Author Topic: Does a Roth make more sense in my situation?  (Read 3890 times)

tharidumuf

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Does a Roth make more sense in my situation?
« on: July 14, 2016, 08:49:41 PM »
Age of self and spouse: 30

Current household income = $125,000
Anticipated household income in 10 years = $165,000-$185,000
Anticipated household income in 20 years = $200,000-$220,000

I can retire at age 50 with a pension (~$45,000) with mandatory retirement at 57.  Ill likely seek another job using my professional skill set.  My spouse will retire at 65 with a pension of ~$40,000.  I contribute to social security but my spouse does not.

The question: Does it make more sense to go the tax-deferred or Roth route with regard to our investments?

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #1 on: July 14, 2016, 09:53:00 PM »
Age of self and spouse: 30
Current household income = $125,000
Anticipated household income in 10 years = $165,000-$185,000
Anticipated household income in 20 years = $200,000-$220,000
I can retire at age 50 with a pension (~$45,000) with mandatory retirement at 57.  Ill likely seek another job using my professional skill set.  My spouse will retire at 65 with a pension of ~$40,000.  I contribute to social security but my spouse does not.

The question: Does it make more sense to go the tax-deferred or Roth route with regard to our investments?
Taking this info at face value (e.g., no kids) your current marginal rate is 25%, likely to stay there for the next 20 years, and you have $0 in traditional 401ks, IRAs, etc.  You don't know for sure if that pension will be there for you in 20 years, nor for your spouse in 45 years, nor what pay you will be able to get in another job.  $45K in 20 years is ~$30K today, assuming 2% inflation.  $30K today would give you a 10% marginal rate.

25% now vs. 10% later indicates the best choice for you now is traditional.  See https://www.bogleheads.org/wiki/Traditional_versus_Roth.

Change any of the above assumptions and the best choice might also change. ;)

beltim

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Re: Does a Roth make more sense in my situation?
« Reply #2 on: July 14, 2016, 10:07:32 PM »
Age of self and spouse: 30
Current household income = $125,000
Anticipated household income in 10 years = $165,000-$185,000
Anticipated household income in 20 years = $200,000-$220,000
I can retire at age 50 with a pension (~$45,000) with mandatory retirement at 57.  Ill likely seek another job using my professional skill set.  My spouse will retire at 65 with a pension of ~$40,000.  I contribute to social security but my spouse does not.

The question: Does it make more sense to go the tax-deferred or Roth route with regard to our investments?
Taking this info at face value (e.g., no kids) your current marginal rate is 25%, likely to stay there for the next 20 years, and you have $0 in traditional 401ks, IRAs, etc.  You don't know for sure if that pension will be there for you in 20 years, nor for your spouse in 45 years, nor what pay you will be able to get in another job.  $45K in 20 years is ~$30K today, assuming 2% inflation.  $30K today would give you a 10% marginal rate.

25% now vs. 10% later indicates the best choice for you now is traditional.  See https://www.bogleheads.org/wiki/Traditional_versus_Roth.

Change any of the above assumptions and the best choice might also change. ;)

Literally 0 pensions quote their benefit in "20 years ago" dollars so adjusting for inflation is pretty silly here, unless there's reason to think that the salary will not increase as fast as inflation and considering the OP does not think so, I think it's a very silly assumption.

Also, I find it interesting you're focused on the 8-15 year period between pensions, when the OP said they would find work anyway, and for some reason you're not including the spouse's salary.

Sure, assumptions can change, but your assumptions don't make sense with what was written.

In contrast, if you look at the longest period of time, income will be at least 85k, which puts the family ~10k shy of the 25% tax bracket, not including Social Security.  This might be a case where Roth contributions make more sense now, since the household anticipates moving up a tax bracket between now and retirement, and the projected retirement income from pensions and Social Security may get the family into the tax bracket they're currently in.

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #3 on: July 14, 2016, 10:27:39 PM »
Literally 0 pensions quote their benefit in "20 years ago" dollars so adjusting for inflation is pretty silly here, unless there's reason to think that the salary will not increase as fast as inflation and considering the OP does not think so, I think it's a very silly assumption.
Why is adjusting for inflation in order to estimate the retirement marginal tax rate "silly"?

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Also, I find it interesting you're focused on the 8-15 year period between pensions, when the OP said they would find work anyway, and for some reason you're not including the spouse's salary.
Good point on the spouse's salary - but we don't know what it is.  Following http://forum.mrmoneymustache.com/ask-a-mustachian/how-to-write-a-'case-study'-topic/ would help.  Also, delaying pensions and SS specifically to allow traditional->Roth conversions at low marginal rates can be a great strategy.

