Author Topic: Traditional 401k v. Roth 401k  (Read 4733 times)

outtaheresoon

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Traditional 401k v. Roth 401k
« on: April 14, 2015, 07:37:59 AM »
My company offers both a traditional and Roth 401k's.  I had started contributing to the Roth option (spilt my contributions between both) when it was first offered.  After 2013's tax bill - had to pay-  I decided to stop contributing to the Roth hoping it would bring down my taxes contributing solely to the traditional 401k.  Just paid this years taxes, a little less than 2013's but still had to pay ($1900 fed) and am wondering if I should go back and start contributing to the Roth option again.  Currently I have $464,000 in the traditional and $74,000 in the Roth.  I am hoping to retire in 5 years (at 55) Thoughts?

SuperSecretName

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Re: Traditional 401k v. Roth 401k
« Reply #1 on: April 14, 2015, 07:43:59 AM »
what is your marginal tax rate?

velocistar237

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Re: Traditional 401k v. Roth 401k
« Reply #2 on: April 14, 2015, 07:47:30 AM »
Usually the decision between Traditional and Roth is determined by whether you earn more now than you expect to spend later. Since this is almost universally true of MMM folks (aside from those who are students or are underemployed), most people opt for the Traditional.

It sounds like your exemptions might need some tweaking. Your employer probably withheld less tax in 2014 than the previous year because of your 401k choice, but still relatively too much, based on the exemptions you specified.

outtaheresoon

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Re: Traditional 401k v. Roth 401k
« Reply #3 on: April 14, 2015, 08:14:42 AM »
Usually the decision between Traditional and Roth is determined by whether you earn more now than you expect to spend later. Since this is almost universally true of MMM folks (aside from those who are students or are underemployed), most people opt for the Traditional.

It sounds like your exemptions might need some tweaking. Your employer probably withheld less tax in 2014 than the previous year because of your 401k choice, but still relatively too much, based on the exemptions you specified.

I just changed my exemptions from 2 Married to 1 Married.

seattlecyclone

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Re: Traditional 401k v. Roth 401k
« Reply #4 on: April 14, 2015, 08:53:10 AM »
The fact that you still owed money at the end of the year doesn't mean your taxes stayed the same. If you look at your pay stubs, you'll see that your withholding went down when you switched to Roth contributions. If your salary was about the same from year to year you should also see that the total tax reported on your 1040 went down from year to year as well. To avoid underpayment penalties you should increase your withholding, by submitting a new W-4 with the same number of exemptions and an "additional withholding" amount of ($1900 / the number of pay periods remaining in the year). That should get you in the right ballpark.

As to whether Roth contributions are better than traditional contributions, the other posters pretty much nailed it. Traditional contributions are typically better for those of us who spend less than we earn and don't plan to massively increase our spending when we retire.

MDM

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Re: Traditional 401k v. Roth 401k
« Reply #5 on: April 14, 2015, 11:12:38 AM »
I just changed my exemptions from 2 Married to 1 Married.
Each withholding allowance on the W-4 is "worth" the individual exemption amount on form 1040.  For 2015, that is $4,000.

One then needs to know one's marginal tax bracket to translate exemption to tax.  E.g., in the 15% bracket a $4,000 exemption saves $600 and in the 25% bracket that $4,000 saves $1,000.

To increase withholding by $1,900/yr, someone firmly in the 15% bracket would decrease W-4 allowances by $1900/$600 = 3.  In the 25% bracket it would be $1900/$1000 = 2.  Note that, due to rounding, it won't be an exact change, but close enough....

As the first third of 2015 withholding will have already been done with the existing W-4, a change now would need to decrease by 1900/600*3/2 = 5 or 1900/1000*3/2 = 3 for the above examples.

Also see http://forum.mrmoneymustache.com/ask-a-mustachian/how-can-we-optimize-our-withholdings/

...withholding went down when you switched to Roth contributions.
Not sure why switching to Roth (either from nothing or from traditional) would cause withholding to go down.  Seems it would either not change or go up...?

Quote
To avoid underpayment penalties you should increase your withholding, by submitting a new W-4 with the same number of exemptions and an "additional withholding" amount of ($1900 / the number of pay periods remaining in the year). That should get you in the right ballpark.
This is a more exact way than the "adjusting the exemption allowances" described above, because you aren't restricted to one significant digit.

seattlecyclone

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Re: Traditional 401k v. Roth 401k
« Reply #6 on: April 14, 2015, 12:34:11 PM »
...withholding went down when you switched to Roth contributions.
Not sure why switching to Roth (either from nothing or from traditional) would cause withholding to go down.  Seems it would either not change or go up...?

