Author Topic: 401K vs. IRA vs. Taxable Account  (Read 6229 times)

fleaherald

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401K vs. IRA vs. Taxable Account
« on: July 03, 2016, 01:31:35 PM »
Hello everyone.

I'm 26, and just began a new job. I will now have the opportunity to enroll in my company's Fidelity 401K plan. I predict I will have about $30,000 this year to invest in stocks, and I'm trying to determine which investment accounts to fund first. 

I currently have the 401k, a Roth IRA, and a Wealthfront taxable account. I've read a number of articles on the topic and as of right now, my best guess is to do the following:

1) Max out my 401k ($18,000 + 50% employer match up to 6%)
2) Invest the remainder into the Wealthfront taxable account (balance of $500)
3) Leave the Roth IRA alone (balance of about $10,000)

Alternatively, I could max out the 401k AND the Roth IRA, and then invest the remaining funds into the taxable account.  My only fear with this strategy is that by not contributing more to the taxable account, I won't have enough accessible funds when I retire early in the next 5-10 years.  I also operate an LLC on the side if that makes any difference in strategy, or opens additional possibilities.   



csdreaming

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Re: 401K vs. IRA vs. Taxable Account
« Reply #1 on: July 03, 2016, 01:54:40 PM »
I'm in favor of the latter. You can always withdraw your Roth IRA contributions. I will leave to others to offer more reasons to favor or not favor Roth contributions over the taxable account.

I would recommend opening a Roth IRA and taxable account at Vanguard and moving your money over there. Vanguard is free for their ETF's and mutual funds and $2 for stocks once you have 50k in an account.

> I also operate an LLC on the side if that makes any difference in strategy, or opens additional possibilities.

It does, you can open up a SEP-IRA and make employer side deductible contributions without touching the 18k employee limit.
« Last Edit: July 03, 2016, 02:01:03 PM by csdreaming »

seattlecyclone

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Re: 401K vs. IRA vs. Taxable Account
« Reply #2 on: July 03, 2016, 06:35:51 PM »
Retirement accounts are accessible in early retirement! Don't believe me? Read this blog post and this forum thread to find out how! Ask if you have any questions.

Your side business offers the opportunity for more tax-advantaged saving. You can put away 25% of your net business profit in a solo 401(k) or SEP IRA. Who knows? Maybe you won't need to save in a taxable account at all!

fleaherald

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Re: 401K vs. IRA vs. Taxable Account
« Reply #3 on: July 08, 2016, 11:09:12 AM »
Great.  Thanks for the insight.  Now I just need to figure out whether to opt for the traditional 401k or Roth 401k.

Indexer

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Re: 401K vs. IRA vs. Taxable Account
« Reply #4 on: July 09, 2016, 03:20:14 PM »
Great.  Thanks for the insight.  Now I just need to figure out whether to opt for the traditional 401k or Roth 401k.

Traditional.

Completing a roth conversion ladder when you retire early requires having a lot in a pre-tax account. You can withdraw roth conversions that came from a pre-tax account after 5 years. You can also withdraw roth contributions. You can't withdraw roth earnings before 59 1/2 unless you want penalties.

If you put everything in a roth now then in the future after compounding you will have a little in contributions and a lot in earnings. You can't withdraw those earnings unless you want penalties so there goes your early retirement plan. You will eat through those roth contributions in no time at all.

Now if you instead put it in pretax now(the 401k) then you can start a roth conversion ladder when you retire. In this scenario you have to wait 5 years to access each conversion but close to 100% of your money is accessible in early retirement.

fleaherald

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Re: 401K vs. IRA vs. Taxable Account
« Reply #5 on: July 12, 2016, 03:11:35 PM »
Thanks Indexer.  Makes a lot of sense.

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #6 on: July 12, 2016, 03:43:16 PM »
I see things differently than Indexer

This is coming from the perspective that you never know what might happen in the future. Since your 401k is already tax deferred, I think it makes more sense to "diversify" and have accounts where tax is already paid and will never be taxed again.