Quote
Sure, assumptions can change, but your assumptions don't make sense with what was written.
In contrast, if you look at the longest period of time, income will be at least 85k, which puts the family ~10k shy of the 25% tax bracket, not including Social Security.  This might be a case where Roth contributions make more sense now, since the household anticipates moving up a tax bracket between now and retirement, and the projected retirement income from pensions and Social Security may get the family into the tax bracket they're currently in.
One can assume everything will be so rosy that pensions and SS will be so lucrative that retirement tax rates will be as high as current tax rates and thus one should use all Roth.  Or one can use a more conservative set of assumptions.  The downside of being wrong when using "all Roth" is worse than the downside of being wrong when using "all traditional" - correct?

beltim

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Re: Does a Roth make more sense in my situation?
« Reply #4 on: July 14, 2016, 11:04:19 PM »
Literally 0 pensions quote their benefit in "20 years ago" dollars so adjusting for inflation is pretty silly here, unless there's reason to think that the salary will not increase as fast as inflation and considering the OP does not think so, I think it's a very silly assumption.
Why is adjusting for inflation in order to estimate the retirement marginal tax rate "silly"?

Because no one quotes unearned pensions in nominal rather than inflation-adjusted dollars, so you don't need to adjust it again.

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Sure, assumptions can change, but your assumptions don't make sense with what was written.
In contrast, if you look at the longest period of time, income will be at least 85k, which puts the family ~10k shy of the 25% tax bracket, not including Social Security.  This might be a case where Roth contributions make more sense now, since the household anticipates moving up a tax bracket between now and retirement, and the projected retirement income from pensions and Social Security may get the family into the tax bracket they're currently in.
One can assume everything will be so rosy that pensions and SS will be so lucrative that retirement tax rates will be as high as current tax rates and thus one should use all Roth.  Or one can use a more conservative set of assumptions.  The downside of being wrong when using "all Roth" is worse than the downside of being wrong when using "all traditional" - correct?

How rosy or conservative the projections are depend on some factors that aren't known.  For example, if they're already vested in the pensions, I think it's short-sighted to not include them in tax planning.

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #5 on: July 14, 2016, 11:54:07 PM »
Because no one quotes unearned pensions in nominal rather than inflation-adjusted dollars, so you don't need to adjust it again.
Perhaps I misunderstand what you are saying and we actually agree.

The Megacorp pension estimate I get tells me how many $/yr I can expect (assuming all the assumptions hold) in some future year.  That number is independent of inflation.  In order to estimate the marginal tax on that amount, one needs either to inflate the tax brackets or deflate the pension estimate.  Perhaps Megacorp is the only firm to do it this way...?

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How rosy or conservative the projections are depend on some factors that aren't known.
On that, we agree.

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For example, if they're already vested in the pensions, I think it's short-sighted to not include them in tax planning.
Sure.  And if those pension estimates assume continued employment with some annual salary increase between now and the listed pension start age, we're back to the unsymmetric upside/downside of being correct/incorrect on the Roth/traditional choice.

In short, the OP mentioned nothing about any traditional account balance.  If that is the case, it seems they ought to rectify that situation and put at least a few years' worth of $36K contributions into traditional plans.  After a few years they can re-evaluate for subsequent choices.

seattlecyclone

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Re: Does a Roth make more sense in my situation?
« Reply #6 on: July 15, 2016, 12:06:33 AM »
I can retire at age 50 with a pension (~$45,000) with mandatory retirement at 57.  Ill likely seek another job using my professional skill set.  My spouse will retire at 65 with a pension of ~$40,000.  I contribute to social security but my spouse does not.

You won't be 50 for 20 more years. Your spouse won't be 65 for 35 more years. A lot can happen in that time. The pension is a fine goal to work toward as long as you both genuinely enjoy your jobs, but who's to say that will be the case for decades? Maybe after you save some more money and approach financial independence you'll decide that there's something else you would rather do with your time than go into work every day for the next decade just to qualify for a pension that you no longer actually need because you've saved enough to do fine without it.

But let's suppose you both stick around in the same job long enough to qualify for pensions. Your current income puts you in the 25% tax bracket, while your expectations 20 years out would have you in the 28% tax bracket. By contrast, your $85k pension income all on its own would put you in the 15% tax bracket after considering the standard deduction and personal exemptions.

