Author Topic: Laid off, lost 401K, new job, no 401K, switch from Roth IRA to Traditional now?  (Read 4013 times)

astvilla

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25 years old, in 25% tax bracket ($37,451 to $90,750).  I make around 46-50K total gross, total NW is 77K (this feels impossible..)

Old job had 401k, let me contribute 40%.  It was a per diem job so I maxed it out, didn't hit max because didn't work enough and make enough. 

New job very similar to old.  But pay is 20% higher roughly, but no 401K.  So no more 401k sigh....

I had a Roth IRA before, but now I'm wondering if I should switch to Traditional IRA? 

This is one of those traditional vs Roth IRA battles.  I read MadFientist but I didn't understand the last part of slowly shifting traditional IRA to Roth IRA and how this conversion works.
Quote: "Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A"

I'm not sure if I make enough to know if traditional IRA is worth it.  Also I already contributed to Roth IRA this year, not sure I can ask to switch it back?  I expect my income to double in a couple years so I know some say...put in Roth, then traditional. 

Also a question on how to use IRA space.  The Principles of Tax Fund Placement on Boglehead wiki says place REITs, Bonds, least tax efficient in tax deferred space like IRAs.  Currently I have VNQ, BND, and a bit of VXUS.  I guess it's because the dividends, etc won't get taxed.  However, why not put in VTSAX or VTI in Roth IRA and have the rise in price, gain, tax free? If I have VXUS in Roth or any IRA, is that a waste because of foreign tax credit, which I'm not sure how works.

How does Traditional IRA work when adding to it anyway?  You don't get taxed less on your paycheck.  Do you declare traditional IRA contribution on IRS tax filing and get a slight bigger tax refund?  How do the savings come back to you?  Cause I don't remember seeing my union dues, or other things improve my tax refund with TurboTax.

seattlecyclone

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25 years old, in 25% tax bracket ($37,451 to $90,750).  I make around 46-50K total gross, total NW is 77K (this feels impossible..)

Old job had 401k, let me contribute 40%.  It was a per diem job so I maxed it out, didn't hit max because didn't work enough and make enough. 

First off, it's possible (and in fact likely) that you're on track to hit the 15% bracket. The tax brackets are based on taxable income, not gross income. Taxable income is your adjusted gross income minus your deductions and personal exemption. If you take the standard deduction ($6,300) and add a personal exemption ($4,000), that means the 25% tax bracket starts at $47,750 of adjusted gross income. Note that traditional IRA and 401(k) contributions don't even count toward your AGI, so if you've been making these contributions your AGI will be less than your gross salary.

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New job very similar to old.  But pay is 20% higher roughly, but no 401K.  So no more 401k sigh....

I had a Roth IRA before, but now I'm wondering if I should switch to Traditional IRA? 

This is one of those traditional vs Roth IRA battles.  I read MadFientist but I didn't understand the last part of slowly shifting traditional IRA to Roth IRA and how this conversion works.
Quote: "Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A"
The Mad Fientist is referring to Roth conversions after leaving the workforce. During your career, pre-tax retirement contributions will generally be a better idea, especially if your income is growing to where you will actually be in the 25% bracket. The reason is that your spending after retirement will typically be lower than your salary beforehand. Your income in retirement will generally be no higher than your spending, and will in fact be lower if you have some Roth accounts where the withdrawals don't count as income. Since current salary > retirement spending ≥ retirement taxable income, it's logical to assume that your retirement tax bracket will be no higher than your current tax bracket. Given that, you should make pre-tax contributions to reduce your taxes at the higher bracket now, and pay tax on that income after you retire.

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I'm not sure if I make enough to know if traditional IRA is worth it.  Also I already contributed to Roth IRA this year, not sure I can ask to switch it back?  I expect my income to double in a couple years so I know some say...put in Roth, then traditional. 

It's not really a matter of where your income will be in a couple of years. If you currently earn more than you expect to spend in retirement, pre-tax retirement accounts are probably a better choice. If you expect to have some lifestyle inflation creep in after your salary doubles, such that your current salary won't pay for your retirement spending, maybe a Roth would be a better choice. I throw the word "maybe" around a lot because it's impossible to know what the better choice was until you actually retire and know what the tax rates are at that time. The best we can do now is make some guesses and hope they turn out right.

