My 2021 Plan: Roth vs. Traditional 401k/IRA Contributions

[bozemanboy]

Thanks for checking out my first post. In short, I am seeking advice regarding the choice between Roth and Traditional contributions for 2021.

Life Situation: MFJ, 27 years old, living in Chicago on more or less a single income (I'm a grad student with a modest stipend and some gig income), with no debts. In 2021, we plan to max out DW's 401k, our HSA, and IRAs for both of us, with any remaining savings invested in our taxable account.

Gross Salary/Wages: Around $100k depending on DW's annual bonus, an anticipated raise, and my gig work

Taxes: Total (FICA, federal & state) taxes are projected between $13k (if we make Traditional-only contributions) and $21k (if we make Roth-only contributions)

Current expenses: $35k in 2020, carefully tracked - I'll save those face punches for another post

Assets: $225k

• Cash: $19k
• HSA: $5k
• Roth 401k (DW): $59k
• Roth IRA (DW): $39k
• Roth IRA (DH): $39k
• Taxable Brokerage: $64k

Specific Question: Given our current single income situation we have been opting for Roth-only contributions to DW's 401k and our IRAs, with the idea that once I finish school and get a job (in about 2 years, with a move very likely) we will switch over to making Traditional contributions because our combined income will be higher than it is now and higher than any amount we are likely to spend per annum in retirement. This means that we currently have $137k in Roth vehicles and nothing in Traditional ones. Is this is a good plan, or should we consider making Traditional contributions sooner (or later)?

[terran]

The only thing that matters when deciding between Roth and traditional is your marginal tax rate now (sounds like that's probably 12%) and marginal tax rate in retirement. How much do you plan to spend in retirement? See https://www.bogleheads.org/wiki/Traditional_versus_Roth

Given that you mention of age 60, unless you really plan to work that long, which seems somewhat unlikely given the forum you're on, take a look at https://www.madfientist.com/how-to-access-retirement-funds-early/ for how to access your retirement accounts before you're 60.

You might consider opening a solo 401(k) for your side gig income (assuming it's 1099 not W2) before investing in taxable. If you do then contributing to Roth solo 401(k) is and traditional in other accounts is preferable to the reverse because traditional solo 401(k) contributions reduce your Qualified Business Income deduction while Roth solo 401(k) and both Roth and traditional other accounts don't.

An AGI of $75k shouldn't end up anywhere near $21k in federal taxes (more like $5600), although state taxes and self employment taxes would increase that.

[bozemanboy]

Thanks for your response. I'll definitely check out the links you provided (I think I've read both at one point or another), and I'll also look into and consider solo 401k for my side gig income, which is usually a mix of W-2 and 1099.

You were totally right about the tax info not adding up. I accidentally presented our taxable income as AGI, which should be $100k, so the marginal rate is actually 22%, but your point remains the same. $21k for taxes includes FICA, federal, and state. I've edited my original post to correct this.

Thanks again!

[cool7hand]

Here is a link to a useful resource: https://forum.mrmoneymustache.com/investor-alley/investment-order/.

[MDM]

$20,968 is what the case study spreadsheet gets for all federal and state taxes for a $100K W-2 income, MFJ in Illinois.

Don't know if IL plans any state tax changes for 2021.

[bozemanboy]

I understand the Roth conversion ladder and the mechanics of accessing funds before age 59 1/2, but what is less clear to me is how DW's Roth 401k might fit into that picture, as it would be rolled-over directly into her Roth IRA and would therefore bypass the typical conversion step. If my thinking is correct, we would be better off delaying that rollover to maximize the 401k account value rather than rollover immediately when we move and DW gets a new job, because only the amount rolled-over could be withdrawn penalty-free after 5 years.

[Holocene]

The 12% tax bracket goes up to $81k for MFJ.  Add the $24k standard deduction and you're at $105k of income while still being in the 12% bracket.  Since you expect your income to go up quite drastically in another couple years, I'd say doing Roth in the 12% bracket is not a bad plan.  It may not end up being completely optimal, but a tax rate of 12% really isn't too bad.  If your income starts going above the $105k, then I'd recommend putting enough in the Traditional 401k to get below that threshold and get you back into the 12% bracket.

