Author Topic: roth or traditional  (Read 4588 times)

mac91red

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roth or traditional
« on: January 31, 2016, 08:01:49 AM »
I am trying to figure out how to invest and I am struggling on understanding the case study.  Sorry I am not as well versed in this.  My wife and I currently make 100k gross.  I contribute 4% of my pay to my 401k to get the 100% match from my employer.  We have 2 kids and our home.  From what I can tell we are in the 25% tax bracket.  This year (2015) i contributed the max to a roth 401k b/c I liked the idea of tax free earnings and had planned on doing the same for 2016 for me and my wife before moving as much as I can back to the 401k. 

Based on the below I should be maxing out the traditional instead correct?  I've been attempting to follow the case study excel but I don't exactly know what I am doing.   From what I can tell I am not at a point yet where I will be able to contribute enough to get into a lower tax bracket.  I hope I am making sense.  Basically, I have ~$15,000 in which to invest.  $3200 goes to my 401k for the employee match.  What is the best way to invest the remaining $11,800?



And one more, I found this advice from MDM in a couple of places while doing more reading:
"WHAT   
0. Establish an emergency fund to your satisfaction   
1. Contribute to 401k up to any company match   
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.   
3. Max HSA   
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for a tIRA, swap #4 and #5)   
6. Fund mega backdoor Roth if applicable   
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.   
8. Invest in a taxable account with any extra.   
   
WHY   
0. Give yourself at least enough buffer to avoid worries about bouncing checks   
1. Company match rates are likely the highest percent return you can get on your money   
2. When the guaranteed return is this high, take it.   
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.   
4. Rule of thumb: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic.)
5. See #4 for choice of traditional or Roth for 401k   
6. Applicability depends on the rules for the specific 401k   
7. Again, take the risk-free return if high enough   
8. Because earnings, even if taxed, are beneficial 

GrowingTheGreen

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Re: roth or traditional
« Reply #1 on: January 31, 2016, 08:27:04 AM »
I vote for maxing your Roth with $5,500 then taking the remaining ~$6k and dumping it back in your 401k.

jim555

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Re: roth or traditional
« Reply #2 on: January 31, 2016, 08:34:45 AM »
Just wondering why not max out the 401k, Roth 401K first? 
When I worked I made to much to do deductible IRA contributions.

mac91red

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Re: roth or traditional
« Reply #3 on: January 31, 2016, 08:51:09 AM »
I vote for maxing your Roth with $5,500 then taking the remaining ~$6k and dumping it back in your 401k.

so the idea is the tax free growth is better than any tax saving currently with this method right?  Just trying to make sure I understand. 

I am not close to retiring but my goal is by 50.

seattlecyclone

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Re: roth or traditional
« Reply #4 on: January 31, 2016, 10:59:32 AM »
Max out your traditional 401(k) before you put another cent in the Roth IRA. When choosing between Roth and traditional, the only thing that matters is whether you expect your tax bracket to be higher now or in retirement. You make $100k right now, putting you in the 25% tax bracket if you make no traditional contributions. If you're even a little bit frugal you probably won't pay that much in retirement.

GrowingTheGreen

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Re: roth or traditional
« Reply #5 on: January 31, 2016, 11:30:33 AM »
Max out your traditional 401(k) before you put another cent in the Roth IRA. When choosing between Roth and traditional, the only thing that matters is whether you expect your tax bracket to be higher now or in retirement. You make $100k right now, putting you in the 25% tax bracket if you make no traditional contributions. If you're even a little bit frugal you probably won't pay that much in retirement.

Assuming tax rates don't rise. If you're confident in that, then this option works. Personally, I like to diversify from not only an investment standpoint, but also from a tax standpoint.

MustacheAndaHalf

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Re: roth or traditional
« Reply #6 on: January 31, 2016, 11:39:25 AM »
Let's say you're in the 25% tax bracket deciding where to place $4,000.  $4,000 pre-tax and $3,000 after tax.  Here's why I think a 401(k) with 50% matching (or more) should come first:

1) for an emergency fund, you pay taxes and place $3,000 after tax in an emergency fund.
2) using a 401(k) with matching, your $4,000 gets matched by adding $2,000 and you have $6,000 in the 401(k).
3) for a Roth IRA, you pay taxes and place $3,000 in the Roth IRA.

