Am I understanding tax consequence of Roth IRA correctly?

[mousebandit]

So, am I understanding the tax consequences of a ROTH IRA vs a traditional IRA correctly? 

If I contribute to a traditional IRA, my contributions are tax-deductible for this year, but I pay taxes on contributions AND growth when I pull funds out later.

If I contribute to a Roth IRA, my contributions are taxable for this year, but I pay NO TAXES on contributions OR growth when I pull the funds out later.

If I'm leaving funds in the IRA to grow for any substantial period of time, and I'm not in a wildly high tax bracket now, isn't the Roth the WAY better deal, because I'm getting all the growth tax-free forever??

This is probably old-hat for everyone, but it seems fabulous and incredible to me, to get income without being taxed on it, LOL. 

Thanks!

[SynapticFits]

Let's try a numerical example. You have $1000 dollars you want to invest. You can pay taxes on it now or later, in 10 years. Rate of return is 6%.

If your marginal income tax rate is 25% both now and in retirement:

Traditional IRA: tax-free $1000 goes in. You make 6% returns so your total at the end of 10 years is 1000*1.06^10 = $1790.85. You pay 25% tax on the entire amount, so your final after-tax withdrawal is $1343.14.
Roth IRA: You make $1000, pay 25% tax immediately, and invest $750. In 10 years you have 750*1.06^10 = $1343.14, which you withdraw tax free.

Obviously this is a simplified example. Re-do this math but vary the tax rates between the traditional and Roth and you will see that the traditional IRA comes out ahead when your income taxes are lower in retirement than they are currently.

The argument behind Roth IRAs is that taxes will be higher in the future, therefore you're better off paying them now. This is true for many people, because people who make $100,000 and spend most of it will also want to spend $100,000 per year in retirement, and many people believe income taxes are going to rise in the future. But if you're pulling in six figures now and plan to live off of $30,000 after retirement, your tax bracket is almost surely going to be lower then, even if the government raises overall tax rates dramatically.

[maizefolk]

I completely agree with SynapticFits math and explanation. However, one inherent perk of the Roth IRA is that if you're not cash flow limited, it actually lets you save a bit more than a traditional IRA. This sounds confusing since the contribution limits are identical, but let's work out the math.

You are going to max out our IRA contribution, otherwise all assumptions are as above. You contribution $5,000 to a traditional IRA. After ten years of compounding 6% interest you have $8,954. When you withdraw it you pay 25% tax and have $6,715 left. You contribute $5,000 to a Roth IRA. After ten years of compounding 6% interest you have $8,954. When you withdraw it you pay 0% tax and have $8,954 left. The reason for this is that a Roth contribution is equivalent to a traditional IRA contribution of $5,000, plus the taxes paid on that contribution. So with a 25% tax rate, contributing $5,000 in a Roth is the equivalent of contributing $6,250 in a traditional IRA which is more than than the contribution limit.

[kpd905]

The biggest benefit for traditional accounts for early retirees is that you get to deduct at your high marginal rate during your working years, and then fill up the tax brackets from the bottom up when you withdraw.

So you might deduct at 25%, then the first $10,000 you withdraw is tax free, then another ~$9200 is at 10%, then about $28,000 is at 15%.  So a single person can withdraw $48,000 before they ever get back to a 25% marginal rate.

[seattlecyclone]

If I'm leaving funds in the IRA to grow for any substantial period of time, and I'm not in a wildly high tax bracket now, isn't the Roth the WAY better deal, because I'm getting all the growth tax-free forever??

This makes intuitive sense, but the logic SynapticFits posted is spot on. Assuming identical tax brackets between now and retirement, the amount of tax you pay will be higher with a traditional IRA, but the amount you get to keep is identical. In the end, the amount you keep is what matters. If you plan to have a different tax bracket in retirement, prefer a traditional IRA if your tax bracket will be lower in retirement and prefer a Roth IRA if your tax bracket will be higher in retirement.

maizeman is also correct that a dollar in a Roth IRA is worth more than a dollar in a traditional IRA. If you're able to max out all of the retirement accounts available to you and you're expecting your tax bracket to be the same in retirement as it is now, Roth wins the tiebreaker because of this effect. However it's really just a tiebreaker. Depending on your time horizon this effect doesn't make up for more than a couple percentage points' difference in expected tax bracket.

