Author Topic: Standard 401k Question: Roth or Traditional?  (Read 10219 times)

RailroadWarrior

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Standard 401k Question: Roth or Traditional?
« on: June 30, 2014, 09:45:43 AM »
Hey guys, I've been lurking around since getting getting my first 'grown-up' job but I finally made an account to post a question I need advice on. It seems to be a standard and often discussed question from what I've already searched but I was hoping to get some feedback for my particular situation. Any guidance is welcome, thanks!

Age: 23 (single)
Income: 59k w/ expected bonus ~10-12k
Tax Bracket: 25%

My company offers wonderful benefits including an HSA (which I've read can be used as a backdoor ROTH of sorts?!) and a healthy 401k match of 6% for my first 4%.

I made a play based upon talking to older colleagues, my accountant friend, my brother, and the companies financial investment contact. I am very frugal and wish to get as much in retirement as early as possible for compounding $$ purposes.

Anyway, where I landed is:
Traditional 401k: 9% (+6% company match = 15%)
Roth 401k: 20%
HSA: barely contributing since I am healthy but made this decision before learning about the benefits of maxing it (can someone confirm?)

My question is pretty basic but also pretty open-ended, did I do the right thing by focusing my retirement into a Roth 401k over Traditional 401k?

Psychstache

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Re: Standard 401k Question: Roth or Traditional?
« Reply #1 on: June 30, 2014, 09:52:33 AM »
In the 25% tax bracket, I am gonna say no, you should be focusing on filling your HSA first (easy enough with the 3300 limit) and then be working on filling up your traditional 401K, hopefully to the max, but at a bare minimum until you get down into the 15% bracket.

You are correct, the HSA is amazing in that it reduces your tax liability now, and the money comes out tax free for medical, or is taxed at your income level without penalty if taken out when you are 60.

edit: spelling.

Psychstache

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Re: Standard 401k Question: Roth or Traditional?
« Reply #2 on: June 30, 2014, 10:24:08 AM »
Welcome to the forum!

Personally, I would go with:

1.  Traditional 401k up to company match
2.  Max out HSA
3.  Finish maxing out traditional 401k ($17,500 as the employee)
4.  Max out traditional IRA
5.  Put any extra in taxable account

Since I want to retire early and will use the Roth conversion ladder, I plan on never paying taxes (or perhaps 10% at most) on any money I currently put into my tax-deferred plans.  Therefore, I would not invest in a Roth 401k or Roth IRA while in the 15% or 25% tax brackets.  YMMV

I change my answer to this (shouldn't post right after rolling out of bed) with the caveat that if you get down to a zero tax liability somewhere in there (based on deductions and exemptions) you should do Roth IRA at that point.

Cheddar Stacker

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Re: Standard 401k Question: Roth or Traditional?
« Reply #3 on: June 30, 2014, 11:04:12 AM »
Welcome to the forum!

Personally, I would go with:

1.  Traditional 401k up to company match
2.  Max out HSA
3.  Finish maxing out traditional 401k ($17,500 as the employee)
4.  Max out traditional IRA
5.  Put any extra in taxable account

Since I want to retire early and will use the Roth conversion ladder, I plan on never paying taxes (or perhaps 10% at most) on any money I currently put into my tax-deferred plans.  Therefore, I would not invest in a Roth 401k or Roth IRA while in the 15% or 25% tax brackets.  YMMV

+1

No offense to your colleagues, accountant friend, brother, plan advisor, etc., but most people are fine with the standard "save 10% into your 401k and retire at 65" type of advice. Read the madfientist link and it should convince you. Put everything you can into tax deferred and you will be set in 10 years. Congrats on finding this site so early in life! Good luck!

RailroadWarrior

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Re: Standard 401k Question: Roth or Traditional?
« Reply #4 on: July 01, 2014, 01:43:59 PM »
Guys, no offense, but I've learned that if something sounds too good to be true... it probably is.

It seems too easy. I want my skepticism squelched...

Cheddar Stacker

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Re: Standard 401k Question: Roth or Traditional?
« Reply #5 on: July 01, 2014, 01:56:49 PM »
Guys, no offense, but I've learned that if something sounds too good to be true... it probably is.

It seems too easy. I want my skepticism squelched...

What do you mean? The roth conversion ladder? People are already doing it. Read this: http://www.gocurrycracker.com/never-pay-taxes-again/

There are other examples as well if you need more.

Even if the roth conversion ladder changes, you know exactly how much tax you are paying right now, and you can avoid/defer it now if you choose to.

Roth's are great, but likely not an optimal choice if you are in the 25% bracket. Your choice though, we're just trying to help.

RailroadWarrior

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Re: Standard 401k Question: Roth or Traditional?
« Reply #6 on: July 02, 2014, 07:06:41 AM »
Cheddar Stacker, I VERY much appreciate the help and advice.

Are we in a very special circle of knowledge then? Why wouldn't everyone follow this plan, furthermore, why wouldn't the government shut this strategy down?

Again, not challenging the knowledge of this forum, I just have a strong skeptic side that makes me ask these questions to feel comfortable. :/

apfroggy0408

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Re: Standard 401k Question: Roth or Traditional?
« Reply #7 on: July 02, 2014, 07:40:50 AM »
Cheddar Stacker, I VERY much appreciate the help and advice.