The penalty for withdrawal is 10%, while matching gives you 50% extra.  So even withdrawing $3,000 to spend will leave you with $1700 after taxes and penalties.  But anywhere else, with 0% matching, the $3,000 is all you get.
« Last Edit: January 31, 2016, 11:48:06 AM by MustacheAndaHalf »

seattlecyclone

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Re: roth or traditional
« Reply #7 on: January 31, 2016, 11:42:52 AM »
Max out your traditional 401(k) before you put another cent in the Roth IRA. When choosing between Roth and traditional, the only thing that matters is whether you expect your tax bracket to be higher now or in retirement. You make $100k right now, putting you in the 25% tax bracket if you make no traditional contributions. If you're even a little bit frugal you probably won't pay that much in retirement.

Assuming tax rates don't rise. If you're confident in that, then this option works. Personally, I like to diversify from not only an investment standpoint, but also from a tax standpoint.

Sure, go ahead and diversify. The OP has already done a bit of this by maxing out a Roth 401(k) for at least one year. Unless you honestly expect the lowest bracket during retirement to be higher than the 25% you're paying now, you should ensure that you have enough in your traditional retirement accounts to fill up that lowest bracket each and every year during your retirement. Once you've done that, then you can consider whether you expect the next-lowest tax bracket to go above 25%. Still pretty unlikely in my opinion, but not impossible.

mac91red

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Re: roth or traditional
« Reply #8 on: January 31, 2016, 01:11:56 PM »
Max out your traditional 401(k) before you put another cent in the Roth IRA. When choosing between Roth and traditional, the only thing that matters is whether you expect your tax bracket to be higher now or in retirement. You make $100k right now, putting you in the 25% tax bracket if you make no traditional contributions. If you're even a little bit frugal you probably won't pay that much in retirement.

I cant imagine that i'd continue to be in the 25% bracket at retirement...With my deductions and dependents (2 kids) and the extra I could throw a a traditional 401k I think i could potentially get back to the 15% bracket lowering my tax bill today - correct?  With this I am getting a tax relief today but will pay taxes on my savings later albeit at a lower tax rate than I am currently in.  Am I following correctly?

Thanks for the feedback.  Just trying to build a sound strategy to stick to. 

seattlecyclone

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Re: roth or traditional
« Reply #9 on: January 31, 2016, 02:41:37 PM »
With my deductions and dependents (2 kids) and the extra I could throw a a traditional 401k I think i could potentially get back to the 15% bracket lowering my tax bill today - correct?  With this I am getting a tax relief today but will pay taxes on my savings later albeit at a lower tax rate than I am currently in.  Am I following correctly?

Exactly right. Some people get caught up with the fact that you might pay more dollars of tax with traditional than Roth, because you pay the taxes after the investment grows a lot. However what matters more than the number of dollars you pay in taxes is the number of dollars you get to keep after paying your tax.

Math below. Assume C is the amount you have available to contribute, pre-tax. Tnow is your current tax rate, Tret is your tax rate in retirement, and G is the amount of investment growth you expect.

With Roth, you pay C * Tnow in taxes this year, leaving you with C * (1 - Tnow) in your Roth IRA. When you retire, that balance will grow to G * C * (1 - Tnow). You've already paid your tax on this money, so you get to keep the whole sum on withdrawal.

With traditional, you pay no tax now, leaving you with C in your traditional IRA. When you retire, that balance will grow to G * C. You'll pay G * C * Tret in taxes, leaving you with G * C * (1 - Tret) leftover.

As you can see, the only difference between the amount you get to keep is related to the difference between Tnow and Tret. If they're the same, it doesn't matter which one you contributed to. If Tret is smaller, go with traditional. If Tnow is smaller, go with Roth.

Of course it's impossible to predict the ways that tax brackets will change in the future. Rates could go up or down. I doubt you'll be off by a whole lot if you just assume they will stay the same as now.

mac91red

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Re: roth or traditional
« Reply #10 on: January 31, 2016, 03:05:57 PM »
Awesome thank you for the feedback and the break down. 