This difference in tax brackets makes some traditional retirement accounts seem like a good idea. Saving 25-28% on your taxes while you're working to later pay 15% when retired is a pretty nice deal! However $85k gross income is close to the top of the 15% bracket, so after few years of saving in traditional retirement accounts you may find that your projections put you in the 25% tax bracket during retirement. At this point there's little difference between the two options assuming that the pension does become a reality. I might probably err on the side of traditional just in case one or both pensions don't end up happening for whatever reason, but you could go either way.

beltim

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Re: Does a Roth make more sense in my situation?
« Reply #7 on: July 15, 2016, 07:00:31 AM »
Because no one quotes unearned pensions in nominal rather than inflation-adjusted dollars, so you don't need to adjust it again.
Perhaps I misunderstand what you are saying and we actually agree.

The Megacorp pension estimate I get tells me how many $/yr I can expect (assuming all the assumptions hold) in some future year.  That number is independent of inflation.  In order to estimate the marginal tax on that amount, one needs either to inflate the tax brackets or deflate the pension estimate.  Perhaps Megacorp is the only firm to do it this way...?

My question to you is this: does your pension estimate go up each year, beyond what would accrue from another year of service?  (usually because your salary has increased) If yes, as with most pensions, then your pension is calculated as a percentage of salary, which should increase at least as fast as inflation.

Your calculation is correct is the inflation is not pension adjusted (may or may not be a good assumption), and the OP stops working in advance of when they will start to collect the pension.  Since we don't have any information about either, it seems odd to me that you're assuming the worst.

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #8 on: July 15, 2016, 07:42:12 AM »
My question to you is this: does your pension estimate go up each year, beyond what would accrue from another year of service?  (usually because your salary has increased)
In short, no.

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If yes, as with most pensions, then your pension is calculated as a percentage of salary, which should increase at least as fast as inflation.
The estimate is based on an assumed annual percentage (user-chosen) salary increase between now and retirement.  The pension estimate is as good as the assumption used.  If one assumes correctly, the pension estimate never changes.

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Your calculation is correct is the inflation is not pension adjusted (may or may not be a good assumption), and the OP stops working in advance of when they will start to collect the pension.  Since we don't have any information about either, it seems odd to me that you're assuming the worst.
Speaking of assumptions, I've been assuming the "downside of choosing all Roth and being wrong is worse than the downside of choosing all traditional and being wrong" is understood and agreed.  Good assumption or should this be explained?

beltim

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Re: Does a Roth make more sense in my situation?
« Reply #9 on: July 15, 2016, 07:47:43 AM »
My question to you is this: does your pension estimate go up each year, beyond what would accrue from another year of service?  (usually because your salary has increased)
In short, no.

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If yes, as with most pensions, then your pension is calculated as a percentage of salary, which should increase at least as fast as inflation.
The estimate is based on an assumed annual percentage (user-chosen) salary increase between now and retirement.  The pension estimate is as good as the assumption used.  If one assumes correctly, the pension estimate never changes.

Weird!  So your pension estimate assumes future employment, like Social Security.  This has not generally been my experience for pension calculations.  Well, that explains that difference.

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Your calculation is correct is the inflation is not pension adjusted (may or may not be a good assumption), and the OP stops working in advance of when they will start to collect the pension.  Since we don't have any information about either, it seems odd to me that you're assuming the worst.
Speaking of assumptions, I've been assuming the "downside of choosing all Roth and being wrong is worse than the downside of choosing all traditional and being wrong" is understood and agreed.  Good assumption or should this be explained?

In general or in this case?  I think in general this is a good assumption, but I think the presence of a potential large pension means that in situations like this one, it needs to be more closely examined.

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #10 on: July 15, 2016, 08:24:20 AM »
Weird!  So your pension estimate assumes future employment, like Social Security.  This has not generally been my experience for pension calculations.  Well, that explains that difference.
Pension estimators, much like pensions themselves, can differ.  E.g., Megacorp allows one to defer the pension after retiring.  In return one gets a higher annual payment when payments do start - again similar to SS.  Apparently (from comments in other threads) not all pensions have this feature.

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In general or in this case?  I think in general this is a good assumption, but I think the presence of a potential large pension means that in situations like this one, it needs to be more closely examined.
If one puts "too much" into traditional (i.e., retirement income is higher than projected) the downside is paying more taxes than necessary on the traditional withdrawals.  The person still has more than enough money so quality of life is unaffected.  The estate at death is a little smaller than it would have been if more Roth had been used.