Many people assume that of course their tax bracket will be higher in retirement than it is now. That may be true for many people, but I do want to challenge that assumption. During your career your income needs to be higher than your spending because you need to have some money left over to save for retirement. During retirement your income generally doesn't need to be higher than your spending anymore. You'll be spending down your savings, and not all of those withdrawals will count as income for tax purposes. Roth IRA withdrawals don't count as income. HSA withdrawals don't either. Withdrawals from your taxable brokerage account only count as income to the extent that you have capital gains; principal doesn't count as income. The higher fraction of your savings is in these types of accounts, the less your income will be during retirement, which means that further contributions to these accounts (as opposed to a traditional retirement account) will be less of a good idea! Just keep this in mind.

[FIREdancer]

I think your understanding is basically correct, mousebandit, and the previous responses are helpful.

I will respond with a comment/question.  It's a question because I'm not sure if my method is necessarily the best, so others can weigh in on that and you can take it with a grain of salt.  But I sort of split the difference when it comes to pre- or post-tax retirement contributions.  But it all depends on your income now and your spending now and in retirement.  So here's what I do:

I'm right on the line between the 25% and 15% tax bracket.  So I contribute pre-tax to my employer's 457(b) plan which puts me solidly in the 15% bracket.  I am almost positive I will be in the 15% bracket in retirement as well, so I go ahead and fully fund a Roth IRA.  And since tax brackets will likely change in the future, I personally like the idea of having a little of both pre-and post- tax savings to sort of hedge my bets in case there are changes in the future.

It all really boils down to your income and spending and limits on what you can and cannot contribute depending on that income.

I also sort of think as Mustachians we are pretty well prepared in any event because of our badassity, we can always earn more or spend less to adjust to any given situation.

[MDM]

+1 to all previous posts.

If you don't have a pension that will put you into the same tax bracket you are now, 100% Roth is certainly wrong because you are giving up the opportunity to save some taxes now while withdrawing at a lower marginal rate later.

100% traditional may or may not be best - you have to look at your specific situation.  See Traditional versus Roth - Bogleheads.

[JCM]

I'm considering this same question now also. An added wrinkle: state income tax. I currently live in a state (Washington) with no state income tax. There is a high likelihood that I will move to another state in retirement, and there is a good chance that there will be a state income tax in that state. My reasoning is that this factor may swing the decision toward Roth while living in Washington. Any thoughts on this?

Other data: Age:27, Income: ~60k/yr pre-tax, Tax Bracket: 25%, expected retirement tax bracket: probably 15%, Pension?: Yes, but not much.

[seattlecyclone]

I'm considering this same question now also. An added wrinkle: state income tax. I currently live in a state (Washington) with no state income tax. There is a high likelihood that I will move to another state in retirement, and there is a good chance that there will be a state income tax in that state. My reasoning is that this factor may swing the decision toward Roth while living in Washington. Any thoughts on this?

Sounds reasonable. The thing to consider is combined federal + state tax bracket now vs. combined federal + state tax bracket in retirement. If your state tax bracket in retirement will be higher than the difference between your pre-retirement and post-retirement federal tax brackets, then Roth can be a good choice.

[beltim]

This is an excellent collection of advice.  I will add one additional point, which potentially conflicts with MDM's comment above.  In general, most people have an income curve that starts low then increases, often significantly.  It is possible that the optimal allocation of dollars involves contributing to a Roth IRA when you start at a low income—even if your marginal tax rate in retirement will be lower—and then switching your contributions to a traditional IRA when your income increases later.

[MDM]

...which potentially conflicts with MDM's comment above.

No conflict at all.  Your point is perfectly valid if one expects to contribute enough at higher marginal rates to bring the withdrawal marginal rate up to what one is currently paying.  "Doctors in residency" and "new graduates starting a full time job mid-year" are a couple of situations where this could apply.

I might not have been clear - when saying "...100% Roth is certainly wrong..." I meant "...100% Roth for your entire career is certainly wrong...."

[beltim]

...which potentially conflicts with MDM's comment above.

No conflict at all.  Your point is perfectly valid if one expects to contribute enough at higher marginal rates to bring the withdrawal marginal rate up to what one is currently paying.  "Doctors in residency" and "new graduates starting a full time job mid-year" are a couple of situations where this could apply.

I might not have been clear - when saying "...100% Roth is certainly wrong..." I meant "...100% Roth for your entire career is certainly wrong...."

