Author Topic: Switch from Roth 401k to Traditional  (Read 9434 times)

Keekster

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Switch from Roth 401k to Traditional
« on: October 23, 2014, 01:53:04 PM »
I am in my first year out of college making $50k. Through discussions with family, I have decided to contribute 100% to a Roth 401k. As my income rises, when should I switch to a traditional 401k? I think within 5-7 years I should be able to make near $100k gross.

Thanks!

Cheddar Stacker

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Re: Switch from Roth 401k to Traditional
« Reply #1 on: October 23, 2014, 02:23:34 PM »
50K-10K (standard deduction and 1 exemption) puts you at $40K taxable which is in the 25% bracket. Do you have student loan interest or any other deductions (maybe health insurance on your paystub) to get your taxable income down to $36,900? That's your magic number for 2014 to stay in the 15% bracket. If you're paying more than 15% tax you are likely better off switching to traditional 401k contributions rather than Roth.

Play around with this: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

Keekster

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Re: Switch from Roth 401k to Traditional
« Reply #2 on: October 23, 2014, 03:30:01 PM »
No student loans and still on my parent's insurance.

Thanks Cheddar!

Cheddar Stacker

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Re: Switch from Roth 401k to Traditional
« Reply #3 on: October 23, 2014, 03:54:51 PM »
No student loans and still on my parent's insurance.

Thanks Cheddar!

Then you should contribute at least $3K into your traditional 401k if you follow the majority of people that hang around here. 15% is the most you should pay in taxes if you can help it. Most people, likely including your parents (no offense), aren't as informed as the early retirement folk. You can keep your tax burden very low once you start drawing down your 401k if you learn a few tricks.

pbkmaine

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Re: Switch from Roth 401k to Traditional
« Reply #4 on: October 27, 2014, 10:20:24 AM »
Is there a company match? Does it work with the Roth? If not, max the match before doing anything else.

nawhite

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Re: Switch from Roth 401k to Traditional
« Reply #5 on: October 27, 2014, 11:21:51 AM »
The things to compare are
1. Expected marginal tax rate now vs. Expected effective tax rate in retirement.
2. Number of years until retirement where your contributions will compound.

For 1, Cheddar Stacker already mentioned that a good rule of thumb is the 25% marginal rate as the cutoff point towards Traditional accounts because most people here will have an expected effective tax rate in retirement significantly lower than 25% (<8% is common).

For 2, the longer your money has to compound, the more valuable Roth's are. For example, if your money compounds at 8% (i.e. doubles ever 9-ish years) and you have 36 years until retirement your Roth will have 16 times as much money at the end and the only taxes paid will be the initial 25% (or whatever the marginal rate is) on the initial contribution, the other 94% won't be taxed at all. This works out to an effective tax rate of 1.56% on the final balance. If you only have 9 years until retirement though, you'll double once, end up paying 25% taxes on half the money and end up with an effective tax rate of 12.5% on the final balance.

So the longer you won't touch the money, the better a Roth is. The greater the difference between your current marginal tax rate and your final effective rate, the better a traditional is. The only way to know for sure for your situation is to do the math.

Gone Fishing

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Re: Switch from Roth 401k to Traditional
« Reply #6 on: October 27, 2014, 11:42:00 AM »
If you plan on retiring early, the Traditional 401(k) and IRA tend to make the most sense.


Read the articles linked in my signature below...


sirdoug007

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Re: Switch from Roth 401k to Traditional
« Reply #7 on: October 27, 2014, 11:55:06 AM »
The things to compare are
1. Expected marginal tax rate now vs. Expected effective tax rate in retirement.
2. Number of years until retirement where your contributions will compound.

For 1, Cheddar Stacker already mentioned that a good rule of thumb is the 25% marginal rate as the cutoff point towards Traditional accounts because most people here will have an expected effective tax rate in retirement significantly lower than 25% (<8% is common).