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Also a question on how to use IRA space.  The Principles of Tax Fund Placement on Boglehead wiki says place REITs, Bonds, least tax efficient in tax deferred space like IRAs.  Currently I have VNQ, BND, and a bit of VXUS.  I guess it's because the dividends, etc won't get taxed.  However, why not put in VTSAX or VTI in Roth IRA and have the rise in price, gain, tax free? If I have VXUS in Roth or any IRA, is that a waste because of foreign tax credit, which I'm not sure how works.

There is some debate about this. Bond interest and REIT dividends are taxed at a higher rate than stock dividends and capital gains, so for purely tax reasons it seems better to put the things that have a lower tax rate in the taxable account. As you point out, however, if your stock fund is likely to do a whole lot better than your bond fund in the long term, you may be better off putting your stock in a Roth IRA and never paying tax on it again, at the expense of paying higher taxes on your bond income. I tend to follow the Bogleheads wiki guidelines because I'm in a pretty high tax bracket right now. Again, it's impossible to know for sure what the best choice would be until you retire and know what your tax rate is at that time.

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How does Traditional IRA work when adding to it anyway?  You don't get taxed less on your paycheck.  Do you declare traditional IRA contribution on IRS tax filing and get a slight bigger tax refund?

Yes, exactly this. The traditional IRA deduction is made before calculating your AGI, so your ability to claim it doesn't depend on whether or not you itemize your deductions.

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How do the savings come back to you?  Cause I don't remember seeing my union dues, or other things improve my tax refund with TurboTax.

Union dues are an itemized deduction. If these deductions are less than your standard deduction ($6,300), then claiming them won't improve your tax situation. Also if your union dues and some other work-related items come out to less than 2% of your AGI, you can't claim those deductions even if you do itemize. As I said above, the IRA deduction doesn't depend on any of this. If your income qualifies to contribute pre-tax to an IRA, you get to chop those contributions right off the top of your income before calculating your tax.

Do be aware that since your previous job did have a 401(k), you will likely be subject to the "covered by a retirement plan" income limit for this year ($61k). Going forward, if you keep your current job that doesn't have a 401(k), in future years you'll be able to take a full deduction regardless of income.

astvilla

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25 years old, in 25% tax bracket ($37,451 to $90,750).  I make around 46-50K total gross, total NW is 77K (this feels impossible..)

Old job had 401k, let me contribute 40%.  It was a per diem job so I maxed it out, didn't hit max because didn't work enough and make enough. 

First off, it's possible (and in fact likely) that you're on track to hit the 15% bracket. The tax brackets are based on taxable income, not gross income. Taxable income is your adjusted gross income minus your deductions and personal exemption. If you take the standard deduction ($6,300) and add a personal exemption ($4,000), that means the 25% tax bracket starts at $47,750 of adjusted gross income. Note that traditional IRA and 401(k) contributions don't even count toward your AGI, so if you've been making these contributions your AGI will be less than your gross salary.

Sorry, I wasn't completely clear on my income.  I have two jobs.  One gets me 26K/year, no 401k, but has health benefits.  The other, around 20K/year no benefits but 401k which is now gone.  So I was doing 40% on the old 20k/year, now will be making 24K/year but no 401k so about even I think.  I'm also single, no dependents, so I don't think I can deduct anything.  I think I'm still in the 25%.  It's honestly really confusing to me how taxes work.  Like how they determine what to tax you, how to calculate based off my pay stub, etc.

Thanks for the reply though, makes a lot more sense.

I'm also looking into individual 401k.  Is that possible?  It sounds like I'd have to make a company.  So if I did, could I take my take home money, put into individual 401k, and use tax saving on my tax return getting bigger refund?  That's not tax fraud is it? 

Or do checks have to be made out to the company I create and then I can do an individual 401k. I can't imagine it being possible to take money that has already been taxed, putting into a 401k and getting money from the IRS back right?
« Last Edit: August 05, 2015, 03:26:03 PM by astvilla »

seattlecyclone

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Sorry, I wasn't completely clear on my income.  I have two jobs.  One gets me 26K/year, no 401k, but has health benefits.  The other, around 20K/year no benefits but 401k which is now gone.  So I was doing 40% on the old 20k/year, now will be making 24K/year but no 401k so about even I think.  I'm also single, no dependents, so I don't think I can deduct anything.  I think I'm still in the 25%.  It's honestly really confusing to me how taxes work.  Like how they determine what to tax you, how to calculate based off my pay stub, etc.

