Author Topic: Should I invest in 401k or Traditional IRA first?  (Read 4832 times)

khotte

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Should I invest in 401k or Traditional IRA first?
« on: November 29, 2014, 03:15:58 AM »
I will finally have my student loans paid off in April of 2015 and will be debt free at that time! I will be diverting that cashflow into retirement accounts, but I'd like to know where to put it.

I make $60k/year putting me in the 25% tax bracket. I currently don't have a 401k match by my employer. I know that if I had one, I'd be putting my money there first.

Since I'm paying my loans off in April, I won't save enough money by the end of the year to max out both the 401k and traditional IRA. From May to December I can save ~$20k, which would put me $3k shy of maxing both the 401k and IRA. So, would it be better to fully fund my 401k or max out my traditional IRA first?

Both will give me a tax deduction at the end of the year, so is it just a matter of what funds are available in my 401k vs. traditional IRA?

Calvawt

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #1 on: November 29, 2014, 09:55:34 AM »
Without a match I would put more in the Traditional IRA since you can invest in anything you want.  Sounds like next year it won't matter since you can max out both.

Good job paying off those loans and starting to save early!

Gin1984

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #2 on: November 29, 2014, 10:13:22 AM »
Max out your 401k because you have until April 2015 to max out your IRA.  With how much you are saving, I bet you can get the extra $3000 from January to April.

khotte

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #3 on: November 29, 2014, 11:16:14 AM »
Do I only have until December 31 2014 for the 401k?

MDM

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #4 on: November 29, 2014, 12:26:42 PM »
I make $60k/year putting me in the 25% tax bracket. I currently don't have a 401k match by my employer. I know that if I had one, I'd be putting my money there first.
...
Both will give me a tax deduction at the end of the year, so is it just a matter of what funds are available in my 401k vs. traditional IRA?
$60,000 - $6,200 (std. deduction) - $3,950 (exemption) = $49,850.   If you put $12,950 into a traditional 401k, that brings you down to $36,900 and the top of the 15% bracket.  Anything beyond $12,950 is a good candidate for Roth.  Whether to do Roth 401k or Roth IRA is exactly as you describe: what funds are available in each (and whether your employer offers a Roth options for the 401k).

Numbers above are for 2014.  They will change a little in 2015 but the strategy can remain the same.

Exflyboy

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #5 on: November 29, 2014, 12:33:05 PM »
yes generally put as much in your 401k first because this will reduce your taxable income.

If it drops you low enough, do a traditional IRA as well because you will not be taxed on the income you put into the IRA either.

Frank

Gin1984

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #6 on: November 29, 2014, 01:13:01 PM »
Do I only have until December 31 2014 for the 401k?
Yes

khotte

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #7 on: November 29, 2014, 06:22:41 PM »
I make $60k/year putting me in the 25% tax bracket. I currently don't have a 401k match by my employer. I know that if I had one, I'd be putting my money there first.
...
Both will give me a tax deduction at the end of the year, so is it just a matter of what funds are available in my 401k vs. traditional IRA?
$60,000 - $6,200 (std. deduction) - $3,950 (exemption) = $49,850.   If you put $12,950 into a traditional 401k, that brings you down to $36,900 and the top of the 15% bracket.  Anything beyond $12,950 is a good candidate for Roth.  Whether to do Roth 401k or Roth IRA is exactly as you describe: what funds are available in each (and whether your employer offers a Roth options for the 401k).

Numbers above are for 2014.  They will change a little in 2015 but the strategy can remain the same.

Would you recommend a Roth IRA or a traditional IRA at the 15% bracket? If I do a traditional, I could end up paying no tax (via a roth pipeline) in retirement vs. paying 15% on it now. Is that thinking correct?

MDM

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #8 on: November 29, 2014, 09:25:43 PM »
Would you recommend a Roth IRA or a traditional IRA at the 15% bracket? If I do a traditional, I could end up paying no tax (via a roth pipeline) in retirement vs. paying 15% on it now. Is that thinking correct?
Good question.  I've highlighted the most important word, because if you know exactly what tax rate you will pay in retirement then the traditional vs. Roth question is easy to answer.  If you will end up paying no tax in retirement then your thinking is 100% correct.