Sorry, meant to say "switched to traditional contributions," which is what the OP actually did.

Indexer

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Re: Traditional 401k v. Roth 401k
« Reply #7 on: April 14, 2015, 03:41:56 PM »
There are several things to consider. 

The obvious is tax bracket.  Higher bracket now trad makes more sense.  Lower bracket now and Roth makes more sense.  Think of it this way, with the Roth contributions you are 'locking in' your current tax rate.  Locking in a 10-15% tax rate is normally a smart thing to do.  You said you were MFJ so looking at the tax tables if you have a combined 'taxable' income under 75k the Roth "probably" makes more sense.  If you are over the Trad probably makes more sense.  $74900 is the split between the 15% and 25% tax brackets for MFJ.  Exceptions:  If you are in a high bracket now and know you will be in an even higher tax bracket at retirement(unlikely for mustachian) then a Roth might still make sense.  Since half of this is trying to predict the future not even a CPA can give a 100% for sure answer on which is better.

Now since we are on the MMM forums lets throw a wrench in the normal logic.  If you plan on retiring before 59 1/2 there is something else to consider.
Traditional:  You can't touch a dime until 59 1/2 unless you convert it to a Roth and then wait 5 years.
Roth:  You can always touch the contributions at any time, but you can't touch the earnings till 59 1/2(& at least 5yrs after first contribution).

So if you are 100% Roth you run into a problem.  Lets say you retire with 650k total; 300k is contributions, 350k is earnings.  You withdraw 25k a year... well oops... you run out of contributions after 12 years.  Now all that is left are earnings which you can't touch till after 59 1/2 unless you want a bunch of penalties. 

Which brings us to the perfect scenario.  125k+ in taxable(roth "contributions" also work) assets, and 500k+ in Traditional.  Each year you take 25k out of the taxable for spending, and at the same time you convert 25k from the trad to the Roth.  Taxable income = 25k which even with some capital gains* from the taxable account will keep you in the lowest brackets with 0% long term capital gains rates so you avoid paying taxes on the capital gains.  After 5 years you are out of taxable assets but you have 25k in Roth assets you can touch(from the conversion you did 5 years earlier).  Repeat every year until 59 1/2.  If this doesn't make sense search "Roth conversion ladder."  There are a few topics on it.

If you want to get EVEN more complicated you can try to make sure and set it up so that by age 70 1/2 you have almost nothing left in traditional.  Almost everything is in Roth.  This is because at 70 1/2 you have to take money from a traditional and if you had a very very large balance the required amount you had to take out each year could push you into a higher tax bracket. 

* Limiting capital gains in the taxable account will require tax efficient investing.  Vanguard stock ETFs are my personal favorites for staying tax efficient.
« Last Edit: April 14, 2015, 03:44:29 PM by Indexer »

seattlecyclone

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Re: Traditional 401k v. Roth 401k
« Reply #8 on: April 14, 2015, 06:10:48 PM »
Now since we are on the MMM forums lets throw a wrench in the normal logic.  If you plan on retiring before 59 1/2 there is something else to consider.
Traditional:  You can't touch a dime until 59 1/2 unless you convert it to a Roth and then wait 5 years.

False. All that happens if you make an early withdrawal from a traditional IRA is that you pay income tax on the amount withdrawn (which you will have to do anyway no matter how and when you get the money out) plus a 10% early withdrawal penalty. Suppose you're five years out from retirement and have all of your savings in pre-tax retirement accounts. Should you start making Roth conversions now to get your pipeline ready? It depends. If you're currently in the 25% bracket (or higher) and plan to retire in the 15% bracket (or lower), you'll likely be better off making early withdrawals after you retire than making Roth conversions now.

Don't let the word "penalty" scare you. It's just a tax that applies to withdrawals in certain circumstances. Often you're better off avoiding it. Sometimes you're not. In no case does the existence of this penalty mean you "can't touch" your savings. Don't fall into the trap of being irrationally averse to paying an early withdrawal penalty.

Quote
Roth: You can always touch the contributions at any time, but you can't touch the earnings till 59 1/2(& at least 5yrs after first contribution).

