401(k) rollover: Roth IRA or Traditional?

[capital]

I'm 24 and have $28,000 in two 401(k)s from previous employers. I also have a bit over $10,000 in a Roth IRA, and about $20,000 in cash I'm planning on investing soon, probably in a taxable account. I'm planning on rolling them over into a Vanguard IRA, but having trouble deciding on whether I want to move them to a Roth or a traditional IRA.

I'd like to make my decisions before the end of the year, when at least some subset of taxes are likely to increase, though probably not mine. My skills are in high demand, so this year will probably be my lowest income, at least in the near-term, so long as I don't take a bunch of time off to travel the world in a few years. Hopefully, I'll be high enough income that I won't be able to make independent Roth contributions in a few years. Beyond that, my long-term goals are somewhat diffuse, but include at least having the option to retire early.

So far as I can tell, the relevant variables are whether I'd want to consider are what my tax rate is at present and what my tax rate will be at retirement. However, my retirement tax rate is pretty hard to determine, as I have no definite plans for when and where I'd retire, nor do I have much idea of what the marginal tax rates will be in 2030 or 2040 or so.

Here are my thoughts in favor of the traditional IRA: If I were to retire early, I would probably take a relatively low income from my investments, as my lifestyle is pretty cheap. I currently live in New York City, which has one of the highest marginal tax rates in the country, with any money rolled over facing state income taxes of about 10% in addition to federal taxes. If I retired early, I would probably be living somewhere with lower income tax rates. Also, since I'm so young, a large proportion of the value of my retirement accounts is likely to be taxed as capital gains.  Moreover, if I took a year off to travel in a few years, I could establish a home base in a lower-tax jurisdiction that year for a rollover.

But in favor of the Roth IRA: tax rates are at a post-war low, and my read of the political situation is that the Republican anti-tax jihad is reaching is end. Likewise, if current demographic trends and medical trends hold (basically, if significantly more immigration isn't permitted, and Medicare continues spending more on medical care to let elderly people live longer, without a significant cultural shift toward hospice care and away from aggressive end-of-life care), the elderly share of the population will be much higher when I'm older, and their medical spending will likewise be higher, necessitating higher taxation to fund Medicare. There's also a pretty high chance capital gains taxes will be higher in the future.

It seems like neither I nor anyone else can say for sure whether my tax rate would be higher or lower in retirement. I'm thinking the right choice would be to roll over half the funds to a Roth, and the other half to a traditional IRA, in order to hedge against tax shifts in either direction. Is there anything I've missed?

[TLV]

You have to rollover to a traditional IRA if it's a pre-tax 401k. You can convert from traditional IRA to Roth IRA, but that's separate from the rollover.

I would go with the traditional for the following reasons:
* NYC state/city taxes. If you're moving somewhere else at retirement, that's a BIG difference.
* You can do the conversion to a Roth later, after you retire and your taxable income is lower.
* Some of your arguments in favor of the Roth don't work - capital gains taxes won't affect either type of account, and additional taxes to support medicare are likely to be payroll taxes (like the current ones) or capital gains taxes (again, no effect on either type) rather than ordinary income taxes.
* You need to compare marginal tax rates now to total effective tax rates at withdrawal (or future rollover) - and remember that the personal exemption and standard deduction will lower your tax bracket even further.

[JohnGalt]

You have to rollover to a traditional IRA if it's a pre-tax 401k. You can convert from traditional IRA to Roth IRA, but that's separate from the rollover.

I would go with the traditional for the following reasons:
* NYC state/city taxes. If you're moving somewhere else at retirement, that's a BIG difference.
* You can do the conversion to a Roth later, after you retire and your taxable income is lower.
* Some of your arguments in favor of the Roth don't work - capital gains taxes won't affect either type of account, and additional taxes to support medicare are likely to be payroll taxes (like the current ones) or capital gains taxes (again, no effect on either type) rather than ordinary income taxes.
* You need to compare marginal tax rates now to total effective tax rates at withdrawal (or future rollover) - and remember that the personal exemption and standard deduction will lower your tax bracket even further.