The usual, one-size-fits-all (even though of course it doesn't), advice tends to be "use traditional in the 25% or higher brackets (subject to the max. earning limit), and Roth in the 15% or lower brackets."  There are plenty of counterexamples so it does pay (as you are doing) to look closely at your own situation, but for a rule of thumb it's not bad.

khotte

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #9 on: December 02, 2014, 07:34:15 AM »
Would you recommend a Roth IRA or a traditional IRA at the 15% bracket? If I do a traditional, I could end up paying no tax (via a roth pipeline) in retirement vs. paying 15% on it now. Is that thinking correct?
Good question.  I've highlighted the most important word, because if you know exactly what tax rate you will pay in retirement then the traditional vs. Roth question is easy to answer.  If you will end up paying no tax in retirement then your thinking is 100% correct.

The usual, one-size-fits-all (even though of course it doesn't), advice tends to be "use traditional in the 25% or higher brackets (subject to the max. earning limit), and Roth in the 15% or lower brackets."  There are plenty of counterexamples so it does pay (as you are doing) to look closely at your own situation, but for a rule of thumb it's not bad.

Can you explain the reasoning of the general advice to use a trad. for the 25% tax bracket or higher and a roth for the 15% and lower?

wtjbatman

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #10 on: December 02, 2014, 08:46:40 AM »
Would you recommend a Roth IRA or a traditional IRA at the 15% bracket? If I do a traditional, I could end up paying no tax (via a roth pipeline) in retirement vs. paying 15% on it now. Is that thinking correct?
Good question.  I've highlighted the most important word, because if you know exactly what tax rate you will pay in retirement then the traditional vs. Roth question is easy to answer.  If you will end up paying no tax in retirement then your thinking is 100% correct.

The usual, one-size-fits-all (even though of course it doesn't), advice tends to be "use traditional in the 25% or higher brackets (subject to the max. earning limit), and Roth in the 15% or lower brackets."  There are plenty of counterexamples so it does pay (as you are doing) to look closely at your own situation, but for a rule of thumb it's not bad.

Can you explain the reasoning of the general advice to use a trad. for the 25% tax bracket or higher and a roth for the 15% and lower?

If your income is being taxed at 25% now then you use Traditional to lower your taxable income with the assumption that you will be taxed less (15% or whatever) in retirement when you withdraw money from the Traditional. If you are already "only" in the 15% tax bracket, you might as well go straight for the Roth so that you can be assured that even if your income is higher in retirement than you expected (pushing you into the 25% or higher brackets), you will be withdrawing from your Roth tax free.

TLDR version: Trad @ 25% tax bracket now saves more money for you as long as you only reach the 15% tax bracket in retirement, which is the expectation for most mustachians.

MDM

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #11 on: December 02, 2014, 08:51:13 AM »
Can you explain the reasoning of the general advice to use a trad. for the 25% tax bracket or higher and a roth for the 15% and lower?
Because "in general" (and there are many counterexamples, thus the advice to consider one's own situation) one could expect taxes in retirement to be between 15% and 25%.  People paying 25% pre-retirement scale back, while those paying 15% are often early in their careers and will make more later.

frugaliknowit

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #12 on: December 02, 2014, 09:15:12 AM »
I know this is not in full alignment with Mustacian principles, but worth considering:

1.  Putting $5,500 into a roth is putting more money to work than putting $5,500 into a traditional account (because it is $5,500 after tax).

2.  No one knows where tax rates will be when you retire or stop working.  The assumption made by most in this forum is they
     will be the same.  Historically, they are the absolute lowest they've ever been.

MDM

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #13 on: December 02, 2014, 09:54:27 AM »
I know this is not in full alignment with Mustacian principles, but worth considering:

1.  Putting $5,500 into a roth is putting more money to work than putting $5,500 into a traditional account (because it is $5,500 after tax).

2.  No one knows where tax rates will be when you retire or stop working.  The assumption made by most in this forum is they
     will be the same.  Historically, they are the absolute lowest they've ever been.

1.  Yes.  For those who like (or at least don't mind) the math, http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 has more details on this. 

2.  Good point.  What matters to an individual is not what tax rates are in general, but what tax rate that individual is and will be paying.

In any case, large changes between before- and after-retirement taxes will drive the Roth vs. traditional decision.  In close cases, however, see above....

