Author Topic: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal  (Read 5768 times)

eyePod

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http://www.forbes.com/sites/ashleaebeling/2013/01/02/roth-401k-conversions-for-all-thanks-to-fiscal-cliff-deal/

I'm hoping my employer gives this as an option.  We don't have Roth 401k's right now.  Is anyone else excited about this like I am?  That's a shit ton of non-taxed dividends.

sherr

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #1 on: January 04, 2013, 07:50:20 AM »
My workplace offers the option of contributing to either a Traditional or Roth 401k (or both). My first few years here I contributed equal amounts to both and figured it was just a form of diversification against tax rates. Then one day I sat down and did the math and found out that the Traditional 401k was much (much much much) better for me.

Generally the main difference between a Traditional and Roth 401k (or IRA) is when it gets taxed, now or later. Roths get taxed now, Traditional gets taxed later. If your *marginal* tax rate now is *lower* than your *average* tax rate when you retire, then the Roth account will save you more money from taxes. However, that is only true for a very small number of people. If your current marginal tax rate is exactly the same as your average tax rate in retirement, then there is no mathematical difference between a Roth and a Traditional account. Sure "tax-free earnings" sounds better than "tax-deferred earnings", but people forget to take into account that given a constant number of pre-tax dollars to invest putting them in a Roth account will result in lower principle due to paying taxes on it. Lost potential earnings on the account due to the lower principal exactly correspond to the earnings lost to taxes on the Traditional account, assuming the tax rates are the same.

The majority of people, especially on this forum, are going to spend a lot less in retirement than they make now. People around here will probably be jumping from a current marginal tax rate of 25 or even 28% down to an average tax rate of 10% or less. Which means that once you reach retirement you will have paid an extra 15-18% more in taxes for every dollar in your Roth account that you could have avoided by putting it in a Traditional account.

There are some minor differences between the two that might make a Roth (IRA / 401k) more attractive for some people. For example, since you've already paid taxes on it you can withdraw principal payments from your Roth at any time. This makes it useful as a kind of emergency fund if you don't have anything else. Smart money would be to just have a better form of emergency account though.

Another difference is that because the federal limits on retirement accounts are calculated on the money that goes into the account it is actually possible to contribute more to a Roth account (albeit at the higher tax rate). For example, the current maximum contribution limit for a 401k is $17.5k. Putting that in a Traditional 401k costs you $17.5k because it is tax-deferred. So once you account for the average 10% tax rate you might have in retirement, you really only have 17.5 * (1 - 0.1) = $15.75k of usable money in the account. If you were to contribute max to a Roth 401k while you are in a 25% tax bracket all $17.5 is usable in retirement but it would cost you 17.5 / (1 - 0.25) = $23.33k out of your paycheck. So you are essentially paying an extra 23.33 - 17.5 = $5.83k to get an extra usable 17.5 - 15.75 = $1.75k in retirement savings per year. That may be worthwhile to some people. It certainly isn't to me.

I strongly urge caution and doing your own math instead of just buying into the industry enthusiasm around Roth accounts. It is amazing to me the number of financial planners who have been giving their clients bad advice because they don't really understand the math behind the different options, and who's jaws literally drop when I explain it to them.

James

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #2 on: January 04, 2013, 08:07:58 AM »
My employer sent out an email yesterday about this option.  I'm at a higher tax rate so it doesn't make much sense for me personally.

Honest Abe

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #3 on: January 04, 2013, 08:59:30 AM »
As someone who will be getting a pension and currently has a 457, having another tax-free avenue will be a good things. ( it doesn't make much sense to have a king's ransom in my 457 if I'm going to trigger a higher tax rate if I need a large lum sum on money... Having a Roth account would be helpful for this.)

JohnGalt

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #4 on: January 04, 2013, 09:00:26 AM »
sherr - I think your missing one potentially important piece of the roth vs traditional decision.  Once you hit 59.5, all of the money in the roth account can be withdrawn tax free.  This includes earnings.  So, say you, overall, contributed $100,000 to traditional and $100,000 to a roth.  The traditional would have saved you $25,000 in taxes at the 25% bracket.  Both grew at 7% per year for 25 years (I'm assuming you contributed it all by 35, retired, and never touched it or contributed until 60 to simplify the math of dealing with the money being in there for different amounts of time) to $540,000.  You now withdraw it all (again to simplify) at your retirement effective tax rate of 10%.  The traditional costs you $54,000 in taxes while the roth costs you nothing.  Granted, the $54,000 isn't quite comparable to $25,000 25 years earlier - but I think that keeps the difference from being quite as dramatic as you think it is. 