+1

[sherr]

You have to rollover to a traditional IRA if it's a pre-tax 401k. You can convert from traditional IRA to Roth IRA, but that's separate from the rollover.

I would go with the traditional for the following reasons:
* NYC state/city taxes. If you're moving somewhere else at retirement, that's a BIG difference.
* You can do the conversion to a Roth later, after you retire and your taxable income is lower.
* Some of your arguments in favor of the Roth don't work - capital gains taxes won't affect either type of account, and additional taxes to support medicare are likely to be payroll taxes (like the current ones) or capital gains taxes (again, no effect on either type) rather than ordinary income taxes.
* You need to compare marginal tax rates now to total effective tax rates at withdrawal (or future rollover) - and remember that the personal exemption and standard deduction will lower your tax bracket even further.

+1

That was an astute question and an extremely well-thought-out answer. I have nothing to add except my congratulations to both of you.

[capital]

Thanks for the help. That definitely helps clarify my thinking. I'm not planning on putting too much effort into getting wealthy enough to retire with a huge income (and thus big taxes), and I have a bit of a tax hedge with the other Roth anyway, so avoiding the high marginal tax rate at present does seem like the way to go.

[hoppy08520]

I probably agree with the others who suggest traditional, especially with your NY city/state taxes. If you lived in a state with no income tax, and you could convert in the 15% Federal tax bracket, then there might be a case for Roth conversion, but if you're in the 25% Federal tax bracket, then there's no way I'd convert to Roth.

[Kriegsspiel]

In this same vein, I have a quick question about what is taxed when you roll over a 401k.

Right now, I max out my Roth IRA, and I have a trad 401k at my employer that I'm maxing out.  Say I retire in 4 years or so, and I want to roll that 401k into my Roth IRA account.  Say I retire in October.

1. If I want to roll the 401k over to the Roth IRA once I retire in October, what will be taxed, the contributions, or the total value of the 401k?

2. What tax rate will it be taxed at?  The last years income (so, say I make $60,000 from January to October, will that be used?  Or since I roll it over when I no longer have a paycheck coming, only investment income, will THAT be used?

Basically, if traditional 401ks work out to where I do not have to pay taxes on the money in my current bracket, but I can wait until I'm in a lower tax bracket (Mustachian-retire) to pay those taxes, I don't see a reason to utilize a Roth 401k that my work offers.

[TN_Steve]

In this same vein, I have a quick question about what is taxed when you roll over a 401k.

Right now, I max out my Roth IRA, and I have a trad 401k at my employer that I'm maxing out.  Say I retire in 4 years or so, and I want to roll that 401k into my Roth IRA account.  Say I retire in October.

1. If I want to roll the 401k over to the Roth IRA once I retire in October, what will be taxed, the contributions, or the total value of the 401k?

2. What tax rate will it be taxed at?  The last years income (so, say I make $60,000 from January to October, will that be used?  Or since I roll it over when I no longer have a paycheck coming, only investment income, will THAT be used?

Basically, if traditional 401ks work out to where I do not have to pay taxes on the money in my current bracket, but I can wait until I'm in a lower tax bracket (Mustachian-retire) to pay those taxes, I don't see a reason to utilize a Roth 401k that my work offers.

TLV has it right, above.  You can't roll traditional 401k directly into Roth.  Need to go into traditional rollover IRA, then convert.  So a two-step process, although it can be done in the same week.

Given that, if you retired in October after making $$ all year, you probably would want to rollover, then wait until the next tax year to convert to Roth (in whole or in part).  Since you are coming from Traditional 401k, 100% of your converted funds will be taxable.  They will be taxed, in your example, beginning at $60,001 income level (ignoring exclusions and deductions).  So, if you are getting taxed at that level and, by waiting till the next January 1, can avoid all taxes, or get in at a lower rate, you should convert in the next year.  So too, there is no requirement to convert everything at once--particularly if it thrusts you into uncomfortable tax situation.

By way of example, I plan to do gradual Roth conversions over most of a decade once we retire.  We have an obscene amount in traditional accounts (Roths barred to us for most of our careers), and if we were to convert them all in one year it would be extremely painful.  Plus, we won't do any conversions until the next calendar year following our retirements (same reason). 