The conversion ladder works great, but it's very precise and relies on the existence of a 0% capital gains tax window (about $48k for single filers and $96k for MFJ in 2016, assuming standard deductions) - the government could decide to take this away/change the rules at any time, and you could also stumble upon found income (MMM for example is now making 400k+ a year from  his writing hobby 10 years after retirement, even GoCurryCracker will run out of space soon to do conversions as his blog is starting to generate some serious cash too), which results in you paying extra taxes. I think if you are able to, you should always take the Roth IRA option (at some point you make too much money and it's phased out)

seattlecyclone

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Re: 401K vs. IRA vs. Taxable Account
« Reply #7 on: July 12, 2016, 04:29:01 PM »
The conversion ladder works great, but it's very precise and relies on the existence of a 0% capital gains tax window (about $48k for single filers and $96k for MFJ in 2016, assuming standard deductions)

No it doesn't. Your money is taxed as ordinary income when it moves from traditional to Roth, and then doesn't even count as income when it comes out of the Roth account.

You're right that the government can change the rules at any time, but the Roth ladder tactic has nothing at all to do with a 0% capital gains rate.

It's true that some people are able to make the Roth ladder work without paying any tax at all because there's no tax on ordinary income below certain levels. However the strategy can be beneficial even for those (such as myself) who fully expect to pay tax on at least some of this money. As long as my marginal rate is lower in retirement than it is now, I win by making traditional contributions now and converting them later.

robartsd

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Re: 401K vs. IRA vs. Taxable Account
« Reply #8 on: July 12, 2016, 05:07:28 PM »
I you project having 5+ years of expenses in Roth contributions + taxable accounts, consider a Traditional IRA after maxing your 401k (only reason not to is to preserve backdoor Roth options); otherwise, max your Roth IRA after claiming your 401k match.

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #9 on: July 12, 2016, 08:19:04 PM »
As long as my marginal rate is lower in retirement than it is now,

The whole point of my post was that we have no idea what the marginal tax brackets and rules will look like. Bernie Sanders wanted to double up FICA tax and raise marginal rates across almost every class. You 100% confident the US public wont vote themselves other people's money in the future?

ender

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Re: 401K vs. IRA vs. Taxable Account
« Reply #10 on: July 12, 2016, 08:29:15 PM »
As long as my marginal rate is lower in retirement than it is now,

The whole point of my post was that we have no idea what the marginal tax brackets and rules will look like. Bernie Sanders wanted to double up FICA tax and raise marginal rates across almost every class. You 100% confident the US public wont vote themselves other people's money in the future?

If this is the worst that happens? I'm even more confident in going traditional.

IRA money is already post-FICA, so doubling or tripling FICA won't change anything. And the marginal rate required to make my conversions higher than 34% (25% federal 9% state) will straight up cripple people actually making the amount I'd need to be converting from traditional into Roth.

People don't seem to get that for taxes to "ruin" the value of the traditional IRA/401k and Roth conversion pipeline it will destroy people in the middle class or lower financially.

Now if you are worried that IRA/401k money will be taxed differently than regular income? That is far more worth worrying about than a marginal rate of 30%+ during contribution becoming worse in retirement or the pipeline years.

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #11 on: July 12, 2016, 08:43:11 PM »
Now if you are worried that IRA/401k money will be taxed differently than regular income? That is far more worth worrying about than a marginal rate of 30%+ during contribution becoming worse in retirement or the pipeline years.

The laws can also change to straight out disallow recharacterizations altogether and only allow normal one year contribution amounts (ie 5500 today) if the government doesnt want roth balances to get too large. Loke i said, there are lots of possibilities we wouldnt think are possible today. Are you telling me that a little bit of tax "diversification" isnt worth it in the long run and the rules that we have in place today will always be the case?

ender

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Re: 401K vs. IRA vs. Taxable Account
« Reply #12 on: July 12, 2016, 08:48:26 PM »
Now if you are worried that IRA/401k money will be taxed differently than regular income? That is far more worth worrying about than a marginal rate of 30%+ during contribution becoming worse in retirement or the pipeline years.

The laws can also change to straight out disallow recharacterizations altogether and only allow normal one year contribution amounts (ie 5500 today) if the government doesnt want roth balances to get too large. Loke i said, there are lots of possibilities we wouldnt think are possible today. Are you telling me that a little bit of tax "diversification" isnt worth it in the long run and the rules that we have in place today will always be the case?

But here's the thing - nearly every scenario you dream of gloom and doom for the early retiree still results in pretax 401k/IRAs still being better than Roth for contributions.

It takes multiple, drastic, and systemic changes in order to make Roth as a contribution preferable for someone in the 25% or higher federal tax bracket. Is that possible? Sure. But keep in mind who they screw over - nearly any change that impacts early retirees negatively enough to make Roth better than traditional will completely screw over the majority of working Americans.