Ah, gotcha.  Yes, I read your comment the second way.  And the "doctor in residency" is the classic example I almost used here.

[seattlecyclone]

This is an excellent collection of advice.  I will add one additional point, which potentially conflicts with MDM's comment above.  In general, most people have an income curve that starts low then increases, often significantly.  It is possible that the optimal allocation of dollars involves contributing to a Roth IRA when you start at a low income—even if your marginal tax rate in retirement will be lower—and then switching your contributions to a traditional IRA when your income increases later.

I'm not sure I agree. Yes, there are plenty of people who will retire to a tax bracket higher than they start out at, because they will be in an even higher tax bracket for the majority of their career and don't want to live like a grad student when they retire. If that's you, make Roth contributions until such time as your current tax bracket surpasses your expected retirement tax bracket. I think the general advice of "prefer traditional if you expect a lower tax bracket in retirement than you have right now" still stands, regardless of how you expect your wages to change prior to retirement.

[steevven1]

Nobody ever mentions this: With a Roth IRA, you can withdraw your contributions (not earnings) ANY TIME, at ANY AGE, tax-free and penalty-free. This allows much greater financial flexibility. With the traditional IRA, you pay income tax plus a 10% additional penalty tax for withdrawing ANYTHING at all before age 59.5.

[maizefolk]

Steeven1, that's because as long as you have at least five years of lead time, it's possible to avoid the penalty: http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

[Spork]

One other thing to think about: RMDs.  With a traditional IRA, you DAMN WILL start taking out minimal amounts of money and paying tax on it when you hit 70.5.  People don't really think much about that because it seems so far out on the horizon.  But with mustacian living, saving and compound interest: that amount just might be significant.  You are very likely to have to withdraw more than you need (assuming you were not able to convert it all to Roth).

[Shor]

Steeven1, that's because as long as you have at least five years of lead time, it's possible to avoid the penalty: http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

And on this note,
money in the tIRA -> Roth Conversion (taxed here) -> wait 5 years -> withdraw penalty free
With the Roth IRA, your contributions you can pull out, but the earnings cannot be pulled out before their time (barring certain circumstances, otherwise you pay taxes on them). This means you will need to have enough money either in taxable account, Roth IRA contributions, or non-tax-advantaged account to tide you over from retirement to 59.5 before you can touch those Roth IRA earnings penalty free.
All of the tIRA earnings can be pulled out before 59.5 if you follow all the rules. This is not so important for those that work up to retirement age, but can be a huge difference if you do plan to retire early.

[beltim]

This is an excellent collection of advice.  I will add one additional point, which potentially conflicts with MDM's comment above.  In general, most people have an income curve that starts low then increases, often significantly.  It is possible that the optimal allocation of dollars involves contributing to a Roth IRA when you start at a low income—even if your marginal tax rate in retirement will be lower—and then switching your contributions to a traditional IRA when your income increases later.

I'm not sure I agree. Yes, there are plenty of people who will retire to a tax bracket higher than they start out at, because they will be in an even higher tax bracket for the majority of their career and don't want to live like a grad student when they retire. If that's you, make Roth contributions until such time as your current tax bracket surpasses your expected retirement tax bracket. I think the general advice of "prefer traditional if you expect a lower tax bracket in retirement than you have right now" still stands, regardless of how you expect your wages to change prior to retirement.

So this gets complicated, because contributing to a Roth IRA early in your career can lead you to be in a lower marginal tax rate in retirement.  It's possible, for example, to be in the 15% tax bracket at the beginning of your career, then a higher tax bracket in the middle, and retire in a 25% tax bracket if you always contribute to a Roth IRA.  If you contributed to a Roth IRA at the beginning of your career, it's possible that you never reach that 25% tax bracket, even though you wind up with more after-tax money at the end of the day.

This is why the actual optimization is maximizing your after tax income, instead of using general rules.

There's a similar problem with allocating stocks and bonds in taxable and tax-advantaged accounts.  Depending on returns and tax rates, it's possible to wind up with a higher after-tax return by paying more current taxes.  You don't actually want to reduce taxes, you want to end up with more after-tax income, and the general rules don't account for all situations.

[seattlecyclone]

Yes, the amount of tax you pay is a secondary concern; maximizing the amount you get to keep after paying taxes is what matters. The math doesn't lie: someone who retires to a higher tax bracket will find that they keep more money after taxes if they contribute to Roth, while someone who retires to a lower tax bracket will find that they keep more money after taxes in a traditional account. Period.