Are we in a very special circle of knowledge then? Why wouldn't everyone follow this plan, furthermore, why wouldn't the government shut this strategy down?

Again, not challenging the knowledge of this forum, I just have a strong skeptic side that makes me ask these questions to feel comfortable. :/

Why doesn't everyone do it? Simple they like to consume everything in sight;  new cars, houses, appliances, clothes and going out.

skunkfunk

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Re: Standard 401k Question: Roth or Traditional?
« Reply #8 on: July 02, 2014, 08:17:22 AM »
I like a Roth simply because it has the same contribution limit but is post tax. You can essentially invest a higher percentage of your income in one before hitting the limit.

Cheddar Stacker

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Re: Standard 401k Question: Roth or Traditional?
« Reply #9 on: July 02, 2014, 08:42:21 AM »
Cheddar Stacker, I VERY much appreciate the help and advice.

Are we in a very special circle of knowledge then? Why wouldn't everyone follow this plan, furthermore, why wouldn't the government shut this strategy down?

There is a lot of collective knowledge on this forum, and yes I think it's a special place. This data is out there and available to everyone, but as apfroggy0408 pointed out people would prefer to just mindlessly consume. When you consume, you need money, and you can not imagine living within the 15% tax bracket so this strategy doesn't occur to most people.

Some people think the government will change tax laws to "shut this strategy down" as you put it. Some people also feel very strongly that eventually the government will look to Roth IRA's for more tax revenue in the future, meaning they might tax the money on the way in, and on the way out. Both strategies carry some risk of future law changes. What you know for certain is that you are paying 25% taxes on your last $ earned, and you can defer/avoid that tax now, so why wouldn't you?

The laws are always changing, but this is the current environment. I don't believe the intention of the laws was to allow frugal early retirees to pay no income tax. I believe it was to not punish (rather to encourage) the middle class for investing. That doesn't mean you shouldn't use the current laws to your advantage if you know how and can accomplish it.

Again, not challenging the knowledge of this forum, I just have a strong skeptic side that makes me ask these questions to feel comfortable. :/

Please challenge. Please question. This is how we all learn.

I like a Roth simply because it has the same contribution limit but is post tax. You can essentially invest a higher percentage of your income in one before hitting the limit.

I love Roth's as well. They have their place, so don't take this post as an anti-Roth rant because it's not. They are great for some people, but if you are paying more than 15% tax right now you might want to re-think this.

Also, I understand what you are saying skunkfunk, but it's really 6 of one and half a dozen of the other. If you put $17,500 in a Roth in the 25% tax bracket you have to pay $4,375 in taxes as well, so you are $21,875 out of pocket. If you put $17,500 in traditional you will have an extra $4,375 to invest in post tax funds. Barring a major change in your tax bracket there is really no difference at the end of your accumulated savings.

You can't control the current or future tax rates, but you can legally manipulate your taxable income while you work, and after you retire. Both of those factors allow you to effectively reduce your tax rate now and control it in the future, and you will likely end up better off with Traditional rather than Roth if you play the game properly.

If you don't trust me search the forum for this topic. This has been discussed endlessly here, and someone else might have explained it better than I just tried to.

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #10 on: July 02, 2014, 10:02:42 AM »
Guys, no offense, but I've learned that if something sounds too good to be true... it probably is.

It seems too easy. I want my skepticism squelched...

What do you mean? The roth conversion ladder? People are already doing it. Read this: http://www.gocurrycracker.com/never-pay-taxes-again/

There are other examples as well if you need more.

Even if the roth conversion ladder changes, you know exactly how much tax you are paying right now, and you can avoid/defer it now if you choose to.

Roth's are great, but likely not an optimal choice if you are in the 25% bracket. Your choice though, we're just trying to help.

I feel like a broken record about this but the rules did change for the conversion ladder this year (2014). It is because of the Affordable Care Act. Basically, you get a subsidy on your taxes to help pay for healthcare when you have a low income. However, as your income goes up, the subsidy goes down. In my case, this works out to a 13% tax on rollovers (every dollar I roll over reduces my subsidy by $0.13).

The GoCurryCracker people can still use this because they intentionally do not pay for health insurance in the US and thus don't get a subsidy. All the other examples of people currently doing it are either A) in the same boat as the GCC people, B) have a high enough income in retirement they aren't elligible for a subsidy anyway or C) in for a rude awakening on their 2014 taxes.

Spread the word: If you plan to to take a health care subsidy in retirement (which with current rules is most American Mustacians), the Roth Conversion Ladder will be expensive tax-wise!
« Last Edit: July 02, 2014, 10:06:02 AM by nawhite »

matchewed

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Re: Standard 401k Question: Roth or Traditional?
« Reply #11 on: July 02, 2014, 10:19:28 AM »
Guys, no offense, but I've learned that if something sounds too good to be true... it probably is.

It seems too easy. I want my skepticism squelched...

What do you mean? The roth conversion ladder? People are already doing it. Read this: http://www.gocurrycracker.com/never-pay-taxes-again/

There are other examples as well if you need more.

Even if the roth conversion ladder changes, you know exactly how much tax you are paying right now, and you can avoid/defer it now if you choose to.