Seņora Savings

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #14 on: December 02, 2014, 10:21:27 AM »
Another advantage to the Roth is the ability to take the principal out after 5 years.  This is especially relevant to the early retiree if most of your assets are tied up in tax advantaged accounts to tide you over until you can get your Roth pipeline in action.

Also, Roth accounts have no required minimum distributions, which allows you more control over your assets in old age.  It's also good for inheritances if you're into that sort of thing.

johnny847

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #15 on: December 02, 2014, 11:53:42 AM »
Another advantage to the Roth is the ability to take the principal out after 5 years.  This is especially relevant to the early retiree if most of your assets are tied up in tax advantaged accounts to tide you over until you can get your Roth pipeline in action.
This is incorrect. You can take out the principal of a Roth at any time for any reason.
What you're thinking about is the 5 year rule for the Roth pipeline - if you convert some money in a traditional IRA to a Roth IRA, you can't withdraw that without penalty for 5 years.

If your income is being taxed at 25% now then you use Traditional to lower your taxable income with the assumption that you will be taxed less (15% or whatever) in retirement when you withdraw money from the Traditional. If you are already "only" in the 15% tax bracket, you might as well go straight for the Roth so that you can be assured that even if your income is higher in retirement than you expected (pushing you into the 25% or higher brackets), you will be withdrawing from your Roth tax free.

TLDR version: Trad @ 25% tax bracket now saves more money for you as long as you only reach the 15% tax bracket in retirement, which is the expectation for most mustachians.
And remember, if you're looking at whether traditional contributions make sense, you should be looking at marginal tax rates now vs expected average tax rates in retirement. The fact that you should be looking at average, not marginal, tax rates in retirement is important - even if you expect to be in the 15% tax bracket in retirement, you're not paying taxes at 15%.

Gone Fishing

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #16 on: December 02, 2014, 12:49:44 PM »
What rate are you paying on your student loans?

Here is an adapted response of mine from a similar question:

If you want to execute an IRA ladder (probably the most tax efficient method to date for a ER, see link in my signature for details), you will need 5 years worth of living expenses in either ROTH contributions or taxable accounts. Just for round numbers, let's say $100,000 in today's dollars this would take around $7k a year returning 8% for 10 years.  Adjust your numbers accordingly.   


This is what I would probably do:

Looks like you have about 20k to invest next year, break it down as follows:

$5,500 (or max if it changes) in a ROTH IRA, you will need this to execute the IRA ladder.

$1,500 in taxable investments, you will also need this to execute the IRA ladder, it will also serve as a no-strings-attached emergency, house down payment, or other "opportunity" fund. The ROTH contributions can back this up but will have more strings/complications.

$13k in the 401(k).       

As your income/savings increase, bump up your 401(k) contributions until you hit the max.  After that point, any additional income will go into taxable investments.  As you increase your taxable investments, you can begin to split your IRA contributions between the ROTH and a Traditional IRA, just as long as you stay on track to have enough to fund your first 5 years of ER between the ROTH and Taxable investments.  This plan will also give you some tax diversification in the event the rules change down the road.

You could also take this a step further and put everything you can into tax deferred accounts if you expect your income to grow to the point where you can fund your initial 5 years of ER expenses out of taxable investments you accrue after maxing out your deferred options.

This sounds complicated, because it is, but tax optimization can shave years off of your working career, so it is worth the effort to at least try to it get as close as you can to perfect.  But don't let it overwhelm you, you have the most important part down, saving.

Sounds like you are on the right track!  As things change along the way, be sure to "re-work" your plan accordingly.  This forum is a great resource to do that and has helped me immensely! 

khotte

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Re: Should I invest in 401k or Traditional IRA first?
« Reply #17 on: December 08, 2014, 10:17:21 AM »
The rate on my student loans is 6.55%. I am on track to have them paid off by April of 2015, which is why I will only have ~$20k to save the rest of the year.

I like the option you suggested about putting everything into tax deferred accounts. After 2015 and my school loans are paid off, I'll be able to max out my 401k and IRA and have a good chunk of change each year left over for a taxable account. I believe the amount of this taxable money will be enough for me to fund my first 5 years of ER until the Roth pipeline kicks in.

Thanks for all the thoughts!