For 2, the longer your money has to compound, the more valuable Roth's are. For example, if your money compounds at 8% (i.e. doubles ever 9-ish years) and you have 36 years until retirement your Roth will have 16 times as much money at the end and the only taxes paid will be the initial 25% (or whatever the marginal rate is) on the initial contribution, the other 94% won't be taxed at all. This works out to an effective tax rate of 1.56% on the final balance. If you only have 9 years until retirement though, you'll double once, end up paying 25% taxes on half the money and end up with an effective tax rate of 12.5% on the final balance.

So the longer you won't touch the money, the better a Roth is. The greater the difference between your current marginal tax rate and your final effective rate, the better a traditional is. The only way to know for sure for your situation is to do the math.

You've got #1 exactly right but #2 is questionable.

The correct way to figure this out is exactly as you said.  Compare your current MARGINAL tax rate to your expected future EFFECTIVE tax rate.  This is a key point of confusion for most people (including myself starting out).  Look at your 2013 taxes.  In my case, my marginal rate was 25% and my effective rate (federal income tax paid / total wages) was around 17%. 

So even if my income and spending is exactly the same in retirement (which it won't be due to paid off house and no work related clothing etc.) I would save 8% in taxes by going with the traditional 401(k).

On point #2 you need to compare apples to apples.  That means that you count the extra taxes you pay on the Roth as added contributions for a traditional 401(k).  So say you have $10,000 pre-tax to put in your 401(k).  Two scenarios:

Traditional: You pay no income tax now.  $10,000 goes in.  Let's say at retirement it is worth 5x more or $50,000.  Then you take it out at a 17% effective rate for an after tax amount of $41,500.

Roth: You pay 25% on the money now since the 401(k) is off the top of your earnings.  $7,500 goes in.  x5 it is $37,500.  You pay no taxes taking it out.

The difference is $4,000.  Or 8% on $50,000.

The same thing works whether it is 5x or 50x.  In all cases the difference between marginal and effective rates means you keep 8% rather than giving it to Uncle Sam.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #8 on: October 27, 2014, 12:33:24 PM »
The things to compare are
1. Expected marginal tax rate now vs. Expected effective tax rate in retirement.
2. Number of years until retirement where your contributions will compound.

For 1, Cheddar Stacker already mentioned that a good rule of thumb is the 25% marginal rate as the cutoff point towards Traditional accounts because most people here will have an expected effective tax rate in retirement significantly lower than 25% (<8% is common).

For 2, the longer your money has to compound, the more valuable Roth's are. For example, if your money compounds at 8% (i.e. doubles ever 9-ish years) and you have 36 years until retirement your Roth will have 16 times as much money at the end and the only taxes paid will be the initial 25% (or whatever the marginal rate is) on the initial contribution, the other 94% won't be taxed at all. This works out to an effective tax rate of 1.56% on the final balance. If you only have 9 years until retirement though, you'll double once, end up paying 25% taxes on half the money and end up with an effective tax rate of 12.5% on the final balance.

So the longer you won't touch the money, the better a Roth is. The greater the difference between your current marginal tax rate and your final effective rate, the better a traditional is. The only way to know for sure for your situation is to do the math.

You've got #1 exactly right but #2 is questionable.

The correct way to figure this out is exactly as you said.  Compare your current MARGINAL tax rate to your expected future EFFECTIVE tax rate.  This is a key point of confusion for most people (including myself starting out).  Look at your 2013 taxes.  In my case, my marginal rate was 25% and my effective rate (federal income tax paid / total wages) was around 17%. 

So even if my income and spending is exactly the same in retirement (which it won't be due to paid off house and no work related clothing etc.) I would save 8% in taxes by going with the traditional 401(k).

On point #2 you need to compare apples to apples.  That means that you count the extra taxes you pay on the Roth as added contributions for a traditional 401(k).  So say you have $10,000 pre-tax to put in your 401(k).  Two scenarios:

Traditional: You pay no income tax now.  $10,000 goes in.  Let's say at retirement it is worth 5x more or $50,000.  Then you take it out at a 17% effective rate for an after tax amount of $41,500.