A few other things to consider:
1. If you're planning to retire very early, you could have a lot of years before 70 (social security, RMDs) to convert traditional to Roth and pay almost no taxes.  Assuming tax brackets stay the same (which they probably won't), you could stay in the 10% bracket if you keep your income under $44k.  With the first $24k tax free, you'd pay around $2k federal tax for an effective tax rate of 4.5%.  Even if you creep into the 12% bracket, your overall effective rate will be much lower than 12% since the first $44k is taxed less.  This is the advantage of living off a low income and retiring early.

2.  If you think you might want to retire to (or at any point move to) a different location, that could definitely have a large impact as well.  Some states have no income taxes, so saving on IL state taxes now and withdrawing in a state with no income tax or even a lower income tax could swing things in favor of traditional now.

3.  Any chance your wife's 401k allows after-tax contributions and in-service rollovers?  This could possibly allow you to contribute more to a Roth instead of taxable.  See https://www.madfientist.com/after-tax-contributions/

You bring up a good point about the Roth 401k.  When it's rolled over to Roth IRA, it's always been a bit fuzzy to me on how that's handled.  I think the basis should carry over from the 401k to IRA, so the timing of the rollover should not matter.  How is that tracked?  No clue.  I don't know if the 401k custodian provides that information to the IRA custodian as part of the rollover.  In case it's not, I'd keep good records of what she's contributing to the Roth 401k each year.  I'm not a tax expert, so I'm basing this off what I read here (Exception 2 section): https://fitaxguy.com/roth-401k-withdrawals/

[terran]

I understand the Roth conversion ladder and the mechanics of accessing funds before age 59 1/2, but what is less clear to me is how DW's Roth 401k might fit into that picture, as it would be rolled-over directly into her Roth IRA and would therefore bypass the typical conversion step. If my thinking is correct, we would be better off delaying that rollover to maximize the 401k account value rather than rollover immediately when we move and DW gets a new job, because only the amount rolled-over could be withdrawn penalty-free after 5 years.

No, the basis (amount originally contributed) in the Roth 401(k) transfers with the rollover. It's basically just like a big Roth IRA. The amount she's contributed will be able to come out any time without tax or penalty once it's in the IRA, but any gains need to stay there until she's 59.5 or she'll owe a penalty.

[bozemanboy]

I understand the Roth conversion ladder and the mechanics of accessing funds before age 59 1/2, but what is less clear to me is how DW's Roth 401k might fit into that picture, as it would be rolled-over directly into her Roth IRA and would therefore bypass the typical conversion step. If my thinking is correct, we would be better off delaying that rollover to maximize the 401k account value rather than rollover immediately when we move and DW gets a new job, because only the amount rolled-over could be withdrawn penalty-free after 5 years.

No, the basis (amount originally contributed) in the Roth 401(k) transfers with the rollover. It's basically just like a big Roth IRA. The amount she's contributed will be able to come out any time without tax or penalty once it's in the IRA, but any gains need to stay there until she's 59.5 or she'll owe a penalty.

Thanks for clarifying. So, in essence, it doesn't matter when the Roth 401k to Roth IRA rollover happens (at least beyond the benefit of greater control of the actual assets held) because the basis is the only part that can be withdrawn without penalty before 59.5, correct?

Taking that into account, it seems that we should consider making Traditional contributions to DW's 401k sooner rather than later in order to prepare for a Roth conversion ladder if early retirement is our goal, especially when combined with the fact that our current 22% marginal tax rate is quite possibly higher than what it will be in retirement, as our annual spend could double and still fall within the 12% marginal rate. And, as an added bonus, by maxing out Traditional 401k contributions in 2021 we could almost completely avoid the 22% marginal rate for the coming year. Any flaws with that logic?

[MDM]

...our current 22% marginal tax rate is quite possibly higher than what it will be in retirement....

That is the primary base on which to rest your choice.

See also Estimating future marginal tax rate portion of that wiki article to check those possibilities.

[chicagomeg]

There's a goofy loop hole in IL that your retirement distributions aren't taxed no matter your age. Therefore, in your shoes I might do a deductible traditional IRA contribution and then convert it to a Roth in the same year, as that saves you the 4.95% in IL taxes.