Author Topic: Invest in 401K vs. Roth 401K?  (Read 1614 times)

frozen

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Invest in 401K vs. Roth 401K?
« on: January 11, 2019, 01:12:57 PM »
I recently joined a new company that offers a regular 401K and a Roth 401K. Is there advice somewhere on the site on how to choose between the two? Is it ever worth investing in both?

I am over 50 and intend to max out my 401k and catch up contribution this year.

Boofinator

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Re: Invest in 401K vs. Roth 401K?
« Reply #1 on: January 11, 2019, 01:59:10 PM »
Depends on expected marginal tax bracket now versus retirement. If expected to be higher now, go traditional; if expected to be higher in retirement, go Roth. (They have exactly equal expected values if you assume the same tax brackets.*) Most people on this site expect to retire early and draw down their retirement savings, which would under the current tax structure result in hardly any taxes at all. So for most Mustachians, traditional is the way to go.

There's also the game theory element. If you don't know whether you are going to retire early or not, here's how the investment options shape up:

Retire Early:  Traditional has a huge advantage over Roth and allows you to retire years earlier.
Don't Retire Early: Roth might (or might not) have a slight advantage over Traditional, but who cares because you have more money than you know what to do with.

So I've strongly recommended Traditional over Roth in the 401k.

*Sort of. Roth would actually be slightly better if you had extra money available since you could invest more (since it's after-tax dollars).

MDM

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Re: Invest in 401K vs. Roth 401K?
« Reply #2 on: January 11, 2019, 04:29:03 PM »
I recently joined a new company that offers a regular 401K and a Roth 401K. Is there advice somewhere on the site on how to choose between the two? Is it ever worth investing in both?

I am over 50 and intend to max out my 401k and catch up contribution this year.
See Investment Order and links therein.

robartsd

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Re: Invest in 401K vs. Roth 401K?
« Reply #3 on: May 31, 2019, 02:57:56 PM »
The thing that convinced me that traditional is almost always better than Roth was an explanation that with Roth you pay your marginal tax rate when you put it in, but with traditional you pay your effective tax rate when you pull it out. Of course this is a bit of an oversimplification, but there are only limited circumstances where Roth is more efficient than traditional - especially if your taxable income now is much higher than your expected expenses at the time of withdraw.

Reasons to choose Roth:
  • you can make a Roth contribution, but aren't able to deduct a traditional contribution
  • you're making a Roth contribution that you have access to at any time because you can't maximize your tax advantaged limits and maintain your taxable emergency fund
  • you've already reduced your taxable income for the year below your future expected annual expenses
  • you project that without increasing Roth contributions you'd reach FIRE with insufficient Roth contributions + HSA claims + taxable balances to cover expenses while setting up a Roth conversion pipeline and don't want to lock yourself into SEPP

Boofinator

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Re: Invest in 401K vs. Roth 401K?
« Reply #4 on: May 31, 2019, 03:38:54 PM »
I'm facing a similar decision of work roth vs traditional. Isn't one benefit of the Roth that you can take out money that you put in (not the earnings though) without penalty before 59.5? I'm trying to figure out how to fund retirement from what will be my mid- to late 40s until 59.5.

With Traditional, you can invest more for a given amount of income than with Roth (because it's pre-tax), therefore you can use the extra savings after investing in Traditional to fund a taxable account that will allow for the Roth pipeline by the time you're ready to retire (or you can use SEPP if you can't save any in taxable). Roth is a horrible deal for an early (Mustachian) retiree.

EvenSteven

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Re: Invest in 401K vs. Roth 401K?
« Reply #5 on: May 31, 2019, 03:51:08 PM »
I'm facing a similar decision of work roth vs traditional. Isn't one benefit of the Roth that you can take out money that you put in (not the earnings though) without penalty before 59.5? I'm trying to figure out how to fund retirement from what will be my mid- to late 40s until 59.5.

For a Roth IRA, yes. But a Roth 401K is different and more restrictive.