Roth: You pay 25% on the money now since the 401(k) is off the top of your earnings.  $7,500 goes in.  x5 it is $37,500.  You pay no taxes taking it out.

The difference is $4,000.  Or 8% on $50,000.

The same thing works whether it is 5x or 50x.  In all cases the difference between marginal and effective rates means you keep 8% rather than giving it to Uncle Sam.

This is a good correction of nawhite.  You can see another illustration of this here: http://forum.mrmoneymustache.com/welcome-to-the-forum/just-realized-i'm-barely-paying-any-fed-taxes-this-year/msg434386/#msg434386

As for this:
Quote
The correct way to figure this out is exactly as you said.  Compare your current MARGINAL tax rate to your expected future EFFECTIVE tax rate.  This is a key point of confusion for most people (including myself starting out).
One reason this is confusing is that your solution only holds for a constant salary.  There are other cases where it's not so simple.  In particular, someone whose salary increases a lot can be better off investing in a Roth account early in a career (while in a low tax bracket), then switching to a traditional account when their income (and tax bracket) increases, even if their effective tax rate in retirement is lower than the marginal tax rate during the early portion of their career.

ender

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Re: Switch from Roth 401k to Traditional
« Reply #9 on: October 27, 2014, 12:58:54 PM »
If you plan on retiring early, the Traditional 401(k) and IRA tend to make the most sense.


Read the articles linked in my signature below...

+1.

Depends a lot on your financial goals.

sirdoug007

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Re: Switch from Roth 401k to Traditional
« Reply #10 on: October 27, 2014, 01:14:42 PM »

Quote
The correct way to figure this out is exactly as you said.  Compare your current MARGINAL tax rate to your expected future EFFECTIVE tax rate.  This is a key point of confusion for most people (including myself starting out).
One reason this is confusing is that your solution only holds for a constant salary.  There are other cases where it's not so simple.  In particular, someone whose salary increases a lot can be better off investing in a Roth account early in a career (while in a low tax bracket), then switching to a traditional account when their income (and tax bracket) increases, even if their effective tax rate in retirement is lower than the marginal tax rate during the early portion of their career.

I agree that a Roth 401(k) is attractive if your marginal tax rate is 15% or less.  But if you are in the 25%+ marginal bracket the deferring taxes until retirement via a traditional 401(k) is going to work out better in most situations.

nawhite

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Re: Switch from Roth 401k to Traditional
« Reply #11 on: October 27, 2014, 04:35:30 PM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

So, I would argue that even at the 15% marginal rate, most people should be doing a Traditional contribution rather than a Roth contribution as the income required in retirement to have a 15% effective rate is really high.

So now my recommendation is, do a traditional in all cases unless:
1. You have a really low marginal tax rate now (like 10%)
2. You expect to have a REALLY high income in retirement (like over $100k/year)
3. You expect tax rates to go up significantly before your retirement.
4. You currently make too much to do traditional contributions.
5. You are nervous about not being able to access money without penalties (because Roth contributions can be withdrawn penalty free).

sol

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Re: Switch from Roth 401k to Traditional
« Reply #12 on: October 27, 2014, 04:46:44 PM »
So now my recommendation is, do a traditional in all cases unless:
1. You have a really low marginal tax rate now (like 10%)
2. You expect to have a REALLY high income in retirement (like over $100k/year)
3. You expect tax rates to go up significantly before your retirement.
4. You currently make too much to do traditional contributions.
5. You are nervous about not being able to access money without penalties (because Roth contributions can be withdrawn penalty free).

I agree with this assessment.  Traditional 401k is better for probably 95% of the people on this site.