I still recommend the traditional route for anyone in the 25%+ bracket with MMM/ERE intentions (especially if you plan on using SEPP or roth pipelines to withdraw it earlier than 59.5), but agree that everyone should run the math themselves for their specific situation. 

Another Reader

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #5 on: January 04, 2013, 10:47:07 AM »
Honest Abe:

The 457 plan has a huge advantage if you are going to retire early.  There is no penalty for early withdrawal, you just pay ordinary income taxes.  For folks that need income between ER and age 59 1/2, you can take out the minimum you need each year and smooth out both income and taxes.  In your shoes, I would max that account out if I intended to take ER.  Unless you are going to be in a much higher tax bracket when you retire, the tax deferral today is worth it.

DK

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #6 on: January 04, 2013, 06:08:33 PM »
http://www.forbes.com/sites/ashleaebeling/2013/01/02/roth-401k-conversions-for-all-thanks-to-fiscal-cliff-deal/

I'm hoping my employer gives this as an option.  We don't have Roth 401k's right now.  Is anyone else excited about this like I am?  That's a shit ton of non-taxed dividends.

If you retire on a lower income (10 or 15% bracket), and they are qualified dividends, you pay 0% tax on them anyway (at least as it stands now). So if I'm figuring right with deductions and what not, you'll be able to have about 45K of earned income and still pay no tax on the "shit ton of dividends" you will be getting in your retirement account. I'd stick with the regular 401k unless you currently are in the 10 or 15% bracket. Unless you plan on having a very high retirement income, or think tax rates will be a lot higher in retirement.

Honest Abe

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #7 on: January 04, 2013, 06:22:32 PM »
Honest Abe:

The 457 plan has a huge advantage if you are going to retire early.  There is no penalty for early withdrawal, you just pay ordinary income taxes.  For folks that need income between ER and age 59 1/2, you can take out the minimum you need each year and smooth out both income and taxes.  In your shoes, I would max that account out if I intended to take ER.  Unless you are going to be in a much higher tax bracket when you retire, the tax deferral today is worth it.

Im a big 457 lover but for a different reason. I agree that the 457 is a huge advantage for ER, However I plan on working till 55 no matter what to take advantage of my pension. I like the lack of age restriction as a sort of insurance against job loss which is why I chose a 457 instead of a 403b. I'm contributing the full amount to my 457 as of Jan 1. My wife is putting into hers as well, though not as aggressively.

sherr

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #8 on: January 05, 2013, 09:55:44 PM »
sherr - I think your missing one potentially important piece of the roth vs traditional decision.  Once you hit 59.5, all of the money in the roth account can be withdrawn tax free.  This includes earnings.  So, say you, overall, contributed $100,000 to traditional and $100,000 to a roth.  The traditional would have saved you $25,000 in taxes at the 25% bracket.  Both grew at 7% per year for 25 years (I'm assuming you contributed it all by 35, retired, and never touched it or contributed until 60 to simplify the math of dealing with the money being in there for different amounts of time) to $540,000.  You now withdraw it all (again to simplify) at your retirement effective tax rate of 10%.  The traditional costs you $54,000 in taxes while the roth costs you nothing.  Granted, the $54,000 isn't quite comparable to $25,000 25 years earlier - but I think that keeps the difference from being quite as dramatic as you think it is. 

I still recommend the traditional route for anyone in the 25%+ bracket with MMM/ERE intentions (especially if you plan on using SEPP or roth pipelines to withdraw it earlier than 59.5), but agree that everyone should run the math themselves for their specific situation.

I did not miss this, this is exactly what my second-to-last paragraph was addressing. Let's use your numbers and go through the examples again.

Assumptions: a person has $125,000 to invest this year, they are in a 25% tax bracket.

Option #1: Imaginary Roth 401k with $100k contribution limit.
Now: Invest $100k in Roth 401k, pay $25k in taxes.
Retirement: Roth 401k account has grown to $540,000, you owe no additional taxes.