Roth's are great, but likely not an optimal choice if you are in the 25% bracket. Your choice though, we're just trying to help.

I feel like a broken record about this but the rules did change for the conversion ladder this year (2014). It is because of the Affordable Care Act. Basically, you get a subsidy on your taxes to help pay for healthcare when you have a low income. However, as your income goes up, the subsidy goes down. In my case, this works out to a 13% tax on rollovers (every dollar I roll over reduces my subsidy by $0.13).

The GoCurryCracker people can still use this because they intentionally do not pay for health insurance in the US and thus don't get a subsidy. All the other examples of people currently doing it are either A) in the same boat as the GCC people, B) have a high enough income in retirement they aren't elligible for a subsidy anyway or C) in for a rude awakening on their 2014 taxes.

Spread the word: If you plan to to take a health care subsidy in retirement (which with current rules is most American Mustacians), the Roth Conversion Ladder will be expensive tax-wise!

Doesn't that just depend on how much you're converting? It is not guaranteed to be expensive, correct? During the Roth Pipeline process you're taking traditional IRA's and converting them to a Roth one piece at a time. Each piece is taxed as income. All you have to do is include that when applying for ACA subsidy. This can be done by spreading out the conversion over smaller amounts or maintaining low expenses (income). It is not guaranteed to be more expensive tax wise.

jpo

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Re: Standard 401k Question: Roth or Traditional?
« Reply #12 on: July 02, 2014, 10:26:58 AM »
Guessing by your username that you may be paying into Railroad Retirement. Unless you stay in the industry for a very long time, I wouldn't count on ever seeing a tangible benefit from that money again. Even the 5 years minimum "vesting" won't help you much beyond standard Social Security.

However, if you do put in the 30 years... you'll be rolling in it.

Cheddar Stacker

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Re: Standard 401k Question: Roth or Traditional?
« Reply #13 on: July 02, 2014, 10:28:57 AM »
Good point nawhite, and I have heard you mention this before. I'm currently ignorant on ACA subsidies so I'll defer to you. So please, teach us. I want to learn, not trying to be an ass.

Questions:
Did you have health insurance in 2013?
How much did it cost?
Do you have health insurance in 2014?
How much does it cost?
Are you actually paying taxes on rollovers, or just losing a subsidy that you didn't have last year anyway?

My point in asking these questions is this: While this is a new development that is detrimental to the potential plans of current/future FIRE candidates, aren't we really just losing a subsidy that was intended for low income people? If someone paid $5,000 for health insurance in 2013, retired on 1/1/14, withdrew funds from an IRA that created a taxable event, and pays $5,000 for health insurance in 2014 because of that taxable event, is this really a tax?

I have a similar situation. Every dollar of my wife's income I put into her 401K reduces her taxable income and I therefore lose a 20% child care credit for every dollar below $6K in taxable income. It's a double edged sword and I'm not sure how I feel about it. It does feel like a tax, so I see what you mean.

Thoughts?

rmendpara

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Re: Standard 401k Question: Roth or Traditional?
« Reply #14 on: July 02, 2014, 10:34:47 AM »
Welcome to the forum!

Personally, I would go with:

1.  Traditional 401k up to company match
2.  Max out HSA
3.  Finish maxing out traditional 401k ($17,500 as the employee)
4.  Max out traditional IRA
5.  Put any extra in taxable account

Since I want to retire early and will use the Roth conversion ladder, I plan on never paying taxes (or perhaps 10% at most) on any money I currently put into my tax-deferred plans.  Therefore, I would not invest in a Roth 401k or Roth IRA while in the 15% or 25% tax brackets.  YMMV

+1 to this.

The only thing I might change would be #4. You can choose either a Roth or Traditional IRA (Traditional IRA income limit is lower than the Roth income limit, just be aware). The difference will be minimal, and it gives you a little bit of tax diversification if you choose Roth (so 17.5k 401k and 5.5k Roth per yr).

If you can manage to save that much, at your income level, you'll be doing great!

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #15 on: July 02, 2014, 11:17:40 AM »
Good point nawhite, and I have heard you mention this before. I'm currently ignorant on ACA subsidies so I'll defer to you. So please, teach us. I want to learn, not trying to be an ass.

Questions:
Did you have health insurance in 2013?
How much did it cost?
Do you have health insurance in 2014?
How much does it cost?
Are you actually paying taxes on rollovers, or just losing a subsidy that you didn't have last year anyway?

My point in asking these questions is this: While this is a new development that is detrimental to the potential plans of current/future FIRE candidates, aren't we really just losing a subsidy that was intended for low income people? If someone paid $5,000 for health insurance in 2013, retired on 1/1/14, withdrew funds from an IRA that created a taxable event, and pays $5,000 for health insurance in 2014 because of that taxable event, is this really a tax?

I have a similar situation. Every dollar of my wife's income I put into her 401K reduces her taxable income and I therefore lose a 20% child care credit for every dollar below $6K in taxable income. It's a double edged sword and I'm not sure how I feel about it. It does feel like a tax, so I see what you mean.

Thoughts?

Unfortunately I'm a terrible example because I've changed jobs twice and my wife and I have had changing health care needs in the past year so I end up needing to use an example to keep things simple. Below I'll run the math with the MMM family as an example.