And at $50k/year, the OP should be able to max out his traditional 401k ($18k next year) and his Roth IRA ($5.5k next year) and still live a life of luxury.  Why choose when you can do both?  Get all of the tax advantages you can, every year that you can.

nawhite

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Re: Switch from Roth 401k to Traditional
« Reply #13 on: October 27, 2014, 04:56:11 PM »
And at $50k/year, the OP should be able to max out his traditional 401k ($18k next year) and his Roth IRA ($5.5k next year) and still live a life of luxury.  Why choose when you can do both?  Get all of the tax advantages you can, every year that you can.

Why not do a traditional IRA in addition to a traditional 401k?

sol

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Re: Switch from Roth 401k to Traditional
« Reply #14 on: October 27, 2014, 05:06:16 PM »
Why not do a traditional IRA in addition to a traditional 401k?

I can think of a couple of marginal reasons, none super compelling to me.

1.  The Roth IRA allows him to access his contributions at any point, including to fund an early retirement.  If he puts them in a traditional IRA, he would have to later convert them to Roth and wait five years to get the money back out.  Especially for a young worker, the Roth IRA can double as an emergency fund.

2.  He's already expressed a desire to use the Roth401k because his taxes are relatively low, so the Roth IRA allows him to fulfill that desire without hurting his bottom so line so much.

3.  Tax diversification is almost always a good thing.  The trad IRA might be a better option in the long run, but I can argue in favor of spreading your eggs between multiple baskets.

DK

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Re: Switch from Roth 401k to Traditional
« Reply #15 on: October 27, 2014, 06:16:58 PM »
Ditto the replies to split the money you put in to keep yourself in the 15% bracket.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #16 on: October 27, 2014, 09:38:14 PM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

nawhite

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Re: Switch from Roth 401k to Traditional
« Reply #17 on: October 28, 2014, 08:27:53 AM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

Is this because you can put "more" into a Roth than a Traditional? In my model, I had X pre-tax dollars I was saving, so the traditional was getting contributions of X each year while the Roth was getting X - taxes (traditional was getting 10k while roth was getting 7.5k each year). If you instead model putting X into each (where the Roth is technically getting more pre-tax money deposited) then I could see the Roth winning in your scenario but only because you deposited more money.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #18 on: October 28, 2014, 08:29:53 AM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

Is this because you can put "more" into a Roth than a Traditional? In my model, I had X pre-tax dollars I was saving, so the traditional was getting contributions of X each year while the Roth was getting X - taxes (traditional was getting 10k while roth was getting 7.5k each year). If you instead model putting X into each (where the Roth is technically getting more pre-tax money deposited) then I could see the Roth winning in your scenario but only because you deposited more money.

No.  I also had X in traditional and .85, .75, or .72 X in a Roth.

sirdoug007

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Re: Switch from Roth 401k to Traditional
« Reply #19 on: October 28, 2014, 11:22:06 AM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

I don't see how this can work out.  Can you show some more math?

$40,000 for a single person is a 15% marginal rate.  Taking out $36,000 per year in retirement from taxable sources has an effective rate of 9.6%.  That is 5.4% in your favor, no?

For a single person to get a 15% effective rate you have to have earned income of $66,000.  So if you are in the 15% marginal bracket but plan on spending more than $66k/year in retirement a Roth has advantages.  $66k/person is living very well.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #20 on: October 28, 2014, 11:56:37 AM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

I don't see how this can work out.  Can you show some more math?

$40,000 for a single person is a 15% marginal rate.  Taking out $36,000 per year in retirement from taxable sources has an effective rate of 9.6%.  That is 5.4% in your favor, no?

I've attached an Excel spreadsheet that I used, but I warn that it's not too intuitive.  The basic calculation I have is that for the first 5 years, you contribute 4250 (= 5000 *.85), and the next five years you contribute 5000 (I used 5000 because I was thinking IRA instead of 401k, but it's the same idea).  At the end of the 10 years, that's 21250 in Roth + 25000 in traditional, excluding investment gains.  At $36k annual expenses, withdrawn in proportion to each account balance, you'd pay 2.6% taxes in my strategy compared to 9.5% in taxes with a 100% traditional account.  50000 * (1 - .095) = 45245 available after tax using all traditional 401k.  Using a hybrid strategy, you have 21250 tax free + 25000 * (1 - .026) = 45603.  45603 > 45245, so the hybrid strategy wins in this case.