Your non-qualified withdrawals from a Roth 401K will not be contributions first like with a Roth IRA; they will be prorated between contributions and earnings.

MDM

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Re: Invest in 401K vs. Roth 401K?
« Reply #6 on: May 31, 2019, 05:27:53 PM »
The thing that convinced me that traditional is almost always better than Roth was an explanation that with Roth you pay your marginal tax rate when you put it in, but with traditional you pay your effective tax rate when you pull it out. Of course this is a bit of an oversimplification....
Not just an oversimplification, but actually plain wrong.

E.g., take a single filer who already expects to have enough in traditional accounts alone (let alone pensions or other income) to fill the 0% and 10% brackets with a 4%/yr withdrawal rate.  That would be $547,500*4%=$21,900 AGI for 2019 tax law.  Again, this is even without another $1 of traditional contributions.

Any further traditional contributions will be withdrawn on top of that amount and thus taxed at the applicable marginal rate.

You aren't the first person to be misled by the "marginal vs. effective" myth, and probably won't be the last....

robartsd

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Re: Invest in 401K vs. Roth 401K?
« Reply #7 on: May 31, 2019, 05:56:00 PM »
The thing that convinced me that traditional is almost always better than Roth was an explanation that with Roth you pay your marginal tax rate when you put it in, but with traditional you pay your effective tax rate when you pull it out. Of course this is a bit of an oversimplification....
Not just an oversimplification, but actually plain wrong.

E.g., take a single filer who already expects to have enough in traditional accounts alone (let alone pensions or other income) to fill the 0% and 10% brackets with a 4%/yr withdrawal rate.  That would be $547,500*4%=$21,900 AGI for 2019 tax law.  Again, this is even without another $1 of traditional contributions.

Any further traditional contributions will be withdrawn on top of that amount and thus taxed at the applicable marginal rate.

You aren't the first person to be misled by the "marginal vs. effective" myth, and probably won't be the last....
I guess that's a reasonable way to look at it - have you filled the lower tax brackets with traditional yet - once you do, you might as well contribute Roth.

Of course if you expect to spend less per year in retirement than your taxable income in accumulation, you never get to the point where you expect your current marginal rate to be lower than your retirement marginal rate; so the simplification works well enough to make a good decision.

Full_Beard

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Re: Invest in 401K vs. Roth 401K?
« Reply #8 on: May 31, 2019, 06:20:18 PM »
There are a lot of ways to slice that cat. Today, we're experiencing some historically low tax rates. What if we go back to the high rates of the 1950s and 1960s (where the top rate was 70%)? Hard to imagine, but that's part of the question of Roth vs. Traditional: how will my taxable income of today compare with my taxable income at retirement, and what will my tax rate be at retirement? If one plans to retire in 10 years at 55 and live to 85, you're trying to assess that over a 40-year time period.

So, my point is that there's no 100% way to know which is better. But, they're also not mutually exclusive. I contribute to both.

MDM

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Re: Invest in 401K vs. Roth 401K?
« Reply #9 on: May 31, 2019, 08:25:13 PM »
Any further traditional contributions will be withdrawn on top of that amount and thus taxed at the applicable marginal rate.

You aren't the first person to be misled by the "marginal vs. effective" myth, and probably won't be the last....
I guess that's a reasonable way to look at it - have you filled the lower tax brackets with traditional yet - once you do, you might as well contribute Roth.
Yes.  Pension, social security, interest, dividends, inherited IRA distributions, etc., can also add to the base income on top of which withdrawals based on future contributions will be taxed.

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Of course if you expect to spend less per year in retirement than your taxable income in accumulation, you never get to the point where you expect your current marginal rate to be lower than your retirement marginal rate
In that case, you can estimate the marginal rates your heirs will pay.  If your heirs are all charities, that will be 0%.  If your heirs are your children who may still be working when forced to take inherited IRA distributions, it may be a high rate.

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so the simplification works well enough to make a good decision.
Doing the right thing for the wrong reason?  ;)

While traditional is better for most, we might as well give people correct advice on how to evaluate their own situations.