It looks like you're arguing that people might contribute to traditional expecting their tax bracket to be lower in retirement, while they actually end up in a higher tax bracket. Yes, that can happen. The mistake was their assumption about current vs. future tax brackets. Their tax bracket in the intervening years had nothing to do with it.

[beltim]

Yes, the amount of tax you pay is a secondary concern; maximizing the amount you get to keep after paying taxes is what matters. The math doesn't lie: someone who retires to a higher tax bracket will find that they keep more money after taxes if they contribute to Roth, while someone who retires to a lower tax bracket will find that they keep more money after taxes in a traditional account. Period.

It looks like you're arguing that people might contribute to traditional expecting their tax bracket to be lower in retirement, while they actually end up in a higher tax bracket. Yes, that can happen. The mistake was their assumption about current vs. future tax brackets. Their tax bracket in the intervening years had nothing to do with it.

Mmm, sort of.  I'm saying that the very decision of which account to contribute to can affect your tax bracket in retirement.  For example, say someone is in the 15% tax bracket now but expects to be in the 25% tax bracket later in their career.  Depending on whether they assume they will contribute to a Roth or Traditional IRA when they're in the 15% tax bracket, it might affect whether their income in retirement is taxed at a marginal rate of 15% or 25%.  In this case, contributions to the Roth early in the career ensure that the marginal tax rate in retirement is 15%.

Am I making sense?

[MDM]

Yes, the amount of tax you pay is a secondary concern; maximizing the amount you get to keep after paying taxes is what matters. The math doesn't lie: someone who retires to a higher tax bracket will find that they keep more money after taxes if they contribute to Roth, while someone who retires to a lower tax bracket will find that they keep more money after taxes in a traditional account. Period.

There is room for a small exception: if (Roth contribution)/(1 - tax_rate) > (maximum traditional deduction) one must account for some taxable investment along with the traditional amount, to keep the before-tax amounts equal.  Then if
- tax drag is high enough, and
- time is long enough, and
- fees in the taxable account aren't too much lower than in the tax-advantaged accounts,
Roth can be better even if the withdrawal marginal rate is "a little bit" lower than the contribution rate.  See Traditional versus Roth - Maxing_out_your_retirement_accounts

Extra fee in tax-advantaged	0.0%
Return from dividends in taxable	2.0%
Return from growth in taxable	5.0%
Total return in tax advantaged	7.0%
Tax rate on dividends	15.0%
Taxable return, including dividend tax	6.70%
Tax rate on capital gains	15.0%
Effective cap. gain tax rate	11.194%
Number of years invested	35
Ratio for equal outcomes	.815
Current marginal tax rate	28.0%
Withdrawal breakeven rate	22.832%	<- prefer Roth if the marginal withdrawal rate will be greater than this.

It looks like you're arguing that people might contribute to traditional expecting their tax bracket to be lower in retirement, while they actually end up in a higher tax bracket. Yes, that can happen. The mistake was their assumption about current vs. future tax brackets. ...

Oh yeah - always good to distinguish errors in assumptions from errors in math!  I don't think there is any problem with beltim's reasoning here, but the general point about agreeing on assumptions before dealing with math is a good one.

[MDM]

I'm saying that the very decision of which account to contribute to can affect your tax bracket in retirement.
...
Am I making sense?

Very much.  Some "traditional vs. Roth" analyses overlook this point by effectively comparing "all Roth for a career" vs. "all traditional for a career" instead of the discrete contribution choices the law allows.

[mousebandit]

Wow - this is very excellent information!!  TY guys!  At this point, we're new to MMM, husband just turned 39, just started contributing to retirement accounts, and would like to FIRE in < 10 years.  We're currently in 15% bracket, despite 6-figure income, due to deductions of 4 cute little kiddos.  We will have them as deductions for another 10-15 years, but they will probably all be gone and on their own after that.  We would like to keep taxable income in the 15% bracket after retirement, but not sure yet how that will look in actual living expenses and funds coming in.  Husband is very much in favor of ROTH due to being able to access his money at any time without penalty (he's new to even liking the idea of planning for retirement).  I'm liking both that concept, and the immediate tax benefits of Traditional IRA contributions, especially while trying to keep his above-the-line income low enough to stay within the child tax credit limits. 