I agree with you that for many people, rolling over causes you to "lose a subsidy you didn't have last year anyway" but that doesn't make me any happier about it. ACA with subsidies allows me to reduce my expected healthcare expenses in retirement but it is a perk I only get if I plan not to use a Roth Conversion Ladder the way it was envisioned by the FIRE Illuminati.

Example (loosely based off of the MMM household)

Lets say in retirement, my family of 3 spends about 30k per year.

Spending = net income = $30k (lets pretend its half regular income, half capital gains)
Federal taxes pre subsidy: $0
Subsidy: $6,597 (according to the kaiser calculator for US average state)

But lets say that they roll over 12k per year (because that is the most they can do without paying federal income taxes on it)
net income = $42k
Federal taxes pre subsidy = $0
Subsidy: $4,979

So that $12k resulted in $1618 less in subsidy. In other words, if they do a Rollover to put the money in a Roth, they will end up with 13.5% less money to spend from their traditional IRA/401k than they would have had if they had funded their retirement a different way (SEPP, taxable accounts, Roths funded some other way, etc) and then used the traditional IRA/401k money after 59.5 normally.

i.e. For this family to do a Conversion ladder, they give up 13.5% of the value of their account in lost benefits. Sounds like the same impact as a tax to me.

Jeremy

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Re: Standard 401k Question: Roth or Traditional?
« Reply #16 on: July 02, 2014, 11:26:49 AM »



I feel like a broken record about this but the rules did change for the conversion ladder this year (2014). It is because of the Affordable Care Act. Basically, you get a subsidy on your taxes to help pay for healthcare when you have a low income. However, as your income goes up, the subsidy goes down. In my case, this works out to a 13% tax on rollovers (every dollar I roll over reduces my subsidy by $0.13).

The GoCurryCracker people can still use this because they intentionally do not pay for health insurance in the US and thus don't get a subsidy. All the other examples of people currently doing it are either A) in the same boat as the GCC people, B) have a high enough income in retirement they aren't elligible for a subsidy anyway or C) in for a rude awakening on their 2014 taxes.

Spread the word: If you plan to to take a health care subsidy in retirement (which with current rules is most American Mustacians), the Roth Conversion Ladder will be expensive tax-wise!


Admittedly I'm the weaker half, but as one of the GCC people I'll take a swing at this, particularly looking at the category C people as this would be us if/when we move back to the US.

The ACA does change how ROTH IRA Conversions are taxed.  It is a good point to be aware of


Last year we converted $12,028 from a Traditional IRA to a ROTH IRA.  This was the ceiling for zero tax on these funds, based on standard deduction and personal exemptions.  Details here:  http://www.gocurrycracker.com/the-go-curry-cracker-2013-taxes/

Since our dividend income alone puts us above 138% of the FPL (Federal Poverty Level) every dollar of this conversion would reduce our subsidy. As is the case for nawhite, this roughly equates to a 13% tax for us, as I discussed here: http://www.gocurrycracker.com/how-obamacare-saved-us-from-extortion/



Total financial impact to us would be about $12,028 * 13% = $1,564 annually or $130 monthly.  Note that we would still receive a subsidy on our health insurance at this point, it would just be $130 less per month than if we didn't do the conversion.  This could be a rude awakening or not, depending on your financial situation.  (4% rule only requires $39k to support this difference)



It doesn't get any better from here, as we additionally harvested some capital gains, and this would also reduce our subsidy by $0.13 per $1.00 harvested.  This is unfavorable, and I would probably do less harvesting, preferring instead to defer taxes by not selling.  For people with most of their money in tax-deferred accounts, this is less important




In the OP's case, I might use the ROTH 401k.  It depends on exact earned income.  As it is, you are on the edge of the 15%/25% marginal tax rate

In most cases I would take a 13% future tax over a 25% tax today, but I would probably pay a 15% tax today vs a questionable 13% future tax.  This is the key thing to evaluate.  Tax now or tax later

At age 23 your income is likely to rise, and hopefully quite a lot over the coming years.  As you get firmly in the 25% and higher tax brackets, the Traditional 401k looks better




matchewed

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Re: Standard 401k Question: Roth or Traditional?
« Reply #17 on: July 02, 2014, 11:39:32 AM »
Good point nawhite, and I have heard you mention this before. I'm currently ignorant on ACA subsidies so I'll defer to you. So please, teach us. I want to learn, not trying to be an ass.

Questions:
Did you have health insurance in 2013?
How much did it cost?
Do you have health insurance in 2014?
How much does it cost?
Are you actually paying taxes on rollovers, or just losing a subsidy that you didn't have last year anyway?

My point in asking these questions is this: While this is a new development that is detrimental to the potential plans of current/future FIRE candidates, aren't we really just losing a subsidy that was intended for low income people? If someone paid $5,000 for health insurance in 2013, retired on 1/1/14, withdrew funds from an IRA that created a taxable event, and pays $5,000 for health insurance in 2014 because of that taxable event, is this really a tax?

I have a similar situation. Every dollar of my wife's income I put into her 401K reduces her taxable income and I therefore lose a 20% child care credit for every dollar below $6K in taxable income. It's a double edged sword and I'm not sure how I feel about it. It does feel like a tax, so I see what you mean.

