Should you max your 401k to lower tax bill?

[Hoosier Daddy]

Hey all! Happy Friday for those of us still working! I was wondering if any of you who use the "Roth pipeline" could give some insights you may have into starting the pipeline, and whether or not you start that pipeline while your still working?

I am aware of the Roth Pipeline. However the 5 years you are still working when you would start converting, your taxable income spikes right? So I am getting the company match defined minimum contribution to my 401k deduction, and I will contribute the $5,500 to the Roth IRA (I know this is not a deduction) this year as well. However, if I also contribute an additional $8k to my 401k, I can stay in the 15% tax bracket. Now when I retire I doubt I will withdraw more than $40k a year, which means I will truly save on taxes because I never go into the 25% bracket right? Except, when you move the money to the Roth IRA, you do pay extra tax because not only are you making the most money you ever will in your life at that point 5 years before retirement, but then you spike it another $25-$40k as you start the Roth Pipeline....

Thus my question: Would you guys use 401k contributions to get to the lowest tax bracket possible, or would you be better off putting it into a post-tax investment account where you don't have to have the 5 year spike at the end of my career? Or do most of you find that when you retire you have enough other post-tax investments to get you through that 5 year period so that you begin the Roth pipeline the first year of your retirement to keep taxes low?

[jj20051]

Ideally here's what you'd do:

1. Put away as much money as possible into tax-differed accounts all the way up until you FIRE. Do not start Roth conversions until Jan 1st of the year after you FIRE.
2. Stock away your expenses for 6 years before you FIRE (plus any other funds you may want) in post-tax money. You will withdraw from this account while you convert the 401k into a ladder.

This means your total taxable income for each year of FIRE will be $30k or less (preferably much less). Thus avoiding spiking your tax bracket while you're saving.

Example:

You stock away the maximum of $17,500 /Yr for 10 years.
You also put away an additional $100,000 - $120,000 in a "savings account" during those 10 years.

When you FIRE you start converting $20k per year from the 401k into a ROTH IRA. That's all the taxable income you have so that's all you pay for. After 5 years your "savings account" has a balance at/near $0 and you start withdrawing from the ROTH IRA tax free. This technically isn't enough money to FIRE upon, but it shows an example of how to use the tax code to your advantage.

In my case I'm aiming for about $600k in "savings" and $200k in 401k. I'll then allow the 401k to grow over a period of about 30 years before I'll need the money in it. At which point the 401k will have a balance of about $648k which should last me the rest of my life.

[MDM]

Thus my question: Would you guys use 401k contributions to get to the lowest tax bracket possible, or would you be better off putting it into a post-tax investment account where you don't have to have the 5 year spike at the end of my career?

Max 401k worked for us and seems a fine strategy.  You are currently paying 25% marginal.  A $40K income, MFJ w/ only standard deduction, would pay 5% overall.

Or do most of you find that when you retire you have enough other post-tax investments to get you through that 5 year period so that you begin the Roth pipeline the first year of your retirement to keep taxes low?

You do want to ensure you can bridge that 5 year span, whether with existing Roths or taxable.  Or even paying the 10% tax on tIRA withdrawals if that is still advantageous - as it would be for you (5% + 10% = 15%, still less than 25%).

[frugaliknowit]

Happy Friday to you as well.

In my case, I no longer have a 401K.

I just want to make the point that your tax bracket in the future is an UNKNOWN.  It could be 50% for all we know...

That said and unlike most others on this forum:  You want to have "tax diversification" (google it, if you are not deeply familiar with the concept), which means:  "taxable buckets", "tax-free" buckets, and "capital gains" buckets.

In your case, if you went:  Match, Roth IRA, then unmatched, what would the tax rate on the $5500 be?  If 15%, then you should definitely do roth ahead of 401k unmatched.  Even if it's 25%, it's something to consider for tax diversification reasons.

[Hoosier Daddy]

Thus my question: Would you guys use 401k contributions to get to the lowest tax bracket possible, or would you be better off putting it into a post-tax investment account where you don't have to have the 5 year spike at the end of my career?

Max 401k worked for us and seems a fine strategy.  You are currently paying 25% marginal.  A $40K income, MFJ w/ only standard deduction, would pay 5% overall.

Or do most of you find that when you retire you have enough other post-tax investments to get you through that 5 year period so that you begin the Roth pipeline the first year of your retirement to keep taxes low?

You do want to ensure you can bridge that 5 year span, whether with existing Roths or taxable.  Or even paying the 10% tax on tIRA withdrawals if that is still advantageous - as it would be for you (5% + 10% = 15%, still less than 25%).