Incidentally, using these brackets, the break-even point is about $30,600 in annual expenses.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #21 on: October 28, 2014, 12:35:24 PM »
There's another case that's easier to understand.  Consider someone currently in the 15% tax bracket who expects to be in the 25% tax bracket in retirement (due to, perhaps, a pension, social security, or a large increase in savings).  Someone with $50k income in retirement (25% tax bracket, 11.6% effective tax rate) would be better off if $1,000 of it came from a Roth when they were in the 15% tax bracket, because the difference at the margin is 15% when they contributed, but 25% when they retired.  Thus, even though this person's 15% marginal tax rate is higher than their effective tax rate in retirement (what you said "is the only thing that matters"), they would have been better off contributing to a Roth.

The key, though, is that you have to fill up the lower tax brackets with taxable income for this to be effective.

nawhite

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Re: Switch from Roth 401k to Traditional
« Reply #22 on: October 28, 2014, 01:34:12 PM »
I don't see how this can work out.  Can you show some more math?

$40,000 for a single person is a 15% marginal rate.  Taking out $36,000 per year in retirement from taxable sources has an effective rate of 9.6%.  That is 5.4% in your favor, no?

I've attached an Excel spreadsheet that I used, but I warn that it's not too intuitive.  The basic calculation I have is that for the first 5 years, you contribute 4250 (= 5000 *.85), and the next five years you contribute 5000 (I used 5000 because I was thinking IRA instead of 401k, but it's the same idea).  At the end of the 10 years, that's 21250 in Roth + 25000 in traditional, excluding investment gains.  At $36k annual expenses, withdrawn in proportion to each account balance, you'd pay 2.6% taxes in my strategy compared to 9.5% in taxes with a 100% traditional account.  50000 * (1 - .095) = 45245 available after tax using all traditional 401k.  Using a hybrid strategy, you have 21250 tax free + 25000 * (1 - .026) = 45603.  45603 > 45245, so the hybrid strategy wins in this case.

Incidentally, using these brackets, the break-even point is about $30,600 in annual expenses.

That "excluding investment gains" is kinda a big deal. The fact that you have more money in the traditional account every year easily outpaces that $400 of benefit you calculated.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #23 on: October 28, 2014, 01:45:17 PM »
I don't see how this can work out.  Can you show some more math?

$40,000 for a single person is a 15% marginal rate.  Taking out $36,000 per year in retirement from taxable sources has an effective rate of 9.6%.  That is 5.4% in your favor, no?

I've attached an Excel spreadsheet that I used, but I warn that it's not too intuitive.  The basic calculation I have is that for the first 5 years, you contribute 4250 (= 5000 *.85), and the next five years you contribute 5000 (I used 5000 because I was thinking IRA instead of 401k, but it's the same idea).  At the end of the 10 years, that's 21250 in Roth + 25000 in traditional, excluding investment gains.  At $36k annual expenses, withdrawn in proportion to each account balance, you'd pay 2.6% taxes in my strategy compared to 9.5% in taxes with a 100% traditional account.  50000 * (1 - .095) = 45245 available after tax using all traditional 401k.  Using a hybrid strategy, you have 21250 tax free + 25000 * (1 - .026) = 45603.  45603 > 45245, so the hybrid strategy wins in this case.

Incidentally, using these brackets, the break-even point is about $30,600 in annual expenses.

That "excluding investment gains" is kinda a big deal. The fact that you have more money in the traditional account every year easily outpaces that $400 of benefit you calculated.

No it doesn't.  Please see SirDoug's and my corrections to your previous post in this thread, as well as the discussion of this point and the commutative property of multiplication on the thread I linked to earlier.  That handles the discussion for strictly comparing all traditional contributions versus all Roth contributions.