The "can't touch" is closer to being true with withdrawals of Roth earnings than with pre-tax retirement funds. You'll pay exactly the same amount of tax and penalty withdrawing Roth earnings early as you will pay when withdrawing pre-tax retirement funds early. The difference is that if you can wait until 59, the Roth withdrawal is completely tax-free, while the traditional withdrawal is subject to income tax on the full amount. Therefore the "hit" you take by withdrawing early can be much higher with a Roth compared to withdrawing later.
« Last Edit: April 14, 2015, 06:13:04 PM by seattlecyclone »

Indexer

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Re: Traditional 401k v. Roth 401k
« Reply #9 on: April 14, 2015, 08:10:42 PM »
seattle:  When I said you can't take money out I was referring to the penalties, and I did reference the penalties in the part of the post you didn't quote.  It is normally a really bad idea to incur those penalties, and I am pretty rationally against paying those penalties if they can be avoided ;).

Plus I think you missed the part where I said the roth conversion ladder starts with using money in a taxable account or roth contributions.  If you are living off those for the first 5 years and doing conversions from the trad to the roth each year in amounts of roughly 25k... then your 'taxable' income will be very low and you will be in the lowest tax brackets.  Doing a Roth conversion when you are in the 10-15% bracket will always be better than taking money from an IRA and paying penalties.



But this did remind me of something. 

Quote from: outtaheresoon
Currently I have $464,000 in the traditional and $74,000 in the Roth.  I am hoping to retire in 5 years (at 55) Thoughts?

If you retire at or after 55 401ks have a rule that you can take the money 'then' without penalties instead of waiting to 59 1/2.

velocistar237

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Re: Traditional 401k v. Roth 401k
« Reply #10 on: April 15, 2015, 05:27:20 AM »
If you retire at or after 55 401ks have a rule that you can take the money 'then' without penalties instead of waiting to 59 1/2.

I think you have to check with the account administrator about this. If I remember correctly, it's not a universal thing.

sisto

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Re: Traditional 401k v. Roth 401k
« Reply #11 on: April 15, 2015, 05:11:07 PM »
"Which brings us to the perfect scenario.  125k+ in taxable(roth "contributions" also work) assets, and 500k+ in Traditional.  Each year you take 25k out of the taxable for spending, and at the same time you convert 25k from the trad to the Roth.  Taxable income = 25k which even with some capital gains* from the taxable account will keep you in the lowest brackets with 0% long term capital gains rates so you avoid paying taxes on the capital gains.  After 5 years you are out of taxable assets but you have 25k in Roth assets you can touch(from the conversion you did 5 years earlier).  Repeat every year until 59 1/2.  If this doesn't make sense search "Roth conversion ladder."  There are a few topics on it.

If you want to get EVEN more complicated you can try to make sure and set it up so that by age 70 1/2 you have almost nothing left in traditional.  Almost everything is in Roth.  This is because at 70 1/2 you have to take money from a traditional and if you had a very very large balance the required amount you had to take out each year could push you into a higher tax bracket."


 Indexer, I'd like a little more information about this scenario. What are you assuming as a retirement age? Also nobody mentioned 72t which seems like a really good option if you have enough money in your traditional 401K. Thanks

Indexer

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Re: Traditional 401k v. Roth 401k
« Reply #12 on: April 15, 2015, 05:58:53 PM »
If you retire at or after 55 401ks have a rule that you can take the money 'then' without penalties instead of waiting to 59 1/2.

I think you have to check with the account administrator about this. If I remember correctly, it's not a universal thing.

It's an IRS thing, not a 401k provider thing.  So it should be universal, but not all 401k plan customer service reps are well versed on it.

http://www.irs.gov/taxtopics/tc558.html
"The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA:

Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50. "

Quote from: sisto
Indexer, I'd like a little more information about this scenario. What are you assuming as a retirement age? Also nobody mentioned 72t which seems like a really good option if you have enough money in your traditional 401K. Thanks

Retirement age shouldn't matter as long as you have the assets to support your income for the time frame.  I got the 600-650k rough estimate because that is what a lot of people use based on a blog post MMM did awhile back.  Personally I aim for more than 600-650k, but I "personally" would rather have a 3-3.5% WR instead of 4%.  25k is 4% of 625k, and MMM's annual spending is around 25k so you can see why a lot of people use 625k.

Roth Conversion Ladder sources:
http://forum.mrmoneymustache.com/ask-a-mustachian/the-millionth-%27roth-conversion-ladder%27-question/
http://forum.mrmoneymustache.com/ask-a-mustachian/roth-conversion-ladder-questions/
http://forum.mrmoneymustache.com/investor-alley/traditional-ira-to-roth-conversion-ladder/
« Last Edit: April 15, 2015, 06:10:32 PM by Indexer »