23 and not sure if I should use Roth or Traditional IRA

[fugaltechie]

According to my w2, these are my numbers for 2016:

Gross Pay:          $ 49,369
401k:               $  3,323
Reported W-2 Wages: $ 45,873

I just graduated and started working in the middle of 2016. Currently I have an emergency fund set up and I should be set to make around $110k in 2017 before tax and I plan on maxing out my 401k (trad) in 2017. Low 401k in 2016 as I wanted to save up a bigger emergency fund and rent isn't exactly cheap where I'm living. From my understanding I should be able to still contribute to an IRA up until tax day for the 2016 tax year. From what I read, I can contribute to an IRA even after having contributed a bit of money to a 401k last year, although I'm not sure if that applies to a Roth IRA or not. At this point I'm thinking I should contribute the $5,500 to a traditional IRA, but a Roth does have some advantages as I don't think I'll have an annual income this low for a while.

It basically boils down to these two questions:
1) Can I still contribute to a Roth IRA after contributing to a 401k?
2) Should I contribute to a traditional or Roth IRA?

[GizmoTX]

You'll need to run a tax scenario both ways. The advantage to a tIRA is that it lowers your Adjusted Gross Income -- see if doing this saves you any income tax beyond what you'll get with your 401K contribution. Note that a tIRA defers income taxes. If the tIRA doesn't materially lower your income tax, go Roth IRA, as it will be forever tax free.

This year you'll likely want to max your 401K ($18K), then put up to $5.5K into your Roth.

[MDM]

...but a Roth does have some advantages as I don't think I'll have an annual income this low for a while.

It basically boils down to these two questions:
1) Can I still contribute to a Roth IRA after contributing to a 401k?
2) Should I contribute to a traditional or Roth IRA?

1) Yes.  See Retirement Topics - IRA Contribution Limits.
2) Roth.  The 1/2 year income puts you at 15% marginal tax saving rate for 2016. 

A case can also be made to use traditional, and in most situations that's what I'd recommend, but you fit one of the exceptions to that rule: the first 1/2 year out of college.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth for more.

[fugaltechie]

Thanks MGM for the info and links! I'm single, so wouldn't the marginal tax rate be 25% instead of 15% as it would be from above $37,650?

[modulus]

Thanks MGM for the info and links! I'm single, so wouldn't the marginal tax rate be 25% instead of 15% as it would be from above $37,650?

Don't forget to subtract $6300 standard deduction and $4050 personal exemption from your adjusted gross income.

[MDM]

Thanks MGM for the info and links! I'm single, so wouldn't the marginal tax rate be 25% instead of 15% as it would be from above $37,650?

Don't forget to subtract $6300 standard deduction and $4050 personal exemption from your adjusted gross income.

+1

Yes, that's why it is 15%.  Some of your 401k did save 25%.

See the case study spreadsheet if you would like to generate marginal rate charts for different items (e.g., 401k contributions, tIRA contributions, salary income, etc.).

[College Stash]

Really curious what field/region you are in to make 110k after graduating. Super impressive and frankly I'm jealous. The first couple years using a Roth may make sense, but after that definitely move to traditional i'd say.

[NorthernBlitz]

Really curious what field/region you are in to make 110k after graduating. Super impressive and frankly I'm jealous. The first couple years using a Roth may make sense, but after that definitely move to traditional i'd say.

I'm not sure about this, but location might also matter if you have state income tax. If so, do you need to pay state income tax when you withdraw money if move to a state with no income tax? I don't know if this is how it works (we recently moved from Canada).

For example: For their working life, someone lives in NYS. Defers state income taxes by putting in tIRA / 401k. Then, they move to Florida to retire. When they start to pull from their traditional accounts, do they owe a cut to NYS?

If that's the case and you live in a state with income tax, traditional might look better because you'd never have to pay the state portion of the deferred tax...

[chops]

This will be the only year you will get a tIRA tax break due to lowering adjusted gross income as this tax break phases out over $71k.  Unless you expect to reduce your (amazing!) starting salary for the rest of your career, you will never be able to do this again.  I'd say go for the tIRA because...

...you can fund a Roth IRA every year for the rest of your career (no income restrictions) as long as you do the Roth backdoor method.  Basically, this means you fund a tIRA after tax without getting the tax break (because you will make over $71k) and then convert it immediately into a Roth.  This is a tried and true method that is all over the MMM forums and bogleheads.

 - Chops

 

[Proud Foot]

This will be the only year you will get a tIRA tax break due to lowering adjusted gross income as this tax break phases out over $71k.  Unless you expect to reduce your (amazing!) starting salary for the rest of your career, you will never be able to do this again.  I'd say go for the tIRA because...

...you can fund a Roth IRA every year for the rest of your career (no income restrictions) as long as you do the Roth backdoor method.  Basically, this means you fund a tIRA after tax without getting the tax break (because you will make over $71k) and then convert it immediately into a Roth.  This is a tried and true method that is all over the MMM forums and bogleheads.

 - Chops

The only problem with that is if he contributes to a tIRA this year then he will be taxed at a higher rate when he tries to do the backdoor Roth method.

OP, like MDM said, this is a situation where the Roth IRA is beneficial.

[fugaltechie]

Really curious what field/region you are in to make 110k after graduating. Super impressive and frankly I'm jealous. The first couple years using a Roth may make sense, but after that definitely move to traditional i'd say.