Option #2: Imaginary Traditional 401k with $100k contribution limit.
Now: invest $100k in Traditional 401k, pay $0 in taxes. Pay taxes on your remaining $25k, leaving you with $18,750. Invest remaining $18,750 in taxable investment account at similar interest rates.
Retirement: Traditional 401k account has grown to $540,000. You withdraw it and pay 10% tax, leaving you with $486,000. Your $18,750 taxable investment as grown to $101,764. Now, in current tax law the capital gains tax for long-term investments is 0% if you are below the 25% tax bracket, so realistically you wouldn't actually pay taxes on this when you withdraw. Let's be pessimistic and say that you'll also pay a 10% tax on this. You pay the tax on the gains, and you have $93,462 left over from this account.

Totals:
Roth: $540,000
Traditional + additional: $486,000 + $93,462 = $579,462

Choosing the Traditional over the Roth gives you an extra forty thousand dollars. If you could have put all $125,000 into the Traditional 401k the difference would have been even greater. The only reason Roth accounts sound comparable to Traditional accounts for most people is because they ignore the opportunity cost of the money they pay to the tax man.

Edit: grammar
« Last Edit: January 05, 2013, 10:13:03 PM by sherr »

eyePod

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #9 on: January 07, 2013, 08:37:58 AM »
Now, in current tax law the capital gains tax for long-term investments is 0% if you are below the 25% tax bracket, so realistically you wouldn't actually pay taxes on this when you withdraw. Let's be pessimistic and say that you'll also pay a 10% tax on this. You pay the tax on the gains, and you have $93,462 left over from this account.

There are a lot of if's in all of this.  Does anyone think it's worth putting half in traditional and half in a roth just to hedge your bets?

sol

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #10 on: January 07, 2013, 08:51:01 AM »
Roth accounts don't generally make a lot of sense for people who are saving a large percent of their income and then retiring with minimal expenses, unless they have tax free income.

frugalcoconut

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #11 on: January 10, 2013, 07:12:20 PM »
Glad to know that this option is on the horizon ... thank you to the OP for providing the article link.

My 100% Roth strategy (all contributions in both IRA and 401k) may not be most efficient long-term tax-wise ... but it gives me peace of mind to know the precise account balance for what is actually MY money that I can use at-will without worrying about taxes ... and, until much later when I have to dip into earnings,  penalties. 

tooqk4u22

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #12 on: January 11, 2013, 01:10:44 PM »
Now, in current tax law the capital gains tax for long-term investments is 0% if you are below the 25% tax bracket, so realistically you wouldn't actually pay taxes on this when you withdraw. Let's be pessimistic and say that you'll also pay a 10% tax on this. You pay the tax on the gains, and you have $93,462 left over from this account.

There are a lot of if's in all of this.  Does anyone think it's worth putting half in traditional and half in a roth just to hedge your bets?

You also need to factor in your current tax bracket.  If you are in a low tax bracket now then the Roth is the winner but if you are in a high bracket as Sherr assumed (didn't check the math) then the traditional may be better.

The Roth also protects against higher tax rates and taxes on what types of income in the future and with the tradtional even if you live low you don't know where taxes will be. 

DK

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Re: Forbes - Roth 401(K) Conversions For All Thanks To Fiscal Cliff Deal
« Reply #13 on: January 12, 2013, 01:26:47 PM »
Now, in current tax law the capital gains tax for long-term investments is 0% if you are below the 25% tax bracket, so realistically you wouldn't actually pay taxes on this when you withdraw. Let's be pessimistic and say that you'll also pay a 10% tax on this. You pay the tax on the gains, and you have $93,462 left over from this account.

There are a lot of if's in all of this.  Does anyone think it's worth putting half in traditional and half in a roth just to hedge your bets?

I think it's a good idea to have a mix, just so you have more control over how you get taxed down the road. A generic half and half split I don't think makes the most sense though. Personally what I do is:

1 - Contribute amount to get full employer match in 401k. Free 100% returns. Nice.
2 - Calculate out what my taxable income for the year will be.
3 - Contribute amount to tax deductible (401k) account to put me in 15% tax bracket (~35K) for taxable income.
4 - Contribute amount to taxable (roth) account with leftover investment money.

So for example if you've got taxable income of 40K and have 10K to invest for retirement, 5K goes in 401k, 5K goes in roth.