Author Topic: roth 401k vs. traditional 401k  (Read 731 times)

Solomon960

  • 5 O'Clock Shadow
  • *
  • Posts: 17
roth 401k vs. traditional 401k
« on: August 19, 2018, 02:37:35 PM »
From my forum search, this topic has appeared just once (found here: https://forum.mrmoneymustache.com/ask-a-mustachian/roth-401k-or-traditional-401k-1091/msg15812/#msg15812) but does not make a clear distinction of which circumstances make one significantly "better" than the other. Therefore, I hope fellow Mustachians will debate this topic here if given the following details:

-An employer offers employees both a roth 401k and a traditional 401k retirement savings options
-Neither choice includes an employee matching contribution
-Most employees earn less than $60k/yr (gross) and pay <15% in federal income taxes
-No changes to the above facts are expected during an employee's career

All things being equal, which option - roth 401k or traditional 401k - is the wiser choice for an employee to contribute to? Among co-workers, it's about 50/50 in terms of which 401k they contribute to without any specific, defensible rationale for why beyond a blind belief that (1) having more money "compounding" leads to a larger sum later (traditional 401k) or (2) not owing taxes in retirement makes people happy (roth 401k).

Thank you, in advance, for your thoughts.

MDM

  • Walrus Stache
  • *******
  • Posts: 9496
Re: roth 401k vs. traditional 401k
« Reply #1 on: August 19, 2018, 02:45:38 PM »
See Traditional versus Roth - Bogleheads, in particular the part about the commutative property of multiplication, but the whole article is worth understanding.

If there is no pension expected, then 100% Roth is almost certainly not correct.

For a quick estimate of the withdrawal marginal tax rate, take 4% of the expected traditional balance at retirement (are you familiar with Excel's FV function?).

How does that marginal rate compare with the tax saving rate on traditional contributions today?

Solomon960

  • 5 O'Clock Shadow
  • *
  • Posts: 17
Re: roth 401k vs. traditional 401k
« Reply #2 on: September 03, 2018, 05:19:36 PM »
Thank you for the link, MDM. I read the thread and concluded that continuing to invest as I do now is preferred vs saving in roth accounts exclusively. Under my current formation, I paid <3% federal income tax in 2017 and expect the same in 2018. If I switch to all roth accounts, I'll be paying between >12% but <24% annually. Believing I'll be in the 12-24% bracket during retirement, I appear better off deferring while I actively work.

I also attempted to read the Bogleheads marginal tax rate thread, but found it too technical. For my reality, my current salary will be what I earn for the rest of my life regardless of how it is received. I typically receive a 1% annual raise, but no lump-sum bonuses or promotion pay increases will significantly alter my taxable gross income y/y for the next twenty years.

I maxed out both my roth IRA and traditional 401k this year. ~$500 was removed from my September paystub as income taxes.

MDM

  • Walrus Stache
  • *******
  • Posts: 9496
Re: roth 401k vs. traditional 401k
« Reply #3 on: September 03, 2018, 05:41:45 PM »
I also attempted to read the Bogleheads marginal tax rate thread, but found it too technical.
I think you are correct about that.  It's unfortunate, because the higher math (limits, calculus, etc.) portions are not relevant to the financial use of marginal rate.

Simple algebra works: marginal rate = [(tax paid if nothing is done) - (tax paid if something is done)] / (dollar amount of the something)

Note that "effective" tax rate (which is probably what "<3% federal" refers to) is inappropriate for this question.  See Marginal Vs Effective Tax Rates And When To Use Each.

See Calculations!T2:U29 in the case study spreadsheet for the size of traditional account you need before a 4% withdrawal ratio from that alone would get you into various retirement tax brackets.  It takes a lot of traditional money (or large pension, etc.) for the withdrawal marginal rate to reach the contribution marginal rate, which is why traditional is better for most.

COEE

  • Pencil Stache
  • ****
  • Posts: 612
Re: roth 401k vs. traditional 401k
« Reply #4 on: September 03, 2018, 07:01:30 PM »
I feel ya on the bogleheads wiki.  It can be mind boggling (pun intended).

The advice I've always heard given:
If you expect to be in a higher tax bracket in retirement then Roth. 
If you expect to be in a lower tax bracket, then traditional. 
If you expect to be in the same tax bracket - it probably doesn't matter, but I lean toward traditional.

Here's what I've done:
When I first started out I made enough that I was in the 15% tax bracket.  $0.15 per dollar makes sense to me to pay to put it in a roth and never have to pay taxes on it again.
As I got older, I eventually was making enough that I wanted to try to stay in the 15% tax bracket (and not bump up to the 25% bracket (at the time)) so it made sense to contribute to traditional to lower my taxable income.
Now as I'm starting into the back-end of my career, I find myself phasing out of my tIRA contributions and am forced to use rIRA or a backdoor roth to contribute additional retirement funds.  I have continued to use t401k based on the rules above now that I'm solidly in the 22% tax bracket and I expect to bee in the 15% tax bracket when I retire.

This strategy provided a good amount of time to stash as much as we could in Roth while we were young - giving many years of growth.  But it also allowed us to spread funds between Roth AND traditional which will help us limit our taxable income when we reach retirement.  It's really the best of both worlds.

So my answer is usually
1) When you're in a low tax bracket contribute to Roth
2) As you begin earning more, use traditional to limit taxable income.
3) Eventually you phase out of tIRA and are forced to save in rIRA again - at a higher tax rate.
4) Have a bit of both for a well balanced portfolio.