Thoughts?

Unfortunately I'm a terrible example because I've changed jobs twice and my wife and I have had changing health care needs in the past year so I end up needing to use an example to keep things simple. Below I'll run the math with the MMM family as an example.

I agree with you that for many people, rolling over causes you to "lose a subsidy you didn't have last year anyway" but that doesn't make me any happier about it. ACA with subsidies allows me to reduce my expected healthcare expenses in retirement but it is a perk I only get if I plan not to use a Roth Conversion Ladder the way it was envisioned by the FIRE Illuminati.

Example (loosely based off of the MMM household)

Lets say in retirement, my family of 3 spends about 30k per year.

Spending = net income = $30k (lets pretend its half regular income, half capital gains)
Federal taxes pre subsidy: $0
Subsidy: $6,597 (according to the kaiser calculator for US average state)

But lets say that they roll over 12k per year (because that is the most they can do without paying federal income taxes on it)
net income = $42k
Federal taxes pre subsidy = $0
Subsidy: $4,979

So that $12k resulted in $1618 less in subsidy. In other words, if they do a Rollover to put the money in a Roth, they will end up with 13.5% less money to spend from their traditional IRA/401k than they would have had if they had funded their retirement a different way (SEPP, taxable accounts, Roths funded some other way, etc) and then used the traditional IRA/401k money after 59.5 normally.

i.e. For this family to do a Conversion ladder, they give up 13.5% of the value of their account in lost benefits. Sounds like the same impact as a tax to me.

Why do they need to pull 12k when they already pulled 30k?

In your example they're pulling taxable income twice.

Wouldn't they do it once? Pull 30k and be done with it?

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #18 on: July 02, 2014, 12:22:58 PM »
Why do they need to pull 12k when they already pulled 30k?

In your example they're pulling taxable income twice.

Wouldn't they do it once? Pull 30k and be done with it?

When you are preparing the Ladder, you need to put money into the Roth every year that you are going to let sit in the account for 5 years before you can withdraw it. So in the first 5 years, you have to recognize taxable income on all of your taxable income to live and then an additional amount to roll over into the roth that you'll be able to withdraw 5 years from now. I guess that after you got your first 5 years in the account and you can start withdrawing from the Roth tax free, the taxable income to live on would go down and your total net income would level off again.

So I guess my "subsidy tax" only applies in the first 5 years when you are adding to your Roth but not yet withdrawing from it. Did I understand your question correctly?

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Re: Standard 401k Question: Roth or Traditional?
« Reply #19 on: July 02, 2014, 12:37:03 PM »
Nawhite, thanks for the example. I understand what you are saying. People do need to be aware of this. I really see this as more of a lost benefit of a brand new subsidy that never existed until this year, not a new tax, but I know what you mean by "it feels like a tax".

So that $12k resulted in $1618 less in subsidy. In other words, if they do a Rollover to put the money in a Roth, they will end up with 13.5% less money to spend from their traditional IRA/401k than they would have had if they had funded their retirement a different way (SEPP, taxable accounts, Roths funded some other way, etc) and then used the traditional IRA/401k money after 59.5 normally.

The part I bolded above is incorrect. If you use a SEPP, the annual withdrawal is taxable income. If you have a regular brokerage account that generates income you have taxable income. Both of these things would also reduce your subsidy. Virtually any taxable income will reduce your subsidy. You are correct in that a Roth shouldn't based on current tax laws, but who knows what the future will bring.

Jeremy (aka currycracker-er) - I love that linking to one of your posts is equivalent to sending out the bat signal! I think this is the 3rd time now on this forum I've linked that post and you've come to chime in. Thank you for adding your current real life scenario into the discussion. I hope all is well with the travels. I need to circle back and read the last few posts.

matchewed

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Re: Standard 401k Question: Roth or Traditional?
« Reply #20 on: July 02, 2014, 01:08:16 PM »
Why do they need to pull 12k when they already pulled 30k?

In your example they're pulling taxable income twice.

Wouldn't they do it once? Pull 30k and be done with it?

When you are preparing the Ladder, you need to put money into the Roth every year that you are going to let sit in the account for 5 years before you can withdraw it. So in the first 5 years, you have to recognize taxable income on all of your taxable income to live and then an additional amount to roll over into the roth that you'll be able to withdraw 5 years from now. I guess that after you got your first 5 years in the account and you can start withdrawing from the Roth tax free, the taxable income to live on would go down and your total net income would level off again.

So I guess my "subsidy tax" only applies in the first 5 years when you are adding to your Roth but not yet withdrawing from it. Did I understand your question correctly?

For the most part. Let's look at your example again.

Person A has expenses of 30k per year. They have various assets. Perhaps primarily a 401k as is highly recommended by this board. But they also have things like a Roth IRA and regular taxable account already. We could even say that they have 150k in their Roth IRA at FIRE in addition to some other amount in a taxable account.

Year one.

Pull 30k from the Roth IRA for expenses - a non taxable event assuming you're taking your contribution out. [Their are other methods I could list including dipping into a standard taxable account which would net some small "income" from capital gains].