Software Engineering and Seattle at a tech company after having a couple of internships. While I agree it's impressive and I didn't imagine a few years ago I would be making anywhere near as much after graduating, it's actually not that uncommon for new grads to be making this much starting at a tech company and it only get more ridiculous from here. There are some downsides (working long hours and weekends occasionally, being on an on call rotation, occasionally having things get stressful, constantly having to learn new stuff to keep up, dealing with other software engineers that might not have the most polished people skills, etc) it's overall a pretty nice field. Seattle is also nice as there is quite a bit of tech for career growth, but the cost of living is lower than the bay area and there is no state income tax. Plus I like it more for the opportunity to do outdoorsy things and there is just something about the bay area that doesn't click with me. Weather could be a bit better though.

[MustacheAndaHalf]

I assume your company was good enough to offer a company match to your 401(k).  For others in this situation, an employer tends to match +50% or even +100%.  That outpaces the interest rates credit cards charge, so it actually makes sense to put things on a credit card - without paying them off - while grabbing more of the company match.  Emotionally, it's probably tougher, but financially the +50% is hard to pass up.

[seattlecyclone]

I think there's a good case to be made for traditional contributions here, as you do have a high income and will be ineligible to deduct traditional IRA contributions going forward.

The main thing to look at in this Roth vs. traditional thing is your current marginal tax rate vs. your marginal tax rate at retirement.

Your retirement tax bracket is determined, to a large extent, by your retirement spending. However, as long as you don't have a pension or something else that would pay you more than you plan to spend, your spending basically acts as an upper bound to your income. Roth withdrawals generally don't count as income, nor do HSA withdrawals. Withdrawals from a taxable account only count as income to the extent that the sale price exceeds the cost basis, and even then you get a special tax rate on it.

Projecting your career forward, you should expect that you'll be able to max out a traditional 401(k) and a Roth IRA each year (Roth IRA because you'll earn too much for traditional), plus whatever extra money will go into taxable. The more frugal you are, the more you'll end up putting in taxable, and this will in turn decrease the fraction of your savings that will live in traditional retirement accounts.

In general you'll be the most tax-efficient during retirement by smoothing your income out as much as possible from year to year. For example you'll usually do better withdrawing $20k from traditional and $20k from Roth each year rather than alternating years of withdrawing $40k from traditional and $40k from Roth.

Given that, you should assume that your withdrawals each year would generally match your overall portfolio: if you retire with 50% in taxable, 30% in traditional, and 20% in Roth, that's probably pretty close to your optimal withdrawal ratio.

Let's get back to marginal tax rates. Again, what you should do this year is mostly determined by how you expect your current marginal tax rate compares to what your marginal tax rate will be in retirement. Currently you're at 15%. If you expect to have the same tax rate in retirement, you can go either way with this year's contributions. But notice how the higher your income and savings rate, the lower your traditional retirement accounts will be as a percentage of your overall portfolio. With only a third of your money in traditional, you can rack up some pretty anti-Mustachian spending during retirement without even hitting the 15% bracket, and you'll have to go pretty wild to hit 25%.

[SeattleCPA]

I think there's a good case to be made for traditional contributions here, as you do have a high income and will be ineligible to deduct traditional IRA contributions going forward.

The main thing to look at in this Roth vs. traditional thing is your current marginal tax rate vs. your marginal tax rate at retirement.

Your retirement tax bracket is determined, to a large extent, by your retirement spending. However, as long as you don't have a pension or something else that would pay you more than you plan to spend, your spending basically acts as an upper bound to your income. Roth withdrawals generally don't count as income, nor do HSA withdrawals. Withdrawals from a taxable account only count as income to the extent that the sale price exceeds the cost basis, and even then you get a special tax rate on it.

Projecting your career forward, you should expect that you'll be able to max out a traditional 401(k) and a Roth IRA each year (Roth IRA because you'll earn too much for traditional), plus whatever extra money will go into taxable. The more frugal you are, the more you'll end up putting in taxable, and this will in turn decrease the fraction of your savings that will live in traditional retirement accounts.

In general you'll be the most tax-efficient during retirement by smoothing your income out as much as possible from year to year. For example you'll usually do better withdrawing $20k from traditional and $20k from Roth each year rather than alternating years of withdrawing $40k from traditional and $40k from Roth.

Given that, you should assume that your withdrawals each year would generally match your overall portfolio: if you retire with 50% in taxable, 30% in traditional, and 20% in Roth, that's probably pretty close to your optimal withdrawal ratio.

Let's get back to marginal tax rates. Again, what you should do this year is mostly determined by how you expect your current marginal tax rate compares to what your marginal tax rate will be in retirement. Currently you're at 15%. If you expect to have the same tax rate in retirement, you can go either way with this year's contributions. But notice how the higher your income and savings rate, the lower your traditional retirement accounts will be as a percentage of your overall portfolio. With only a third of your money in traditional, you can rack up some pretty anti-Mustachian spending during retirement without even hitting the 15% bracket, and you'll have to go pretty wild to hit 25%.

Excellent, excellent commentary... +1

[jim555]

My rule was if it saved 25% or more then Traditional, else do the Roth.

[Landslave]

Do you want to pay tax on the seed or the harvest? 

[MDM]

Do you want to pay tax on the seed or the harvest?

Based on the commutative property of agriculture, if the tax rate is the same the resulting amount of food to eat is also the same.