If one puts "too much" into Roth (i.e., retirement income is lower than projected) the downside is not being able to reclaim the taxes that were paid upfront when the money is needed in retirement.  The person does not have enough money in retirement, so the quality of life suffers.

Errors in estimating retirement income can occur due to misestimating market returns, contribution amounts, pension and/or SS income, etc.

The closer one gets to retirement, the more accurate the estimates are likely to be.

beltim

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Re: Does a Roth make more sense in my situation?
« Reply #11 on: July 15, 2016, 09:00:40 AM »
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In general or in this case?  I think in general this is a good assumption, but I think the presence of a potential large pension means that in situations like this one, it needs to be more closely examined.
If one puts "too much" into traditional (i.e., retirement income is higher than projected) the downside is paying more taxes than necessary on the traditional withdrawals.  The person still has more than enough money so quality of life is unaffected.  The estate at death is a little smaller than it would have been if more Roth had been used.

If one puts "too much" into Roth (i.e., retirement income is lower than projected) the downside is not being able to reclaim the taxes that were paid upfront when the money is needed in retirement.  The person does not have enough money in retirement, so the quality of life suffers.

Errors in estimating retirement income can occur due to misestimating market returns, contribution amounts, pension and/or SS income, etc.

The closer one gets to retirement, the more accurate the estimates are likely to be.

In both cases putting too much in one type of account results in a higher tax bill than if they had contributed to the other type of account.  Anything beyond that is just projecting what you think the likely result of that is.  People aren't generally confused about whether it's better to contribute to a traditional or Roth account the year before they retire instead, like in the OP, they're not sure about predicting the future decades in advance.  Holding to a fixed plan set decades in advance, without further consideration closer to retirement, could result in a terrible retirement.  But that's not what people should do.

MDM

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Re: Does a Roth make more sense in my situation?
« Reply #12 on: July 15, 2016, 10:23:17 AM »
Holding to a fixed plan set decades in advance, without further consideration closer to retirement, could result in a terrible retirement.  But that's not what people should do.
Agreed.  At least in this thread nobody has suggested such a fixed plan.

E.g.,
In short, the OP mentioned nothing about any traditional account balance.  If that is the case, it seems they ought to rectify that situation and put at least a few years' worth of $36K contributions into traditional plans.  After a few years they can re-evaluate for subsequent choices.
This difference in tax brackets makes some traditional retirement accounts seem like a good idea. Saving 25-28% on your taxes while you're working to later pay 15% when retired is a pretty nice deal! However $85k gross income is close to the top of the 15% bracket, so after few years of saving in traditional retirement accounts you may find that your projections put you in the 25% tax bracket during retirement. At this point there's little difference between the two options assuming that the pension does become a reality. I might probably err on the side of traditional just in case one or both pensions don't end up happening for whatever reason, but you could go either way.

Dicey

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Re: Does a Roth make more sense in my situation?
« Reply #13 on: July 16, 2016, 08:23:37 AM »
Do both.

oneday

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Re: Does a Roth make more sense in my situation?
« Reply #14 on: July 18, 2016, 06:52:03 PM »
Age of self and spouse: 30
Current household income = $125,000
Anticipated household income in 10 years = $165,000-$185,000
Anticipated household income in 20 years = $200,000-$220,000
I can retire at age 50 with a pension (~$45,000) with mandatory retirement at 57.  Ill likely seek another job using my professional skill set.  My spouse will retire at 65 with a pension of ~$40,000.  I contribute to social security but my spouse does not.

The question: Does it make more sense to go the tax-deferred or Roth route with regard to our investments?
Taking this info at face value (e.g., no kids) your current marginal rate is 25%, likely to stay there for the next 20 years, and you have $0 in traditional 401ks, IRAs, etc.  You don't know for sure if that pension will be there for you in 20 years, nor for your spouse in 45 years, nor what pay you will be able to get in another job.  $45K in 20 years is ~$30K today, assuming 2% inflation.  $30K today would give you a 10% marginal rate.

25% now vs. 10% later indicates the best choice for you now is traditional.  See https://www.bogleheads.org/wiki/Traditional_versus_Roth.

Change any of the above assumptions and the best choice might also change. ;)

MDM, thanks for the Bogleheads link.  Very useful just now as I am preparing to make IRA contributions for the year!