
Good perspective.  As you note one's situation changes as one accumulates more in the tax-deferred account.  Gets even more complicated when one has to decide "in what year?" a contribution made today will be withdrawn, as one's bracket may well change (e.g., due to SS, RMDs, etc.).

ShoulderThingThatGoesUp

  • Magnum Stache
  • ******
  • Posts: 3057
  • Location: Emmaus, PA
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #7 on: April 27, 2015, 01:04:40 PM »
My employer offers both traditional 401k and Roth 401k.  It's through Vanguard, which is awesome, and I'm able to maximize my contributions.  However, I had been under the impression that "maximizing" meant contributing $18,000 to the traditional 401k and $5,500 for the Roth 401k.

It does, at least that's the assumption I've been operating on. Can you point to a reference that says otherwise?

I think you misread.  Both items referenced above are 401k contributions.  It's correct if the second one is an IRA instead, but that's not what's written.

Oh, jeepers. I may have screwed up here. Not that it really matters, savings is savings, right?

Cheddar Bob

  • 5 O'Clock Shadow
  • *
  • Posts: 20
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #8 on: April 27, 2015, 02:16:12 PM »
Is it possible to have this retirement mix:
-$12,500 Traditional 401k
-$5,500 Roth 401k
-$5,500 Roth IRA

If not, I think I will do $18,000 traditional 401k and $5,500 Roth IRA.  I can contribute the max to both and I also need to open a brokerage account with Vanguard to dump my savings.

seattlecyclone

  • Magnum Stache
  • ******
  • Posts: 4982
  • Age: 34
  • Location: Seattle, WA
    • My blog
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #9 on: April 27, 2015, 02:26:23 PM »
Is it possible to have this retirement mix:
-$12,500 Traditional 401k
-$5,500 Roth 401k
-$5,500 Roth IRA

If not, I think I will do $18,000 traditional 401k and $5,500 Roth IRA.  I can contribute the max to both and I also need to open a brokerage account with Vanguard to dump my savings.

Yes. You have an $18k contribution limit for your 401(k) that you can split however you want between pre-tax and Roth. Completely separately from this, you have a $5,500 contribution limit for IRAs that you can split however you want between pre-tax and Roth (provided you meet the relevant income requirements).

Cheddar Bob

  • 5 O'Clock Shadow
  • *
  • Posts: 20
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #10 on: April 27, 2015, 06:28:07 PM »
Thanks everyone for clearing up my confusion.  Will definitely need to give some thought to how I want to set my retirement mix.  I have enough to contribute the max and I'm not subject to any income phase-outs.

One last thing...so is the only benefit of an employee-sponsored 401k the potential matching of contributions?  Otherwise, you could just set up your own retirement account if you were self-employed, right?

Joel

  • Pencil Stache
  • ****
  • Posts: 775
  • Location: California
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #11 on: April 27, 2015, 10:26:31 PM »
Specifically, what overall tax rate will you pay on your tax-deferred withdrawals later, compared with the marginal tax rate you save by investing now.

I've seen this guideline a few times (comparing overall tax rate at retirement to marginal tax rate now), but I don't really understand the reasoning behind it. It seems that you should be able to take your current tax-deferred account balance as well as any other potential retirement income sources, and extrapolate what your taxable income in retirement might be if you stopped all of your pre-tax contributions and went with Roth from now on.

Given that you already have some sort of baseline for what your tax bracket might be if you don't contribute to a traditional 401(k) anymore, by adding more money to the traditional account you're adding marginal dollars to your taxable income at retirement, and should therefore consider what your marginal tax rate will be at that time. The overall tax rate doesn't seem like a useful metric because you already might be planning to use up the lowest bracket or two, and the marginal dollar is what would matter more. You're just trading marginal taxes now for marginal taxes later. Am I missing something here?

Agreed. It's bad advice. You should be looking at your expected marginal rate in retirement. I may be at a marginal 25% tax rate right now, but my overall tax rate upon retirement is not relevant for to whether or not I should contribute another dollar. If I have enough tax deferred savings to put me in the 25% marginal tax rate upon retirement already, then it is a wash, and a Roth could actually make sense in case you need to draw on those contributions your first few years of retirement. Of course, you have to build a sizeable tax deferred nest egg before this situation is a reality, but you still should be comparing marginal now to marginal upon retirement.

MDM

  • Walrus Stache
  • *******
  • Posts: 9609
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #12 on: April 28, 2015, 02:44:08 AM »
Agreed. It's bad advice. You should be looking at your expected marginal rate in retirement. I may be at a marginal 25% tax rate right now, but my overall tax rate upon retirement is not relevant for to whether or not I should contribute another dollar. If I have enough tax deferred savings to put me in the 25% marginal tax rate upon retirement already, then it is a wash, and a Roth could actually make sense in case you need to draw on those contributions your first few years of retirement. Of course, you have to build a sizeable tax deferred nest egg before this situation is a reality, but you still should be comparing marginal now to marginal upon retirement.

Hah!  Right you and SC are.  Need to go back to gocurrycracker and note that Roth doesn't suck quite so much...after I edit some of my own posts. ;)

Easy enough to see that if other income is available in retirement, the deferred funds are taxed "on top of" the other income, but yes even if the income is 100% from tax-deferred the comparison needs to be made on marginal rates.

Should've trusted the Bogleheads thread that showed Roth is better even with identical marginal rates if one maximizes contributions.





seattlecyclone

  • Magnum Stache
  • ******
  • Posts: 4982
  • Age: 34
  • Location: Seattle, WA
    • My blog
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #13 on: April 28, 2015, 08:01:19 AM »
If you max out your retirement accounts and you plan to have the same or higher marginal tax rate in retirement and you know you won't need to withdraw the earnings from your Roth account early, Roth contributions are slightly better than tax-deferred contributions. The reason is that the money you save on taxes when contributing to your traditional 401(k) has to go somewhere. If it's a taxable account you'll be stuck paying tax on the dividends and capital gains until you retire (or longer, if you plan to have a fancypants retirement in the 25% bracket). If you contribute to the Roth account instead and don't have that chunk of tax savings to invest, any intermediate transactions are tax-free.

Now this doesn't mean you should be maxing out your Roth account for most of your career when you have a tax-deferred option available to you. The great paradox with Roth accounts is that the more you contribute to them, the less likely these contributions will be a good idea because every Roth contribution lowers your expected retirement income, and thus your expected retirement tax bracket. Again, it's all about what you expect your marginal rate at retirement to be.

oldfierm

  • 5 O'Clock Shadow
  • *
  • Posts: 47
  • Age: 38
Re: benefit of a Roth 401k? confused about traditional, roth, 401k, IRA
« Reply #14 on: April 28, 2015, 08:11:53 AM »

[\quote] Yes. You have an $18k contribution limit for your 401(k) that you can split however you want between pre-tax and Roth. Completely separately from this, you have a $5,500 contribution limit for IRAs that you can split however you want between pre-tax and Roth (provided you meet the relevant income requirements).
[/quote]

THIS.  This is true.  Some employers offer both Roth and pre-tax 401Ks, with a total deferal limit of 18,000.  The Roth IRA is seperate from this 401K.  How you decide to divide everything up, however, is up to you. 

I know this is redundant, but I saw a lot of incorrect information in the early responses and wanted to help ensure the right information got to OP. 
« Last Edit: April 28, 2015, 08:15:14 AM by oldfierm »