Convert 30k from Traditional IRA (the previously mentioned 401k is assumed to have been rolled over) to the Roth IRA. Taxable event for 30k of income tax, or as you already summed it up -

Quote
Spending = net income = $30k (lets pretend its half regular income, half capital gains)
Federal taxes pre subsidy: $0
Subsidy: $6,597 (according to the kaiser calculator for US average state)

Nothing says you have to prepare the conversion ladder during FIRE. In theory you could start it before you FIRE.

You could also contribute to an IRA to lower your MAGI. Start a business and have some deductions for it.

In short there are several ways to keep your MAGI low for ACA purposes without any pinch on a FIRE person. You'll just have another aspect of it to navigate.

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #21 on: July 02, 2014, 01:29:18 PM »
Cheddar Stacker and Matchewed, you are both right about the assumptions I was making affecting this problem.

I guess when someone says "should I do a Roth or Traditional?" many people say "Do a traditional because then you won't have to pay taxes on any of it b/c of the ladder." That only works if you don't prep the ladder until after you FIRE (otherwise you'd be paying higher taxes on the Roth contributions), and that means that the first 5 years of your retirement, you will have a higher taxable income than you would have if you did not use a ladder method. If SEPP and taxable accounts are enough to fund your retirement until 59.5, then you don't need a ladder and your taxable income for the first 5 years remains at 30k instead of 42k like the example.

So I guess I'm still on the side that a person should probably go traditional instead of Roth (if your post-retirement income will be less than your pre-retirement income like most of us here and you aren't really young and planning to keep the money in the Roth for a REALLY long time) but you need to understand that if your plan to withdraw money involves a Ladder, you should be aware that you'll have a reduced subsidy for the 5 years that you are prepping it if you don't prep until retiring.

So yes, "just another aspect to navigate."

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Re: Standard 401k Question: Roth or Traditional?
« Reply #22 on: July 02, 2014, 01:46:40 PM »
Cheddar Stacker and Matchewed, you are both right about the assumptions I was making affecting this problem.

I guess when someone says "should I do a Roth or Traditional?" many people say "Do a traditional because then you won't have to pay taxes on any of it b/c of the ladder." That only works if you don't prep the ladder until after you FIRE (otherwise you'd be paying higher taxes on the Roth contributions), and that means that the first 5 years of your retirement, you will have a higher taxable income than you would have if you did not use a ladder method. If SEPP and taxable accounts are enough to fund your retirement until 59.5, then you don't need a ladder and your taxable income for the first 5 years remains at 30k instead of 42k like the example.

So I guess I'm still on the side that a person should probably go traditional instead of Roth (if your post-retirement income will be less than your pre-retirement income like most of us here and you aren't really young and planning to keep the money in the Roth for a REALLY long time) but you need to understand that if your plan to withdraw money involves a Ladder, you should be aware that you'll have a reduced subsidy for the 5 years that you are prepping it if you don't prep until retiring.

So yes, "just another aspect to navigate."

Emphasis mine. Maybe I'm reading too much into this post, and the other one I quoted, but it seems like you're emphasizing 59.5 a lot in these scenarios. That age doesn't affect what we're talking about much. Obviously a lot hinges on that in a traditional retirement, but it's not really a magical age. You are correct in that you don't need a ladder then, but...

Everything withdrawn from an IRA from that point on is still taxable (there's just no penalties and less restrictions) and will affect your ACA subsidies in the same way.

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #23 on: July 02, 2014, 01:55:30 PM »
Cheddar Stacker and Matchewed, you are both right about the assumptions I was making affecting this problem.

I guess when someone says "should I do a Roth or Traditional?" many people say "Do a traditional because then you won't have to pay taxes on any of it b/c of the ladder." That only works if you don't prep the ladder until after you FIRE (otherwise you'd be paying higher taxes on the Roth contributions), and that means that the first 5 years of your retirement, you will have a higher taxable income than you would have if you did not use a ladder method. If SEPP and taxable accounts are enough to fund your retirement until 59.5, then you don't need a ladder and your taxable income for the first 5 years remains at 30k instead of 42k like the example.

So I guess I'm still on the side that a person should probably go traditional instead of Roth (if your post-retirement income will be less than your pre-retirement income like most of us here and you aren't really young and planning to keep the money in the Roth for a REALLY long time) but you need to understand that if your plan to withdraw money involves a Ladder, you should be aware that you'll have a reduced subsidy for the 5 years that you are prepping it if you don't prep until retiring.

So yes, "just another aspect to navigate."

Emphasis mine. Maybe I'm reading too much into this post, and the other one I quoted, but it seems like you're emphasizing 59.5 a lot in these scenarios. That age doesn't affect what we're talking about much. Obviously a lot hinges on that in a traditional retirement, but it's not really a magical age. You are correct in that you don't need a ladder then, but...

Everything withdrawn from an IRA from that point on is still taxable (there's just no penalties and less restrictions) and will affect your ACA subsidies in the same way.

I agree that the funds are still taxable and will affect your subsidies in the same way, but you won't need to have extra taxable income while you are prepping your ladder. So it is just the extra prepping you need to do which makes it worse.

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Re: Standard 401k Question: Roth or Traditional?
« Reply #24 on: July 02, 2014, 02:03:43 PM »
Got it. Agreed. At some point you need to generate some funds to use for the first few years of FIRE. Now we just need to figure out a way to do that without killing your ACA subsidies.