So, we will look at this more, but I think that as long as we can stay within the limits for the child tax credit, he will prefer contributing more heavily to ROTH right now, and maybe once there's a good stash in there, and as his income continues to climb over the next few years, we will contribute more to the Traditional IRA.  And surely his employer will get the 401k set up soon, LOL! 

My initial mistake was overlooking the idea of subtracting out the up-front taxes from the Roth IRA contribution.  I hadn't thought about it that way.  So, now I see how they come out even, as long as tax bracket stays the same. 

THANK YOU!  I am learning tons! 

MouseBandit

[MDM]

We would like to keep taxable income in the 15% bracket after retirement, but not sure yet how that will look in actual living expenses and funds coming in.

It’s Difficult to Make Predictions, Especially About the Future - but have you estimated what your retirement marginal tax rate will be, using different assumptions for traditional vs. Roth contributions?

[seattlecyclone]

Mmm, sort of.  I'm saying that the very decision of which account to contribute to can affect your tax bracket in retirement.  For example, say someone is in the 15% tax bracket now but expects to be in the 25% tax bracket later in their career.  Depending on whether they assume they will contribute to a Roth or Traditional IRA when they're in the 15% tax bracket, it might affect whether their income in retirement is taxed at a marginal rate of 15% or 25%.  In this case, contributions to the Roth early in the career ensure that the marginal tax rate in retirement is 15%.

Am I making sense?

Your scenario makes sense. The Roth/traditional/taxable split you have at retirement definitely can determine your tax bracket at that time. I have already mentioned the fact that Roth contributions today can make Roth contributions tomorrow be a worse idea than they would otherwise be, for this exact reason. You've hit on the converse where traditional contributions today can make traditional contributions tomorrow be a worse idea than they would otherwise be.

But I still think this mostly comes down to relative tax brackets between now and retirement. Someone who is expecting that they will be in a high tax bracket for several years before retirement should also be expecting that they'll be maxing out their traditional retirement accounts for that period. They should use that assumption to predict a certain tax bracket at retirement. If that's higher than their tax bracket in residency/grad school/entry level job/whatever, then Roth contributions for that time make a lot of sense.

There's a lot of unknowns here. What will your income be between now and retirement? How much do you plan to save in each year? How do you expect tax policy to change? In the end you just need to make the best decision you can based on the information available to you. Between Roth and traditional, neither option is wrong. Both are great ways to save, and either one could be optimal in certain scenarios.

[mousebandit]

I haven't looked at any calculators, but here's how I am thinking about it.  Let me know if this is completely absurd, LOL, because it may very well be. 

The 15% tax bracket goes up to $75,300 taxable income for 2016.  There's room for another $12,600 in income with the standard deduction.  That's dang near $80k income per year. 

Post retirement, we will be living in a paid-for home, most likely living a pretty self-sufficient, homestead-ranching type lifestyle.  we will be in the same home for at least 10 years straight, hopefully forever.  :-)  Homestead infrastructure will be in place. 

Even with the 4 kids at home, homeschooling expenses, a lot of capital expenditures for moving and switching homes/ homesteads every couple of years, new infrastructure at each new homestead, health insurance for 6 (employer doesn't pay anything), and still running mortgages, our living expenses are well under $50,000 /yr, closer to $40,000.  Our target annual income for FIRE, with kids home and homeschooling at the high school level (higher costs during those years), is still only $36,000.  Post-kids, we could potentially be looking at secondary educational costs for them being added in, but most likely not.  And I haven't looked at it, but I am thinking that there will be some tax-credit or deduction available if we do pull out significant chunks of cash to pay for undergraduate schooling for them.  And, even if there weren't, we'd still have to pulling out $44,000 per year for college costs (which, I guarantee you, my husband won't do, LOL), before we breach that $80k threshold. 

I do realize that once we hit our 70s and have to do the RMDs, things could change, depending on how much we have in savings at that point.  I haven't factored for that at all. 

Is that a reasonable way of looking at things, or do I need to get much more detailed with calculators and a lot of factors I'm not considering?  I'm basically estimating annual spending needs, and considering that we stay 15% bracket until we breach $80,000 income. 