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #13 on: July 12, 2016, 09:02:17 PM »
If you're higher than 25%, you cant deduct traditional ira anyways because of phaseouts (admittedly this coild change in the future from a law change or "catchup" in excess of wage or tax bracket inflation), and the only tax deferal you can get is through a Roth, so what exactly are we discussing?

ender

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Re: 401K vs. IRA vs. Taxable Account
« Reply #14 on: July 12, 2016, 09:10:33 PM »
If you're higher than 25%, you cant deduct traditional ira anyways because of phaseouts (admittedly this coild change in the future from a law change or "catchup" in excess of wage or tax bracket inflation), and the only tax deferal you can get is through a Roth, so what exactly are we discussing?


That's... not true.

Plus, many people have access to Roth 401ks which means they have this decision for their 401k (not just IRA) pretty much regardless of what they make.

Indexer

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Re: 401K vs. IRA vs. Taxable Account
« Reply #15 on: July 12, 2016, 10:01:55 PM »
The conversion ladder works great, but it's very precise and relies on the existence of a 0% capital gains tax window...

No. Not true. Conversions count as ordinary income so you wouldn't be looking at the LTCG tax tables. 

If you're higher than 25%, you cant deduct traditional ira anyways because of phaseouts (admittedly this coild change in the future from a law change or "catchup" in excess of wage or tax bracket inflation), and the only tax deferal you can get is through a Roth, so what exactly are we discussing?

No. Not true. There are phase outs, but they don't line up with the tax brackets... not even close. There are also other considerations. For some tax filers the phase out prevents any deductions if they make over 10k, for others is can be around 65k, still others can be around 180k, and some taxpayers ALWAYS get to take a deduction for IRA contributions regardless of income. In addition, there are phaseouts for the Roth so if you are hitting the phase out for the traditional IRA you might be hitting the phase out for Roth as well. Roth phase outs also change with circumstances and for some taxpayers the Roth phase outs are equal to the IRA phase outs.

The whole point of my post was that we have no idea what the marginal tax brackets and rules will look like. Bernie Sanders wanted to double up FICA tax and raise marginal rates across almost every class. You 100% confident the US public wont vote themselves other people's money in the future?

The deduction for IRA and 401(k) contributions lowers your income taxes. It doesn't change your FICA taxes. You are still paying FICA even on the money that went into your 401(k). You don't pay FICA on traditional or Roth withdrawals. What exactly do FICA taxes have to do with an IRA VS Roth discussion?


I'll agree some tax diversification is a good idea. So if you are throwing 18k/yr in a 401(k) I can see the argument for putting 5500 in a Roth. However, this doesn't change the fact that someone who plans on retiring prior to age 59 1/2 using a roth conversion ladder should probably put the vast majority of their contributions into a pre-tax account so the roth conversion ladder has plenty of pre-tax money for future conversions. Considering all of the republicans want to lower taxes and the democrats are primarily interested in raising them only on the top households I don't see an immediate worry that mustachians are going to see their tax rates skyrocket in retirement. What I think could be more likely is that Congress could shut down the roth conversion ladder strategy. If that happens both the traditional IRA and the Roth IRA will have some big downsides(penalties) for someone retiring before age 59 1/2.

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #16 on: July 13, 2016, 06:37:12 AM »
That's... not true.

Plus, many people have access to Roth 401ks which means they have this decision for their 401k (not just IRA) pretty much regardless of what they make.

Come on. First of all, I specifically said Roth IRA in my very first post in the thread:

I think if you are able to, you should always take the Roth IRA option (at some point you make too much money and it's phased out)

Secondly, OP said he's contributing max to 401k, and while he didn't say if he was married or not, having access to a 401k automatically phases him out if he's single and above 25% tax bracket, and MFJ 28% bracket begins at 151k, which means he's also phased out (118k) because he has access to a 401k.

If we were having a general discussion, then sure, you are 100% correct. Feel better?

EDIT: My mistake, OP was asking about traditional or Roth 401k. You are correct Ender, he would make a much better decision going with a traditional 401k. I think it would make more sense to do Roth IRA after maxing 401k and not taxable, but it appears my reading comprehension needs some work!
« Last Edit: July 13, 2016, 06:49:54 AM by Aphalite »

Aphalite

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Re: 401K vs. IRA vs. Taxable Account
« Reply #17 on: July 13, 2016, 06:46:57 AM »
No. Not true. Conversions count as ordinary income so you wouldn't be looking at the LTCG tax tables. 