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Re: Standard 401k Question: Roth or Traditional?
« Reply #25 on: July 02, 2014, 02:04:08 PM »
Cheddar Stacker and Matchewed, you are both right about the assumptions I was making affecting this problem.

I guess when someone says "should I do a Roth or Traditional?" many people say "Do a traditional because then you won't have to pay taxes on any of it b/c of the ladder." That only works if you don't prep the ladder until after you FIRE (otherwise you'd be paying higher taxes on the Roth contributions), and that means that the first 5 years of your retirement, you will have a higher taxable income than you would have if you did not use a ladder method. If SEPP and taxable accounts are enough to fund your retirement until 59.5, then you don't need a ladder and your taxable income for the first 5 years remains at 30k instead of 42k like the example.

So I guess I'm still on the side that a person should probably go traditional instead of Roth (if your post-retirement income will be less than your pre-retirement income like most of us here and you aren't really young and planning to keep the money in the Roth for a REALLY long time) but you need to understand that if your plan to withdraw money involves a Ladder, you should be aware that you'll have a reduced subsidy for the 5 years that you are prepping it if you don't prep until retiring.

So yes, "just another aspect to navigate."

Emphasis mine. Maybe I'm reading too much into this post, and the other one I quoted, but it seems like you're emphasizing 59.5 a lot in these scenarios. That age doesn't affect what we're talking about much. Obviously a lot hinges on that in a traditional retirement, but it's not really a magical age. You are correct in that you don't need a ladder then, but...

Everything withdrawn from an IRA from that point on is still taxable (there's just no penalties and less restrictions) and will affect your ACA subsidies in the same way.

I agree that the funds are still taxable and will affect your subsidies in the same way, but you won't need to have extra taxable income while you are prepping your ladder. So it is just the extra prepping you need to do which makes it worse.

I would probably just redefine it as "people should be aware that a Traditional IRA conversion to a Roth IRA conversion is counted in your MAGI. Your ACA subsidy uses your MAGI to determine how much of a subsidy you are entitled to.", all the rest of it is just going to be very particular to the individual. If someone has five years worth of expenses in a mix of taxable account, CD's, savings account, and Roth contributions they may be able to navigate their ladder preparation without any impact on ACA subsidy. Tons of ways to skin the cat here.

nawhite

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Re: Standard 401k Question: Roth or Traditional?
« Reply #26 on: July 02, 2014, 02:07:53 PM »
matchewed, that's a great way to put it. Conveys the complications a little better than "If you plan to to take a health care subsidy in retirement (which with current rules is most American Mustacians), the Roth Conversion Ladder will be expensive tax-wise!"

Jeremy

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Re: Standard 401k Question: Roth or Traditional?
« Reply #27 on: July 02, 2014, 09:31:18 PM »
Jeremy (aka currycracker-er) - I love that linking to one of your posts is equivalent to sending out the bat signal! I think this is the 3rd time now on this forum I've linked that post and you've come to chime in. Thank you for adding your current real life scenario into the discussion. I hope all is well with the travels. I need to circle back and read the last few posts.

Haha, this is too funny!  Life is good here, I've been filling most of my daylight hours with learning Chinese and playing guitar and W is enrolled in 3 (or is it 4?) different art and music classes.  It is a lot of fun!

Thanks again for sharing links to our blog.  Seeing what people are thinking and talking about in regards to early-retirement taxes helps me keep learning

matchewed, that's a great way to put it. Conveys the complications a little better than "If you plan to to take a health care subsidy in retirement (which with current rules is most American Mustacians), the Roth Conversion Ladder will be expensive tax-wise!" (bold is mine)

In our case, the total expense isn't that great when we look at the total picture

Before the ACA, we were paying $233 a month for a HDHP with no HSA.

After the ACA, with subsidy based on $30k/year income we would pay $126 per month for a better plan with HSA, $107 less than the pre-ACA policy

If on top of this we did a ROTH IRA conversion equivalent to last year's, we would reduce our subsidy by $1564 annually or $130 / monthly, bringing our effective insurance cost to $256 per month

Compared to the original case, we would only be paying $23 more per month.  As an effective tax on the $12,000+/- ROTH Conversion, this is only 2.3%, pretty mild as far as taxes go.  And with the addition of an HSA, we have another tool in our future tax reduction arsenal.

This is without attempting to optimize anything, i.e. there is no reason all $30k of living expenses has to be part of MAGI.  Some of it could come from savings / return of capital, etc...  as mentioned by matchewed (quote below).  I'm pretty sure I could optimize things and end up with a net gain


I would probably just redefine it as "people should be aware that a Traditional IRA conversion to a Roth IRA conversion is counted in your MAGI. Your ACA subsidy uses your MAGI to determine how much of a subsidy you are entitled to.", all the rest of it is just going to be very particular to the individual. If someone has five years worth of expenses in a mix of taxable account, CD's, savings account, and Roth contributions they may be able to navigate their ladder preparation without any impact on ACA subsidy. Tons of ways to skin the cat here.

matchewed

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Re: Standard 401k Question: Roth or Traditional?
« Reply #28 on: July 03, 2014, 08:48:11 AM »
Hey guys, I've been lurking around since getting getting my first 'grown-up' job but I finally made an account to post a question I need advice on. It seems to be a standard and often discussed question from what I've already searched but I was hoping to get some feedback for my particular situation. Any guidance is welcome, thanks!

