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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: tannybrown on June 27, 2012, 01:41:28 PM

Title: Roth 401k or Traditional 401k
Post by: tannybrown on June 27, 2012, 01:41:28 PM
I know others have asked this question but I was hoping to get something specific to our situation. 

-We are in the 15% tax bracket so we put in 5% pre-tax my 401k ($3425/year), and get a 5% match from the company (for another $3425)
-We also make a 5% Roth 401k contribution into the same plan
-Any bonuses from work go 50/50 between Roth 401k and Traditional 401k
-Max out both her Roth IRA and mine ($5k each)

As we're in a low 15% tax bracket now, our strategy was to load up in Roth-type accounts now and book the low tax rate.  However, a majority of our retirement savings are now in the Roth-type accounts ($13,425/year) vs. tax deferred 401k ($6,850).

When my wife gets her PhD and starts working, or if I get raises, and we go to the 25% bracket we'd switch to put all our 401k contributions as tax deffered.

Is this the right strategy?  I've heard arguments to say that even though we're in the 15% bracket now, our effective tax rate is still higher now (maybe 10%) than it will be in retirement (closer to 0%) so we're still better off deferring, almost regardless of our current income.  Changes to the tax code could also effectively tax Roth distributions if a tax on consumption is enacted.

On the flip side, income taxes could be significantly higher 10, 20, 30 years from now.

What say you, MMM gurus?
Title: Re: Roth 401k or Traditional 401k
Post by: grantmeaname on June 27, 2012, 01:47:00 PM
If you're retiring early, you need a minimum of five years' living expenses in Roth or regular brokerage accounts, because that's how long it takes money you've taken from a regular 401k sitting in a Roth IRA before it's accessible.
Title: Re: Roth 401k or Traditional 401k
Post by: tannybrown on June 27, 2012, 01:50:07 PM
Does that hold true for Roth 401k contributions (not earnings) transferred to a Roth IRA, too?
Title: Re: Roth 401k or Traditional 401k
Post by: grantmeaname on June 27, 2012, 02:16:22 PM
I believe ( that Roth 401k rollover contributions are considered as old as the IRA they're going into. And yes, that's contributions only; the earnings withdrawals are penalized like in a traditional 401k.
Title: Re: Roth 401k or Traditional 401k
Post by: tannybrown on June 27, 2012, 02:25:31 PM
Thanks, grantmeaname.  (BTW, I grant you the name, "Tim".)

Given that, would you recommend continuing as we are with a 5% Roth 401k contribution, or put all contributions as tax deferred?
Title: Re: Roth 401k or Traditional 401k
Post by: skyrefuge on June 27, 2012, 03:32:15 PM
As I'm sure you know, I'm part of the "Traditional!" cheerleading group, though not because it's straight up "better" than the Roth, more just to make sure people consider it mathematically and don't simply end up Roth-ing by default.  But in your case (though I don't have super-detailed access to your numbers/future), while I still might lean towards more into the traditional 401(k), you're close enough to the mid-point on the balance between the two types, with unknowable future factors being the main thing that would clearly push you from one to the other.  So I'd say that your 50/50% approach seems like a good choice for now, that way when you reach a point where you know what the future ended up being, you can be happy about the 50% where you were "right" and ignore the 50% where you were "wrong". 

I think that tax rates will generally go up in the future, but perhaps not at all for the "poor", so the closer you expect to be to "poor" in your retirement, the more advantageous the traditional 401(k) becomes (because the marginal rate for the poor might not rise, and deductions/exemptions shield a huge part of your income from tax), and that's before I even considered the potential of a consumption tax eating into your Roth money that you mentioned.

Going off on a tangent regarding Tim's comment about having 5 years of income accessible, I wonder how often that's an issue that needs to be explicitly planned for.  I'm 14 years into a ~20 year working career, and have been maxing out my tax-sheltered savings for the last 8-10 years, and then about 5 years ago started contributing to a brokerage account, not to keep it "available", but simply because I had nowhere left to shelter it.  I already have ~10 years of living expenses in that brokerage account.  I guess it's more of an issue for people with lower incomes and expenses, for whom the tax-sheltered limits are large enough to absorb almost all of their yearly savings.  But for me it's not even close to enough (this year I think I'll end up saving >$50k, with only $22k of it shelterable)
Title: Re: Roth 401k or Traditional 401k
Post by: tannybrown on June 27, 2012, 06:43:03 PM
First off, kudos on that kind of annual savings.  I like hearing about that as it pushes me to 'save harder'.

Is there more information I can provide that would help get to a specific answer?  Right now I'm kind of doing 6 of one, half dozen of the other, b/c I'm not sure what the future holds.