For the mixed strategy, you can put in investment gains and see the result.  Here, the investment gains do change the amount of benefit of a crossover strategy (and the crossover point), but they don't change the fact that under certain circumstances a mixed strategy is better than an all traditional strategy.

sirdoug007

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Re: Switch from Roth 401k to Traditional
« Reply #24 on: October 28, 2014, 01:56:36 PM »
After reading the responses, I stand corrected. Or rather, I was half right/half wrong. I ran a couple simulations in Excel and was surprised to see that the ONLY variable that matters is marginal rate now vs effective rate in retirement. How much you contribute, how long you contribute, what rate of return you get, nothing else matters. If anyone is interested in the excel spreadsheet I can post it.

No.
I agree with most of your conclusions, but you missed a factor that matters — changes in salary.  For example, model a doubling of salary after 5 years.  Depending on your expenses in retirement, a split strategy (Roth at lower salary, traditional at higher salary) can be the best scenario.  One scenario I found, for example, was salary at $40k for 5 years, followed by salary at $80k, and retirement expenses of $3k per month.  In this case, using the Roth for the first 5 years, then switching to a traditional results in higher income in retirement.  Granted, the effect is modest (about 1% better, whereas the 100% traditional is better than doing 100% Roth by about 12%), but this is also the case where all retirement savings occurs at a marginal rate higher than effective tax rate in retirement.

I don't see how this can work out.  Can you show some more math?

$40,000 for a single person is a 15% marginal rate.  Taking out $36,000 per year in retirement from taxable sources has an effective rate of 9.6%.  That is 5.4% in your favor, no?

I've attached an Excel spreadsheet that I used, but I warn that it's not too intuitive.  The basic calculation I have is that for the first 5 years, you contribute 4250 (= 5000 *.85), and the next five years you contribute 5000 (I used 5000 because I was thinking IRA instead of 401k, but it's the same idea).  At the end of the 10 years, that's 21250 in Roth + 25000 in traditional, excluding investment gains.  At $36k annual expenses, withdrawn in proportion to each account balance, you'd pay 2.6% taxes in my strategy compared to 9.5% in taxes with a 100% traditional account.  50000 * (1 - .095) = 45245 available after tax using all traditional 401k.  Using a hybrid strategy, you have 21250 tax free + 25000 * (1 - .026) = 45603.  45603 > 45245, so the hybrid strategy wins in this case.

Incidentally, using these brackets, the break-even point is about $30,600 in annual expenses.

There is an error in your spreadsheet.  When you calculate the effective tax applied to discount the traditional account you take the tax in retirement over the whole $35,000 rather than just the taxable $18,919.  So the effective tax applied to the traditional account is actually 4.64%.  The key point is that the income tax you pay of $877 only takes a bite from the traditional account, not the full retirement spending. 

The comparison then comes out (see attached):

Full Roth - $40,000
Hybrid     - $45,091
Full Trad. - $45,323

It doesn't make sense to pay 15% when you will be paying <10% in retirement.  The only way a Roth is advantageous is as you said if you have some other income taking up the low brackets or if your in the 15% marginal bracket now and spending is pretty high in retirement (>$66k/person) to have an effective tax rate of more than 15% in retirement.

« Last Edit: October 28, 2014, 01:58:52 PM by sirdoug007 »

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #25 on: October 28, 2014, 02:19:00 PM »
There is an error in your spreadsheet.  When you calculate the effective tax applied to discount the traditional account you take the tax in retirement over the whole $35,000 rather than just the taxable $18,919.  So the effective tax applied to the traditional account is actually 4.64%.  The key point is that the income tax you pay of $877 only takes a bite from the traditional account, not the full retirement spending. 

The comparison then comes out (see attached):

Full Roth - $40,000
Hybrid     - $45,091
Full Trad. - $45,323

Yes, you're right.  That was a mistake.  I know sincerity is sometimes hard to read online, but I'm quite sincere in my appreciation.