[Kriegsspiel]

Ok, so yes, the entire 401k (or IRA, rather) would be taxed?  So really, the thing to consider is if I will pay less taxes on the contributions going in at my current tax bracket, OR on the contributions + earnings in a lower tax bracket?

[TN_Steve]

Ok, so yes, the entire 401k (or IRA, rather) would be taxed?  So really, the thing to consider is if I will pay less taxes on the contributions going in at my current tax bracket, OR on the contributions + earnings in a lower tax bracket?

The entire amount converted each year would be subject to tax.  (I am assuming that you don't have to deal with the pro-rata headaches of "nondeductible IRAs," but even if you are, they don't change the analysis that much).

So yea, you weigh the amount you would pay today (at your present highest marginal rate) versus the tax in retirement, which would be at a far lower rate if you don't have other income coming in.  In fact, by converting in stages, you could conceivably owe no tax at all for the conversions, or could choose to pay no more than the lowest marginal rate for each year's conversion.  Note also that if your other income is low in the conversion years, the 401k/IRA assets essentially would be getting taxed at your average rate, rather than your marginal rate, which makes the process even more attractive.

[dhiltonp]

Wow, this is exactly what I needed to know, too!

Thanks everyone for your questions and answers :)

[Dianas Report]

ehgee, let me first start off by saying that you are doing awesome thus far, bravo! Being 24 yr.'s old and saving wisely that is something to congratulate. Hopefully you are sharing your knowledge with all your associates, friends, relations.

I would really recommend  ROTH IRA, it grows tax free vs. traditional, you have to pay tax on all your earnings and you must withdraw at a certain age while Roth IRA doesn't have to be withdrawn and can be passed on to your spouse/children/etc. and it belongs to them (tax free). There are many more perks of ROTH, look them up!

Yes, the tax rate will increase by the time either of us retire but atleast you won't be taxed on your gains all those years if you invested in ROTH.

[sherr]

I would really recommend  ROTH IRA, it grows tax free vs. traditional, you have to pay tax on all your earnings...

Hi Dianas Report, while this is technically true it is also highly deceptive and can cause people to choose Roth accounts over Traditional when in fact the Traditional would be better for them. It is true that once your money is in a Roth account and you have paid taxes on it then everything is tax free after that. It is also true that you will have to pay income taxes on all the money in your Traditional account when you withdraw it, including the earnings. However, this does not automatically make Roth accounts better, because you have to pay taxes on the Roth accounts upfront whereas you get to deduct any money you put into a Traditional account. It all comes down to which tax rate will be higher, your marginal tax rate now or you average tax rate in retirement. If your tax rate is higher now then Traditional accounts are better. If your tax rate is higher in retirement then Roth accounts are better. Given that people generally spend much less in retirement than they make while they are working it's a safe bet that a Traditional IRA is the better choice for most people. I would say that anyone in a 25% or higher bracket should use Traditional accounts as much as possible, while anyone in a 15% or lower bracket probably should use a Roth account.

If your tax rates are the same now as in retirement then the accounts are more or less equivalent. This is due to the associative property of multiplication. If we let P = principle you have to invest, TR = tax rate, Y = average percent yeild, and y = number of years you are investing, then:

Roth:
P * (1 - TR) * (1 + Y)^y = Total money you will have at the end.
Traditional:
P * (1 + Y)^y * (1 - TR) = Total money you will have at the end.

The principle, average percent yield, and number of years you invest will be the same either way. If the tax rates you are paying are the same now as they will be when you retire then the two equations are equivalent. It doesn't matter if you subtract taxes at the beginning or the end, if the rates are the same you will end up with the same amount of money.

Yes, the tax rate will increase by the time either of us retire but atleast you won't be taxed on your gains all those years if you invested in ROTH.

You don't know that. I think it is likely that tax rates will rise in general, but I think it is *unlikely* that the rates on the "poorest" people in society, those in the 15% brackets and below, will rise all that much.

but atleast you won't be taxed on your gains all those years if you invested in ROTH.

Wrong, you were already taxed on them at the beginning. You would have had more gains if you were able to invest that money you lost to taxes. It works out the same.