You are 100% correct. I was thinking of harvesting LTCG from taxable accounts, my mistake!

No. Not true. There are phase outs, but they don't line up with the tax brackets... not even close... In addition, there are phaseouts for the Roth so if you are hitting the phase out for the traditional IRA you might be hitting the phase out for Roth as well. Roth phase outs also change with circumstances and for some taxpayers the Roth phase outs are equal to the IRA phase outs.

You are right in a general sense, but in OP's case, he has access to a 401k, and if he's above 25% tax bracket (which is what Ender brought up), he is phased out of traditional but could still contribute to Roth (since the phaseouts are much higher), or backdoor a Roth

The deduction for IRA and 401(k) contributions lowers your income taxes. It doesn't change your FICA taxes. You are still paying FICA even on the money that went into your 401(k). You don't pay FICA on traditional or Roth withdrawals. What exactly do FICA taxes have to do with an IRA VS Roth discussion?
Good point, my mistake

I'll agree some tax diversification is a good idea. So if you are throwing 18k/yr in a 401(k) I can see the argument for putting 5500 in a Roth. However, this doesn't change the fact that someone who plans on retiring prior to age 59 1/2 using a roth conversion ladder should probably put the vast majority of their contributions into a pre-tax account so the roth conversion ladder has plenty of pre-tax money for future conversions. Considering all of the republicans want to lower taxes and the democrats are primarily interested in raising them only on the top households I don't see an immediate worry that mustachians are going to see their tax rates skyrocket in retirement. What I think could be more likely is that Congress could shut down the roth conversion ladder strategy. If that happens both the traditional IRA and the Roth IRA will have some big downsides(penalties) for someone retiring before age 59 1/2.

This is the only point that I wanted to make. We can't just assume that the future will be like the present anymore than we can assume the future will be like the past (in terms of investment returns) - risk is situations that you don't think will occur DOES occur. How many people thought Bernie would get so close to election with the crazy tax plan he had? If you're contributing the max to your 401k and HSA, you're at 4x-5x your Roth IRA contributions, you can still ladder very effectively. Not trying to doom and gloom, just pointing out the possibilities and that we are at the whims of regulators, I mean, it was within the past 10 years that Roth conversions even became possible for filers making over 100k

robartsd

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Re: 401K vs. IRA vs. Taxable Account
« Reply #18 on: July 14, 2016, 10:21:52 AM »
As far as potential changes to how retirement accounts are handled, I don't see any reason politicians would close the Roth conversion ladder. The short term effect would likely be deceased tax revenue, those that are using it would be very unhappy, the average american would be confused, and it does not specifically target high income taxpayers. I could see politicians going after the "backdoor" Roth loophole, which could change the Roth vs. traditional decision for some taxpayers who expect to earn too much for tax deductable IRA contributions in the future.

beltim

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Re: 401K vs. IRA vs. Taxable Account
« Reply #19 on: July 14, 2016, 10:56:28 AM »
Now if you are worried that IRA/401k money will be taxed differently than regular income? That is far more worth worrying about than a marginal rate of 30%+ during contribution becoming worse in retirement or the pipeline years.

The laws can also change to straight out disallow recharacterizations altogether and only allow normal one year contribution amounts (ie 5500 today) if the government doesnt want roth balances to get too large. Loke i said, there are lots of possibilities we wouldnt think are possible today. Are you telling me that a little bit of tax "diversification" isnt worth it in the long run and the rules that we have in place today will always be the case?

But here's the thing - nearly every scenario you dream of gloom and doom for the early retiree still results in pretax 401k/IRAs still being better than Roth for contributions.

It takes multiple, drastic, and systemic changes in order to make Roth as a contribution preferable for someone in the 25% or higher federal tax bracket. Is that possible? Sure. But keep in mind who they screw over - nearly any change that impacts early retirees negatively enough to make Roth better than traditional will completely screw over the majority of working Americans.

Well, all that would have to happen is for Congress to change the conversion rules back to what they used to be before 2010 or so, and for someone's retirement marginal rate to be 10% (or less) lower than their current marginal rate.  That's one very simple change back to rules that existed for longer than the current rules have.