Quote
It doesn't make sense to pay 15% when you will be paying <10% in retirement.  The only way a Roth is advantageous is as you said if you have some other income taking up the low brackets or if your in the 15% marginal bracket now and spending is pretty high in retirement (>$66k/person) to have an effective tax rate of more than 15% in retirement.

Here, though, you're still not quite right .  See my example of $50k retirement income (25% marginal, <12% effective).  I've attached a spreadsheet showing that in the hybrid example, you come out ~$150 ahead compared to a traditional strategy.


sirdoug007

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Re: Switch from Roth 401k to Traditional
« Reply #26 on: October 28, 2014, 02:37:13 PM »
Ok, now I see where the hybrid case works.  Thanks for the clarifications, it's helped my understanding of this stuff.

In the specific spreadsheet example, hybrid comes out ahead on any retirement spending over about $49k.

The math gets a lot more complicated with the hybrid case but you do come out ahead in some cases if you do Roth while in the 15% bracket and then spend in retirement up in the 25% marginal rate range.

I expect most of the folks on this site will be under that number with a paid off house.

beltim

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Re: Switch from Roth 401k to Traditional
« Reply #27 on: October 28, 2014, 02:47:07 PM »
My pleasure.  Doing these spreadsheets has also helped my understanding, and I've enjoyed discussing this with you. 

This also shows how incredibly complicated these cases can get.  I agree that most folks on this site with a paid off house will be under the $49k spending level.  There is a similar border case at the 10%/15% level, though.

In general, this approach is more useful for people anticipating a traditional retirement, or for those retiring at higher income levels.

GardenFun

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Re: Switch from Roth 401k to Traditional
« Reply #28 on: October 28, 2014, 05:39:47 PM »
Does anyone have a pulse on the probability of income tax rates changing in the future?  The whole debate between Roth and Traditional depends on income tax rates staying relatively the same as present values. 

 

sol

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Re: Switch from Roth 401k to Traditional
« Reply #29 on: October 28, 2014, 05:43:06 PM »
Does anyone have a pulse on the probability of income tax rates changing in the future?  The whole debate between Roth and Traditional depends on income tax rates staying relatively the same as present values.   

Given recent trends in elected government, no one is going to be raising personal income taxes significantly in the next two administrations.  Beyond that, who knows?  If Elizabeth Warren were to run and win by a wide margin in 2028, you might see rates move up then.  Between now and then, I wouldn't sweat it.

GardenFun

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Re: Switch from Roth 401k to Traditional
« Reply #30 on: October 28, 2014, 05:48:35 PM »
Does anyone have a pulse on the probability of income tax rates changing in the future?  The whole debate between Roth and Traditional depends on income tax rates staying relatively the same as present values.   

Given recent trends in elected government, no one is going to be raising personal income taxes significantly in the next two administrations.  Beyond that, who knows?  If Elizabeth Warren were to run and win by a wide margin in 2028, you might see rates move up then.  Between now and then, I wouldn't sweat it.

Good to know.  Had been using this "what if" scenario as a plus for Roth IRA's in the 15% tax bracket.   

seattlecyclone

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Re: Switch from Roth 401k to Traditional
« Reply #31 on: October 28, 2014, 05:49:48 PM »
Does anyone have a pulse on the probability of income tax rates changing in the future?

The probability of change is approximately 100%. New brackets get added, removed, or changed every few years. Trying to guess exactly what changes will happen and when is a fool's game. Plan around the taxes that are currently in place, but expect to change your plan in the future to match the incentives in place at the time.

Some people like to come up with doomsday tax scenarios ("what happens if they start taxing my Roth withdrawals?" is but one of many examples). I believe changes of this magnitude are politically impossible. So many people have Roth IRAs and changing the taxation of withdrawals from existing IRAs would be rightly seen as an unfair modification of the deal Congress made with retirement savers. Ending future Roth contributions or closing certain loopholes (like the backdoor Roth IRA) are more likely.