[JohnGalt]

I would really recommend  ROTH IRA, it grows tax free vs. traditional, you have to pay tax on all your earnings...

Hi Dianas Report, while this is technically true it is also highly deceptive and can cause people to choose Roth accounts over Traditional when in fact the Traditional would be better for them. It is true that once your money is in a Roth account and you have paid taxes on it then everything is tax free after that. It is also true that you will have to pay income taxes on all the money in your Traditional account when you withdraw it, including the earnings. However, this does not automatically make Roth accounts better, because you have to pay taxes on the Roth accounts upfront whereas you get to deduct any money you put into a Traditional account. It all comes down to which tax rate will be higher, your marginal tax rate now or you average tax rate in retirement. If your tax rate is higher now then Traditional accounts are better. If your tax rate is higher in retirement then Roth accounts are better. Given that people generally spend much less in retirement than they make while they are working it's a safe bet that a Traditional IRA is the better choice for most people. I would say that anyone in a 25% or higher bracket should use Traditional accounts as much as possible, while anyone in a 15% or lower bracket probably should use a Roth account.

If your tax rates are the same now as in retirement then the accounts are more or less equivalent. This is due to the associative property of multiplication. If we let P = principle you have to invest, TR = tax rate, Y = average percent yeild, and y = number of years you are investing, then:

Roth:
P * (1 - TR) * (1 + Y)^y = Total money you will have at the end.
Traditional:
P * (1 + Y)^y * (1 - TR) = Total money you will have at the end.

The principle, average percent yield, and number of years you invest will be the same either way. If the tax rates you are paying are the same now as they will be when you retire then the two equations are equivalent. It doesn't matter if you subtract taxes at the beginning or the end, if the rates are the same you will end up with the same amount of money.

Yes, the tax rate will increase by the time either of us retire but atleast you won't be taxed on your gains all those years if you invested in ROTH.

You don't know that. I think it is likely that tax rates will rise in general, but I think it is *unlikely* that the rates on the "poorest" people in society, those in the 15% brackets and below, will rise all that much.

but atleast you won't be taxed on your gains all those years if you invested in ROTH.

Wrong, you were already taxed on them at the beginning. You would have had more gains if you were able to invest that money you lost to taxes. It works out the same.

Sherr - I think you have it mostly right.  The only thing I think you're missing is that for someone expecting the same current tax rate and withdrawal tax rate - they may be better off with the roth option if they are planning on maxing out their contributions regardless of which route they take.  This is because your functions are missing one component to account for the cap on contributions. 

Roth:
MIN(17500,P * (1 - TR)) * (1 + Y)^y = Total money you will have at the end.
Traditional:
MIN(17500,P) * (1 + Y)^y * (1 - TR) = Total money you will have at the end.

So, once you hit the cap, they become:

Roth:
17500*(1+Y)^y
Traditional:
17500*(1+Y)^y*(1-TR)

Of course, to get it completely right, you would then need to account for investing the taxes you are saving on the traditional side in a taxable account - but then you'll be taxed on dividend/capital gains every year you realize them along the way so traditional will fall behind.  Probably not much of a difference overall in the grand scheme of things, but enough to put the roth slightly ahead in a constant tax rate scenario. 

[sherr]

I would really recommend  ROTH IRA, it grows tax free vs. traditional, you have to pay tax on all your earnings...

Hi Dianas Report, while this is technically true it is also highly deceptive and can cause people to choose Roth accounts over Traditional when in fact the Traditional would be better for them. It is true that once your money is in a Roth account and you have paid taxes on it then everything is tax free after that. It is also true that you will have to pay income taxes on all the money in your Traditional account when you withdraw it, including the earnings. However, this does not automatically make Roth accounts better, because you have to pay taxes on the Roth accounts upfront whereas you get to deduct any money you put into a Traditional account. It all comes down to which tax rate will be higher, your marginal tax rate now or you average tax rate in retirement. If your tax rate is higher now then Traditional accounts are better. If your tax rate is higher in retirement then Roth accounts are better. Given that people generally spend much less in retirement than they make while they are working it's a safe bet that a Traditional IRA is the better choice for most people. I would say that anyone in a 25% or higher bracket should use Traditional accounts as much as possible, while anyone in a 15% or lower bracket probably should use a Roth account.