MDM

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Re: roth or traditional
« Reply #11 on: January 31, 2016, 04:44:40 PM »
Awesome thank you for the feedback and the break down.

Good to see that you understand.  In a similar thread at bogleheads, https://www.bogleheads.org/forum/viewtopic.php?f=2&t=182081, the discussion went on for several pages with different ways of trying to explain what seattlecyclone said in so many words above. 

Maybe I'll add that link to the 'Investment Order' write-up....

GrowingTheGreen

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Re: roth or traditional
« Reply #12 on: January 31, 2016, 07:47:23 PM »
Lot's of good info on this thread re: tax advantages.

OP: Just wanted to clarify with you... You recognize that the tax system is progressive, correct?  Your comment about "getting back into the 15% bracket" led me to believe there may be some confusion here.  Perhaps I'm off though.

Regarding getting out of the 25% bracket, I'm guessing you're filing as married filing jointly.  If so, you'll need about $25k in deductions to get to $74,900.  Totally doable if you choose to invest all $15k in your 401k.  That would leave $10k in other deductions which, with kids and mortgage interest, may be feasible.

MDM

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Re: roth or traditional
« Reply #13 on: January 31, 2016, 08:07:52 PM »
I am trying to figure out how to invest and I am struggling on understanding the case study.  ...  I've been attempting to follow the case study excel but I don't exactly know what I am doing.
Might be worth perusing http://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-planning-for-the-long-haul/ for some examples.

If there are things that still don't make sense, just ask.

tj

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Re: roth or traditional
« Reply #14 on: January 31, 2016, 09:05:57 PM »
I would absolutely be going Traditional unless you make too much to take the deduction.

TFB has the best argument on this, IMO. You can always convert to roth later in lower-income years.

http://thefinancebuff.com/case-against-roth-401k.html


mac91red

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Re: roth or traditional
« Reply #15 on: February 01, 2016, 09:00:34 AM »
I am trying to figure out how to invest and I am struggling on understanding the case study.  ...  I've been attempting to follow the case study excel but I don't exactly know what I am doing.
Might be worth perusing http://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-planning-for-the-long-haul/ for some examples.

If there are things that still don't make sense, just ask.

Appreciate it - for starters - I see the room to increase comments but the values are $0 - do I need to fill those values in if I want to plan to contribute?  And the Progress to FI chart when the line reaches my forecasted stash needed is the number of years away I potentially am?

mizzourah2006

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Re: roth or traditional
« Reply #16 on: February 01, 2016, 11:17:06 AM »
Lot's of good info on this thread re: tax advantages.

OP: Just wanted to clarify with you... You recognize that the tax system is progressive, correct?  Your comment about "getting back into the 15% bracket" led me to believe there may be some confusion here.  Perhaps I'm off though.

Regarding getting out of the 25% bracket, I'm guessing you're filing as married filing jointly.  If so, you'll need about $25k in deductions to get to $74,900.  Totally doable if you choose to invest all $15k in your 401k.  That would leave $10k in other deductions which, with kids and mortgage interest, may be feasible.

They should fall under 74.9k without contributing any money to 401ks or iras.

100k gross
personal exemptions: 4*4k = 16k.
standard deduction: 12.6k.

28.6k total

100-28.6 = 71.4k.

OP I am in a similar boat with 1 kid and a MAGI of ~110k. We are going to contribute as much as is allowed to our traditional tax deductible and contribute the rest to Roth. I haven't completed our taxes yet, but we should be able to sneak under the 74.9k threshold as well, which will save us money on our qualified dividends and LTCGs that were triggered this year.

MDM

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Re: roth or traditional
« Reply #17 on: February 01, 2016, 12:50:41 PM »
Appreciate it - for starters - I see the room to increase comments but the values are $0 - do I need to fill those values in if I want to plan to contribute?
Yes.

Quote
And the Progress to FI chart when the line reaches my forecasted stash needed is the number of years away I potentially am?
Close (or maybe this is what you are saying).  It's when the line crosses $0.  The Y-axis is "amount you will have" minus "amount you need" for FI.