Take a look at Form 1040. Based on your old jobs, you would enter $38,000 on Line 7 ($26,000 from the job with no 401(k) plus $12,000 from your other job after you subtract your 401(k) contributions). Assuming no investment or other income, you would have a bunch of zeroes on the rest of the front of the form, and would enter $38,000 as your AGI on lines 37/38. Then on the next page you get a standard deduction (Line 40) of $6,300 in 2015 and one personal exemption (Line 42) of $4,000. Even if you're single with no dependents you get to claim these deductions. They bring your taxable income (Line 43) down to $27,700, which puts you in the 15% tax bracket.

If you replace your old $20k 401(k) job with your new $24k non-401(k) job, your Line 7 wage income goes up by $12,000, and this carries through to put your taxable income up $12,000 at $39,700, which is just barely into the 25% tax bracket.

Since you had the old job for part of the year and the new job for part of the year, your real taxable income for this year will be somewhere between the $27,700 you would have had if you worked the old job for the full year and the $39,700 that you will have when you work your new job for the full year. So this year you'll probably be in the 15% bracket, while next year you might go up to the 25% bracket. But if you go ahead and contribute to your traditional IRA (reported on Line 32), this will then decrease your AGI and taxable income to the point where you'll once again be in the 15% bracket.

Is this starting to make more sense?

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I'm also looking into individual 401k.  Is that possible?  It sounds like I'd have to make a company.  So if I did, could I take my take home money, put into individual 401k, and use tax saving on my tax return getting bigger refund?  That's not tax fraud is it? 

Or do checks have to be made out to the company I create and then I can do an individual 401k. I can't imagine it being possible to take money that has already been taxed, putting into a 401k and getting money from the IRS back right?

In general you have to be working as a contractor and paying self-employment tax for the individual 401(k) to be an option. If you're just getting a regular paycheck with social security and Medicare taxes taken out, this isn't really an option.

astvilla

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seattlecyclone,

Thanks so much.  That's a clear explanation of my situation and thank you for taking the time to write it.  You don't find that all too often except maybe here.

And just to clarify, being in the 25% tax bracket means that every dollar I make above the lower limit ($37450) is taxed at 25%.  So (39700-37450) = $2250 that is taxed at 25%.  I'm wondering why some people purposely try to make less money but I don't think it's for this reason but more for Medicaid, food stamps, etc. 

To me then, it sounds like maxing out traditional IRA isn't necessarily the best option since I'm around the border.  I could put $2250 to take me down to 15%, then put the other $3250 into my Roth, right?  Maxing out a traditional IRA would mean I pay $5130 in taxes.  ($50000-10300-5500)*.15 = 5130, since my taxable income becomes $34200.  My take home is then 44870 (26000 + 24000-5130), not including the 5500 in the IRA so then the total is $50370.  This doesn't make sense...am I doing this wrong?  I'm not sure how to calculate to be honest.  I haven't included state tax, disability, unemployment, but just federal.

Compared to my old job, (27700)*.15 = $4155 owed in taxes.  So my take home not including my 401k would then be (26000+12000) - (4155)= 33845.  Then add the 8000 to it is about $41845 which out of 46000 isn't bad I think. 

In general I'm having a hard time translating my pay stub into what I'm trying to understand.  I'll add up Federal, Medicare, SS, but I'm not sure what the 15 or 25% tax bracket is referring to, anything federal or just federal?  Cause the numbers come up weird, I'd have to PM for a lesson on this.  Wish there was a book or some reference info with case studies to understand taxes and IRS.
Is my math correct?
« Last Edit: August 05, 2015, 06:43:16 PM by astvilla »

seattlecyclone

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And just to clarify, being in the 25% tax bracket means that every dollar I make above the lower limit ($37450) is taxed at 25%.  So (39700-37450) = $2250 that is taxed at 25%.  I'm wondering why some people purposely try to make less money but I don't think it's for this reason but more for Medicaid, food stamps, etc.

Yes, you're right about this. Many people worry too much about "going up to the next tax bracket" because they mistakenly believe that going up to a new tax bracket means you have to pay more tax on all of your previous dollars, but it really only affects the last dollar you earn. The difference in tax between someone earning $1 less than the 25% bracket cutoff and $1 more than the 25% bracket cutoff is 40.