If your tax rates are the same now as in retirement then the accounts are more or less equivalent. This is due to the associative property of multiplication. If we let P = principle you have to invest, TR = tax rate, Y = average percent yeild, and y = number of years you are investing, then:

Roth:
P * (1 - TR) * (1 + Y)^y = Total money you will have at the end.
Traditional:
P * (1 + Y)^y * (1 - TR) = Total money you will have at the end.

The principle, average percent yield, and number of years you invest will be the same either way. If the tax rates you are paying are the same now as they will be when you retire then the two equations are equivalent. It doesn't matter if you subtract taxes at the beginning or the end, if the rates are the same you will end up with the same amount of money.

Yes, the tax rate will increase by the time either of us retire but atleast you won't be taxed on your gains all those years if you invested in ROTH.

You don't know that. I think it is likely that tax rates will rise in general, but I think it is *unlikely* that the rates on the "poorest" people in society, those in the 15% brackets and below, will rise all that much.

but atleast you won't be taxed on your gains all those years if you invested in ROTH.

Wrong, you were already taxed on them at the beginning. You would have had more gains if you were able to invest that money you lost to taxes. It works out the same.

Sherr - I think you have it mostly right.  The only thing I think you're missing is that for someone expecting the same current tax rate and withdrawal tax rate - they may be better off with the roth option if they are planning on maxing out their contributions regardless of which route they take.  This is because your functions are missing one component to account for the cap on contributions. 

Roth:
MIN(17500,P * (1 - TR)) * (1 + Y)^y = Total money you will have at the end.
Traditional:
MIN(17500,P) * (1 + Y)^y * (1 - TR) = Total money you will have at the end.

So, once you hit the cap, they become:

Roth:
17500*(1+Y)^y
Traditional:
17500*(1+Y)^y*(1-TR)

Of course, to get it completely right, you would then need to account for investing the taxes you are saving on the traditional side in a taxable account - but then you'll be taxed on dividend/capital gains every year you realize them along the way so traditional will fall behind.  Probably not much of a difference overall in the grand scheme of things, but enough to put the roth slightly ahead in a constant tax rate scenario.

That is completely correct and fair, I just don't usually delve into that level of detail when responding to "Roth accounts are *tax free* whereas you have to pay tax on *everything* in a Traditional account!" type posts. The reality of the situation is that if you follow the "15% or below bracket: use Roth. 25% or above bracket: use Traditional" advice and you are not planning on spending like crazy in retirement then you are almost certain to come out ahead.

[Mr Mark]

We've had the Roth vs trad IRA discussion before.

It's almost counter-intuitive, but if your income tax rate does not change, there is no difference in returns after tax between a Roth or an IRA. It seems like it must better to go Roth, as all that growth is tax free right?  But this is not mathematically correct. Imagine I'm paying 33% tax. If I split my invest ment into 3 pieces now, and invest them in the index at x% compounded growth, the Roth will be the total of 2 of the 3 after tax. The IRA will be all 3 before tax, but 1 of them will exactly equal the tax due, IF TAX RATES ARE STILL 33%.

If you currently pay low tax rates, go Roth and pay the tax now. If you are paying a high rate now, take a deduction with a traditional IRA and defer the tax until you are over 60.

[TheDude]

If you currently pay low tax rates, go Roth and pay the tax now. If you are paying a high rate now, take a deduction with a traditional IRA and defer the tax until you are over 60.

Boom 100% correct!

The IRA debate drives me nuts.

[Mr Mark]

If you currently pay low tax rates, go Roth and pay the tax now. If you are paying a high rate now, take a deduction with a traditional IRA and defer the tax until you are over 60.

Boom 100% correct!

The IRA debate drives me nuts.

This is where I'm missing input from Sol...  I guess it can get a lot Messer, say if you've maxed out IRA and Roth, and have a 401k with a certain contribution match (almost certainly best first investment) . 

And what about these IRA to Roth conversions... is there a good/bad time to do that?