Author Topic: (Another) Roth vs. Traditional - 23yo  (Read 1140 times)

24andfrugal

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(Another) Roth vs. Traditional - 23yo
« on: May 21, 2019, 11:57:19 AM »
I know, I know. This question has been asked a million times, but I'm still rather new to this and need someone to hold my hand a bit.

I started a new job a few weeks ago and I'll need to make my benefits selections soon. I have about $5k in a Roth 401(k) from my last job, but I'm not sure whether to go Roth or Traditional this time around.

I'm 23 and make $69,000/year, and this coming April will be my last year as a single filer (I'll be getting married later in 2020; my fiance makes $37,500 and works for a small company that doesn't offer much of a retirement plan, in case that's relevant). I will also be getting a HDHP through my employer, so I have an option to (and plan to) contribute to an HSA.

I'd rather be able to take my money out tax free later, but I don't want to shoot myself in the foot by not taking advantage of tax savings. I guess my problem now is that things are still so early for me (and politics are so volatile) that it's hard to tell what my income level/tax bracket will be like and what my expenses will be later in life, as well as at what age we'd reach FI. I also plan to work part time (Barista FI) and may possibly own an Airbnb, if that factors into "what tax bracket would you be in retirement".

What should I do?

Also, is the advantage of a traditional 401k only realized if you're able to max out contributions? I think I could, but that might be pushing it.

Thanks!


EvenSteven

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #1 on: May 21, 2019, 12:09:59 PM »
The one comparison to rule them all when deciding between traditional or Roth is marginal tax now vs. marginal tax upon withdrawal. If your tax rate is lower now, Roth. If it will be lower when withdrawing, traditional.

Nobody can know with certainty, so you will have to make your best estimates. Some people like to have a good mix of both for tax diversification, it won't be perfectly optimal, but it won't be bad either.

thesis

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #2 on: May 21, 2019, 12:20:15 PM »
How much do you have in savings? I ask because this may be a decent indicator of how much risk you can take on currently. There are some great alternative perspectives on emergency funds, but since you are still early in your career and you are planning to get married within the next year, I'd recommend having a decent emergency fund in a low-risk location (something like 6 months worth of expenses would be good)

If you don't have much saved, consider the Roth 401k. Now, distributions of what you have contributed to a Roth 401k are taxed pro-rata, as opposed to a Roth IRA, where distributions of what you have contributed are not taxed, but since many companies still match traditional 401k money for Roth 401k contributions, this is still a decent way to get free money. Just make sure you're clear on what your company does or does not do. Also, hopefully your company's plan allows you to change your contribution number and type. Mine allows everything to be changed (funds, percentages, roth vs. traditional, current allocation, etc).

If you do have a lot saved, just go traditional and decrease your tax burden. Mad Fientist has a good article on why pre-tax money goes the furthest: https://www.madfientist.com/traditional-ira-vs-roth-ira/

In general, "Roth" money is more accessible. With that in mind, it matters how much else you have to fall back on if you need to. Gain a few more years of experience in your field, get your stache rolling, and then you can probably ignore this, but right now it's worth considering

Boofinator

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #3 on: May 21, 2019, 12:28:42 PM »
It's always toughest to decide this question when someone is just starting out and not making much money yet (and hence in a low tax bracket). Since you're in this boat, my official answer is that either Roth or Traditional will be great, and certainly better than the vast majority of people spending every dollar. But since you have to choose, I'd recommend Traditional. Here's why:

First, here's the basic concept separating Traditional and Roth (if you happen not to know yet): Traditional and Roth have essentially equal outcomes given equal marginal tax brackets during contributions and withdrawals. So if you're in the 15% combined marginal bracket now, and 15% when you pull out the money, you'll end up with the same exact amount of money whether you chose Traditional or Roth.

Now, here is the main benefit of Traditional as I see it: Traditional reduces risk. Here's the game theory grid of how things might pan out in your life:

                                      Life Outcome
Investment           Filthy Rich              Mustachian
Traditional                Loses                     Wins
Roth                        Wins                      Loses

So if you're filthy rich, Traditional will likely lose to Roth (there's no way to know for sure since tax code could change). But if this is the case, paying a little more in taxes would barely be noticeable. If you're a Mustachian who FIREs on 25x expenses, you'll pay essentially 0% tax rate on your Traditional contributions over your entire life, and your utility value of that extra money would allow for an earlier FIRE date or significantly higher spending. So if you're filthy rich, you might lose a little using Traditional, but if you're not rich you win a lot by using Traditional.
« Last Edit: May 21, 2019, 12:31:00 PM by Boofinator »

thesis

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #4 on: May 21, 2019, 12:29:57 PM »
Also for what it's worth, I prefer all my 401k contributions in the traditional flavor. Those extra dollars stack up very fast. I use a Roth IRA for my Roth money. I'd like to have more in the Roth IRA than I do currently, but yes, it is for tax diversification. Since the Roth Conversion Ladder requires a waiting period of five years, it's advisable to have at least five years of Roth and/or taxable funds before starting the process, at least if you plan to go from full-time work to no work, so this may not be necessary if you're doing Barista FI. Diversification is generally a good thing. Making "early" withdrawals on traditional 401k/IRA accounts comes at a steep price. You don't want to get backed into a corner where that is your only option.
« Last Edit: May 21, 2019, 12:38:48 PM by thesis »

24andfrugal

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #5 on: May 21, 2019, 01:12:29 PM »
Thank y'all for the replies so far.