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To me then, it sounds like maxing out traditional IRA isn't necessarily the best option since I'm around the border.

It really depends on what you expect your tax bracket to be during retirement. If you expect it to be higher than 15%, Roth is the way to go. If you expect it to be lower than 15%, traditional is the way to go. If you expect it to be exactly 15%, it basically doesn't matter!

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I could put $2250 to take me down to 15%, then put the other $3250 into my Roth, right?

Yes, you may split up your maximum contribution between traditional and Roth. It's hard to know exactly where the border is until the year is over, so you may want to wait until you do your taxes to make your contribution, or you could just make a guess and be pretty close.

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Maxing out a traditional IRA would mean I pay $5130 in taxes.  ($50000-10300-5500)*.15 = 5130, since my taxable income becomes $34200.

Not quite. There's a 10% bracket below the 15% bracket. This bracket covers the first $9,225 of taxable income. So if your taxable income is $34,200, you pay $922.50 + ($34,200 - $9,225) * 15% = $4,668.75.


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My take home is then 44870 (26000 + 24000-5130), not including the 5500 in the IRA so then the total is $50370.  This doesn't make sense...am I doing this wrong?  I'm not sure how to calculate to be honest.  I haven't included state tax, disability, unemployment, but just federal.

I think you added the $5,500 when you should have subtracted. If you want to know how much you would have left after federal tax and IRA contributions, that would be $50,000 - $4,668.75 - $5,500 = $39,831.25.

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In general I'm having a hard time translating my pay stub into what I'm trying to understand.  I'll add up Federal, Medicare, SS, but I'm not sure what the 15 or 25% tax bracket is referring to, anything federal or just federal?  Cause the numbers come up weird, I'd have to PM for a lesson on this.  Wish there was a book or some reference info with case studies to understand taxes and IRS.

The 15% or 25% bracket only applies to federal income tax. In addition to federal income tax, you pay a flat 6.2% for Social Security and 1.45% for Medicare. This comes off the top before any retirement contributions are applied.

The amount taken out of your paycheck for federal income tax is basically just a guess. They use a formula based on the information they have (your pay at that job and your filing status), but they can't get it perfect because they have no idea whether you're contributing to an IRA or not, how much you might be earning at other jobs, what investment income you have, or anything else that would affect your total tax bill. When you fill out your taxes in April you will almost certainly find that the amount taken from your paychecks was off by a bit. You'll either get some money back, or owe some to the IRS.

johnny847

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I could put $2250 to take me down to 15%, then put the other $3250 into my Roth, right?

Yes, you may split up your maximum contribution between traditional and Roth. It's hard to know exactly where the border is until the year is over, so you may want to wait until you do your taxes to make your contribution, or you could just make a guess and be pretty close.

To wait until the year is over is a mistake. You're missing out on all the possible gains from now until the end of the year (then again, you're missing out on all possible losses too). But imagine doing this every year - waiting until the following January to invest. In the long run this is a losing proposition because you're losing out on time in the market.

You can get the split exactly right, every single year, even if you don't know how far into the 25% bracket you will be.

Just contribute your $5500 in whatever split you want to your tIRA and Roth IRA. Then, come tax time, you can recharacterize your contribution. That is, you can in effect retroactively change your contribution from tIRA to Roth (or vice versa). By recharacterizing you make it as if the original contribution never happened and the new contribution took place.
For example:
1) You contribute $5500 to the tIRA. It turns out you needed to put $2250 into the tIRA to get to the 15% bracket and the remaining $3250 to the Roth. Then just recharacterize $2250 of your tIRA contribution to a Roth IRA contribution. You will get a tax deducation for your $2250 tIRA contribution.
2) You contribute $2250 to your tIRA and $3250 to your Roth. It turns out you should have contributed $3000 to your tIRA to get to the 15% bracket. So rechar $750 of your Roth contribution to a tIRA contribution. Now your tIRA contribution is $3000, and you get the corresponding deduction. Your Roth contribution is now $2500.

johnny847

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This makes sense, but I don't think it has to be that complicated ... personally, even though I am in a higher income bracket now, I max out my Roth IRA (via a traditional IRA conversion) every year, and always have, because all of the growth will be tax free. I use it for my more aggressive investments (no bonds), with the hope that over the long haul (30+ years) I'll have a large amount of tax-free growth. Even if I'm in a lower tax bracket in 30 years, I think this will still be the better option. (I should note, though, that I max out my 401k pre-tax contributions and am over the income limit for pre-tax IRA contributions, so it's not really an option for me anyway -- but I took this same approach before I hit the income limit.)