Age: 23 (single)
Income: 59k w/ expected bonus ~10-12k
Tax Bracket: 25%

My company offers wonderful benefits including an HSA (which I've read can be used as a backdoor ROTH of sorts?!) and a healthy 401k match of 6% for my first 4%.

I made a play based upon talking to older colleagues, my accountant friend, my brother, and the companies financial investment contact. I am very frugal and wish to get as much in retirement as early as possible for compounding $$ purposes.

Anyway, where I landed is:
Traditional 401k: 9% (+6% company match = 15%)
Roth 401k: 20%
HSA: barely contributing since I am healthy but made this decision before learning about the benefits of maxing it (can someone confirm?)

My question is pretty basic but also pretty open-ended, did I do the right thing by focusing my retirement into a Roth 401k over Traditional 401k?

Now that we've settled the whole ACA impact thingy I'd like to get back to the OP.

Sorry for hijacking your thread RRwarrior.

You didn't do a right or wrong thing. You may have made a suboptimal choice in going for a Roth 401k as you're paying high taxes now in order to pay no taxes later. While you could make the decision with a traditional to pay less taxes today in order to pay less taxes tomorrow. You'd have to run some numbers. The part of the equation that we as commentators on your situation are missing is your anticipated expenses in FIRE.

Basically what I would do if I were in your shoes is build a basic FIRE budget. Then I'd look at the various tools available to me. Traditional retirement accounts which are tax deferred, Roth retirement accounts which you pay tax now so that you have tax free access later, taxable accounts which fall under standard dividend/capital gains taxation, and a general understanding of when you'll incur a taxation event when using these accounts.

In general it is better to max out traditional retirement accounts than to go Roth. The good thing is you can do both. Max your 401k and then max a Roth IRA any excess cash goes into a taxable account and you have all the three basic tools for managing your FIRE.

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Re: Standard 401k Question: Roth or Traditional?
« Reply #29 on: July 03, 2014, 10:21:11 AM »
Are we in a very special circle of knowledge then? Why wouldn't everyone follow this plan, furthermore, why wouldn't the government shut this strategy down?

Again, not challenging the knowledge of this forum, I just have a strong skeptic side that makes me ask these questions to feel comfortable. :/
Even if you don't decide to do a roth conversion ladder, just looking at how the tax brackets get filled will show you the value of having some money in traditional accounts.  First you get the standard deduction and exemption amount tax free.  The next $9,075 only gets taxed at 10%, then you can earn an additional $27,825 in the 15% bracket.  Do you really want to pay 25% tax on money that would be filling the 0%, 10% and 15% brackets in the future?

I agree with matchewed, having money in traditional, roths and taxable accounts gives you a lot of tax planning options in the future.

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Re: Standard 401k Question: Roth or Traditional?
« Reply #30 on: July 07, 2014, 07:07:47 AM »
Thanks to everyone who contributed advice to my question, it has been incredibly helpful with my understanding of my current situation and my overall knowledge of taxes. I admit, I have lived my life fairly unaware.

A special thanks to matchewed for concisely wrapping up the the conversation for me (still wrapping my head around this advice/ACA)

I think I will be reducing my contribution to my ROTH 401k to 10% (which currently sits at 20%).Not sure whether I will move this into the traditional 401k or have it in more liquid savings. I don't believe I have a chance to change my HSA contribution this year but as soon as I can, I will be maxing that out.

This gives me:
15% traditional 401k (possibly 20-25% if I move a portion of Roth saving rate into acc.)
10% Roth 401k (down from 20%)

The Roth 401k serves the same purpose as a RothIRA, I am just leaving myself the option of contributing more than 5500.

Since I just found this wonderful sight full of like-minded people, I'm going to take some time to read and learn before making my next move in figuring out my retirement. I can't wait to participate and read more and more. Y'all are very helpful, indeed.

matchewed

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Re: Standard 401k Question: Roth or Traditional?
« Reply #31 on: July 07, 2014, 07:14:39 AM »
Thanks to everyone who contributed advice to my question, it has been incredibly helpful with my understanding of my current situation and my overall knowledge of taxes. I admit, I have lived my life fairly unaware.

A special thanks to matchewed for concisely wrapping up the the conversation for me (still wrapping my head around this advice/ACA)

I think I will be reducing my contribution to my ROTH 401k to 10% (which currently sits at 20%).Not sure whether I will move this into the traditional 401k or have it in more liquid savings. I don't believe I have a chance to change my HSA contribution this year but as soon as I can, I will be maxing that out.

This gives me:
15% traditional 401k (possibly 20-25% if I move a portion of Roth saving rate into acc.)
10% Roth 401k (down from 20%)

The Roth 401k serves the same purpose as a RothIRA, I am just leaving myself the option of contributing more than 5500.

Since I just found this wonderful sight full of like-minded people, I'm going to take some time to read and learn before making my next move in figuring out my retirement. I can't wait to participate and read more and more. Y'all are very helpful, indeed.

Feel free to ask any questions you have. Glad we could help. :)