@thesis I have about 95k in non-retirement funds. $45k is in a CD earning 2%; I plan to use it for a 20% down payment on a house which I plan to buy in 3.5-4 years, but almost certainly not before. I am considering reducing the amount I have set aside, putting some of that money into a taxable account, and then replenishing it with savings over the next few years.

The other $50k is just sitting in a money market right now, but I have started the process of opening a taxable account and plan to invest at least half of it in ETFs (don't facepunch me; I know it shouldn't be in cash, but despite being an econ major, I have a fairly limited knowledge of investing strategy and have been trying to wrap my head around all of it while getting on my feet in the workforce).

I also didn't know Roth 401k contributions were taxed pro rata, and I've always gotten the match % on my before-tax wages even though it was contributed after tax.

@Boofinator The reason I'm balking at Traditional is twofold:
1) How much I/my spouse make in Barista FI. What if he opens his own business? What if we have rental properties? What if I work part time, but rather than being a barista, I work as a management consultant and pull in big $$? What if none of that happens and I actually do make $20k/year?
I dislike the corporate grind but I love side hustling, so those could go any way. If I understand correctly, if I make too much, then backdooring the Roth will work out to be more expensive...is that right?
2) How much our expenses will be in 10-15 years. Lifestyle inflation won't be a problem; unexpected life events might be. How much a kid will cost, whether we will have one/adopt, when...etc.

I feel like if I could say for sure that we would stop working at X age, that we would never have kids, etc. then it would be an easier decision. At this point I'm not 100% certain I *can* reach FI at 35 or 40, but I'm damn sure going to try.

thesis

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #6 on: May 21, 2019, 01:30:09 PM »
@thesis I have about 95k in non-retirement funds.

Ha! Excellent. That's a great position to be in, I'd just go full traditional for your 401k.

Quote
I've always gotten the match % on my before-tax wages even though it was contributed after tax.

...but this is really good, too. That match money is one of the best returns.

Quote
The other $50k is just sitting in a money market right now, but I have started the process of opening a taxable account and plan to invest at least half of it in ETFs (don't facepunch me; I know it shouldn't be in cash, but despite being an econ major, I have a fairly limited knowledge of investing strategy and have been trying to wrap my head around all of it while getting on my feet in the workforce).

No facepunches here, I like cash :). Feeling comfortable investing is pretty important, too. Hang around MMM, JLCollins, MadFienist, and some of the other FI bloggers long enough and you'll start to see the bigger picture pretty easily.

Good luck!

Boofinator

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #7 on: May 21, 2019, 02:45:21 PM »
The reason I'm balking at Traditional is twofold:
1) How much I/my spouse make in Barista FI. What if he opens his own business? What if we have rental properties? What if I work part time, but rather than being a barista, I work as a management consultant and pull in big $$? What if none of that happens and I actually do make $20k/year?
I dislike the corporate grind but I love side hustling, so those could go any way. If I understand correctly, if I make too much, then backdooring the Roth will work out to be more expensive...is that right?
2) How much our expenses will be in 10-15 years. Lifestyle inflation won't be a problem; unexpected life events might be. How much a kid will cost, whether we will have one/adopt, when...etc.

One concept I find critical to understanding this dichotomy is the utility value of money: https://www.mrmoneymustache.com/2012/02/09/brave-new-life/. MMM simplifies the concept (and quotes the late great Jack Bogle) by using the phrase "Enough": https://www.mrmoneymustache.com/2011/09/04/book-review-enough-by-john-c-bogle/.

To summarize my thoughts with regards to your 1), the future is uncertain. The value you should seek to optimize in this uncertain future is not your money, as many presume, it is your happiness. And with Traditional, you usually end up getting to "enough" sooner than with Roth, which opens many doors toward a happier life; if it so happens that you become rich after you get "enough" and end up in hindsight not having optimized for your net worth when you die (or your spending when you're old), it doesn't matter, because you would have optimized for your happiness.

With regards to your 2), future expenses are unknown, but hopefully when you're approaching FI they will come into better focus and allow you to make the right decision to optimize your happiness despite the inherent uncertainty we face.

MDM

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #8 on: May 21, 2019, 09:17:18 PM »
...distributions of what you have contributed to a Roth 401k are taxed pro-rata
This statement is not correct.

Qualified distributions from both Roth 401k and Roth IRA accounts are tax free.

See Retirement Plans FAQs on Designated Roth Accounts | Internal Revenue Service.

thesis

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Re: (Another) Roth vs. Traditional - 23yo
« Reply #9 on: May 22, 2019, 11:36:16 AM »
...distributions of what you have contributed to a Roth 401k are taxed pro-rata
This statement is not correct.

Qualified distributions from both Roth 401k and Roth IRA accounts are tax free.

See Retirement Plans FAQs on Designated Roth Accounts | Internal Revenue Service.

Is the OP dead, disabled, or 59.5 years old? Has the money been in the account for at least five taxable years?

You're not wrong, but I'm clearly not talking about "qualified" distributions.  >:/

https://www.irs.gov/retirement-plans/designated-roth-accounts-distributions

For the OP's sake, though, the link MDM provides is a good link, the link I've included here is more of a digest. The rules do get a little tricky, but it doesn't hurt to familiarize yourself with some of the material. For someone who is 23 years old, you're going to want to pay more attention to the caveats of non-qualified distributions.