Does that make sense or am I missing something?

The bolded part is confusing because there is no maximum amount you can convert from traditional to Roth in any given year (well okay you're limited by the total balance of your traditional accounts). What I think you meant is the backdoor Roth, yes? If that's the case, there's no "even though I'm in a higher tax bracket" clause attached to that. Once you've maxed out your 401k, the next place you can put your money is either your taxable or your Roth (because the non-deductible traditional IRA contribution is stupid compared to the Roth), and your Roth is a winner there.


And prioritizing stocks in a Roth is a mistake so many people make ALL. THE. TIME.

There is no need to prioritize stocks, which have the best potential for growth, in a Roth. What you really should be doing is tax adjusting your allocation.

The following example from the link assumes a 25% marginal rate on your withdrawals.
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It is easiest to see why the adjustment is necessary by comparing traditional and Roth accounts. For example, suppose you have $4,000 in a 401(k) and $3,000 in a Roth IRA, and you will be in a 25% tax bracket when you retire. You might choose to invest the entire 401(k) in stock and the entire Roth in bonds. If you do this, and the stock market gains 10% while the bond market gains 5%, your 401(k) would be worth $4,400, and your Roth would be worth $3,150. The IRS will take 25% of your 401(k) when you withdraw it, so you could now withdraw your investments for $6,450. Similarly, if you invested the 401(k) in bonds and the Roth in stock, your 401(k) would be worth $4,200, and your Roth would be worth $3,300. After taxes, you would have the same $6,450. Since both portfolios give you the same 7.5% return that you would expect from a portfolio which was 50% stock and 50% bonds, it is reasonable to treat both portfolios as having a 50/50 asset allocation, rather than the 57/43 and 43/57 which would result from the nominal values.



If you use the nominal values of your assets in determining your portfolio's asset allocation, and then put all your stocks in a Roth and all your bonds in a traditional account, all you've done is overweight stocks compared to your desired asset allocation.

Now of course, many Mustachians aim to convert their traditional accounts to Roth accounts. If you are able to convert your entire traditional account balance whlile only converting just the standard deduction + exemption amount every year, then you can claim that you truly owned every last dollar in the traditional account (as opposed to the IRS owning some of it). However, I'd imagine that this is a pretty rare case, even for Mustachians. Hence, the IRS owns a portion of your traditional account. How much? That's pretty hard to say for most people, but it is some positive amount.

johnny847

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As to allocation, I have figured out what allocation I want overall across my portfolio (something like 10% bonds, 85% stock index funds, and 5% individual stocks that I think are interesting with potential for bigger growth). The bonds are in the 401k, the individual stocks in the Roth, and the index funds are in both. I think this addresses what you're saying, but I'll admit I'm a bit confused by the example...

Thanks!

You completely missed me point.

I think it might be easier to explain with a very extreme example.

Assume you have been investing for several years and have a $100k portfolio. You want a 50/50 portfolio. You ignore the (eventual) effect that taxes will have on your assets and prioritize putting stocks in your Roth, so you have
Traditional 401k: $50k bonds
Roth IRA:  $50k stocks

Now suppose the circumstances change and you want to withdraw all of this money this year. And furthermore, the marginal tax rate is 90% (like I said, an extreme example!). That means you end up with  $55k from your retirement account withdrawals. Where did that come from?
Traditional 401k post tax withdrawal: $5k, came from bonds
Roth IRA: $50k post tax withdrawal, came from stocks.

So was your true asset allocation 50/50? No. It was 50/55 = 90.9% stocks, and 9.01% bonds.

Now obviously the tax rates and withdrawal amount are nicredibly unrealistic. But that's not the point. The point is that all you're doing by prioritizing your Roth for stocks is skewing your asset allocation to be more heavily weighted in stocks than you actually intended.
How much are you skewing it by? It depends on your overall tax rate. of traditional account withdrawals over your lifetime. But unless this tax rate of traditional account withdrawals is zero every single time you withdraw or make a conversion, this tax rate is positive, and hence, prioritizing stocks in a Roth is just skewing your portfolio more heavily towards stocks than you actually intended.