I thought the roth pipeline was specific to IRA conversions? If you just contribute $5,500 cash can you still take that out early without penalty? Or do you guys always use your $5,500 roth contribution from a 401k?

[MDM]

I thought the roth pipeline was specific to IRA conversions?

Correct.

If you just contribute $5,500 cash can you still take that out early without penalty?

Contribute to what?  If to a Roth IRA, then yes - contributions (not conversions) are withdrawable without penalty.

Or do you guys always use your $5,500 roth contribution from a 401k?

Can't go directly from a traditional 401k to a Roth IRA, so the answer seems to be "no, never" - but maybe I misunderstand the question?

[Hoosier Daddy]

I thought the roth pipeline was specific to IRA conversions?

Correct.

If you just contribute $5,500 cash can you still take that out early without penalty?

Contribute to what?  If to a Roth IRA, then yes - contributions (not conversions) are withdrawable without penalty.

Or do you guys always use your $5,500 roth contribution from a 401k?

Can't go directly from a traditional 401k to a Roth IRA, so the answer seems to be "no, never" - but maybe I misunderstand the question?

You understood all correctly. Thank you! Okay so there is no 5 year period related to cash contributions? You can take those out whenever? But I would assume earnings on cash contributions need to wait until 59.5?

Also, I would understand your response to mean you have to go from 401k to trad IRA to Roth IRA to do the Roth Pipeline? Can't go straight there...

[MDM]

Okay so there is no 5 year period related to cash contributions? You can take those out whenever? But I would assume earnings on cash contributions need to wait until 59.5?

Also, I would understand your response to mean you have to go from 401k to trad IRA to Roth IRA to do the Roth Pipeline? Can't go straight there...

Yes to all (with the adder that you may withdraw Roth earnings before 59.5 but you have to pay taxes if you do).  See, among others, the series http://www.fool.com/money/allaboutiras/allaboutiras.htm.

[Hoosier Daddy]

Okay so there is no 5 year period related to cash contributions? You can take those out whenever? But I would assume earnings on cash contributions need to wait until 59.5?

Also, I would understand your response to mean you have to go from 401k to trad IRA to Roth IRA to do the Roth Pipeline? Can't go straight there...

Yes to all (with the adder that you may withdraw Roth earnings before 59.5 but you have to pay taxes if you do).  See, among others, the series http://www.fool.com/money/allaboutiras/allaboutiras.htm.

Thank you MDM, that is so helpful!

[seattlecyclone]

This all depends on your individual situation. As you state, starting Roth rollovers when you're still working will cause you to pay taxes at your current marginal rate, or possibly even bump you into the next bracket. What to do?


• You could quit contributing to your 401(k) and put your money in a taxable account instead. I'd say this is possibly even worse than starting Roth conversions while working, because you're adding to your taxable income at your current marginal rate just the same either way, but with the taxable account you'll be stuck paying taxes on dividends from now until retirement in addition to the one-time conversion tax.
• You could start making Roth contributions instead of traditional contributions while working. Again, this would raise your taxes while you're working exactly the same as making Roth conversions or by increasing taxable saving as in option (1). The difference here is that you don't have to wait five years to withdraw the money or pay tax on dividends.
• You could keep doing your pre-tax saving now and just pay the early withdrawal penalty when you retire. Suppose you're currently in the 25% bracket and plan to be in the 10% bracket when retired. If that's the case, you'll pay 25% now to get money into your Roth account where you can withdraw it penalty-free later, or you could just take the money directly from your traditional account when you need it and pay 20% (10% tax plus 10% early withdrawal penalty) to get it out then.

Of course, all these trade-offs assume that all of your savings until five years before you retire has been in pre-tax retirement accounts. If you have enough money to max out your 401(k) and save even a little bit more than that in a taxable account, you'll likely find that you have enough in taxable to pay for a good portion of these first five years of retirement.

In response to something MDM said, there's no legal requirement that you transfer money from a traditional 401(k) to a traditional IRA before converting to a Roth IRA. You can go directly from 401(k) to Roth IRA. This is something I have done many times with my after-tax traditional 401(k) (aka the "mega backdoor Roth" strategy).

[MDM]

In response to something MDM said, there's no legal requirement that you transfer money from a traditional 401(k) to a traditional IRA before converting to a Roth IRA. You can go directly from 401(k) to Roth IRA. This is something I have done many times with my after-tax traditional 401(k) (aka the "mega backdoor Roth" strategy).

Correct, one can convert a traditional 401(k) into a Roth IRA and pay the taxes (if any) owed.  OP used the word "contribution" which implies something different - or at least might have, thus the question....