[MDM]

The 15% tax bracket goes up to $75,300 taxable income for 2016.  There's room for another $12,600 in income with the standard deduction.  That's dang near $80k income per year. 
...
I'm basically estimating annual spending needs, and considering that we stay 15% bracket until we breach $80,000 income.

Note that "spending" is not the same as "taxable income".  E.g., if 100% of your spending comes from Roth withdrawals and you have no other income, your taxable income = $0.

What do you expect for your retirement taxable income, using different assumptions for traditional vs. Roth contributions while still working?

[mousebandit]

This is good stuff, guys!  TY!!  I really like the way of looking at things with pulling from the different buckets post-retirement.  Had never thought of it that way at all!  I think in terms of income buckets and structuring income NOW, but hadn't thought of it at all for post-retirement. 

And I hadn't thought of SS as a mandatory taxable income base.  If husband keeps working another 10 years, that will probably be significant because he makes really good money now ($103k last year, looking like $112k this year).  That may drop in 5-6 years, if he leaves his employer and goes back to contracting for himself, but SS will still have been getting well-funded for the last 14 years and the next 6, LOL. 

At this point, there's no pension.  THat was done away with in last employer buyout and we cashed it out to help buy this property and get the permits rolling.  I don't see that they'll be setting anything else up in the future. 

I haven't done any calculations yet to determine how much we'll have in investments at FIRE.  We still have a few more months in the rapid debt repayment plan (debt-free in September, mortgage paid off in January), and then we will start aggressively funding the investments.  How aggressive that will be depends entirely on husband's decision whether we stick with his current employer for the next job, which means selling this homestead and moving out of state, again (we've moved 26 times in last 15 years, it's old), OR he comes home (he currently only comes home on weekends) and starts contracting for himself, which will mean more cash outlay for startup costs, and less income overall to invest.  I *think* he will say we're going to the next job, which will be a 5-year job (REALLY long for this line of work) and has lots of other benefits to us to go.  But I haven't bothered to do any calculations until we're closer to September / October, when he will have to make the call. 

My guess is that once we've got enough in investments to do the 4% rule for $36,000 annual income, exclusive of SS, he would consider FIRE.  We've talked about how much he would need in monthly income to feel comfortable and safe, and $3000 is his number. 

We also intend to acquire at least 3 rental properties in the next 10 years (first one will be early next year if we go to the next jobsite), and have that as a substantial portion of our post-FIRE income.  He is very comfortable with rentals, and much less comfortable with traditional investments.  :-)  He will definitely be wanting to put the rentals on 15-year fixed mortgages and work towards paying them off. 

So, that's our (my, haha) rough plan at this point, to get much more solidified as we get into September and the debt is paid off and he makes the decision on moving.  I handle all the finances, and he is pretty happy with how I've got things turned around this last year (Thank You MMM and Forum!!!), so I can pretty much set things up and do as I please with the moolah.  :-) 

I will definitely be doing more thinking and planning and writing down a plan for how to pull funds out for the FIRE phase of things.  I can't believe that hadn't occurred to me yet, haha!  I was just so excited about the idea of having "sufficient" money in investments that I didn't think past that point, LOL. 

MouseBandit

[MustacheAndaHalf]

Surprisingly there's a non-financial point not mentioned yet: Roth has "what you see is what you get".  When you plan for retirement, your Roth money is what you have.  The Traditional IRA is pre-tax, and can involve required distributions, so it's more complicated before you know what it's going to be worth.  If the Roth IRA and Trad IRA are close, I favor Roth for the flexibility and simplicity.

Note you can have both without trying.  At most employers when you take $21k, let it be taxed at 15%, and then stuff the resulting $18 into a Roth 401(k), you still get employer matching.  But the employer match is always Traditional 401(k), so you wind up with a Roth contribution you make and an employer match in a Traditional 401(k).

[Spork]

Note you can have both without trying.  At most employers when you take $21k, let it be taxed at 15%, and then stuff the resulting $18 into a Roth 401(k), you still get employer matching.  But the employer match is always Traditional 401(k), so you wind up with a Roth contribution you make and an employer match in a Traditional 401(k).

I don't know how common this is, but "always" is certainly incorrect.  Where I last worked, the employer match went exactly where you designated it.  It could be 1% Roth/2% Traditional or all Roth or all Traditional.

[seattlecyclone]

Note you can have both without trying.  At most employers when you take $21k, let it be taxed at 15%, and then stuff the resulting $18 into a Roth 401(k), you still get employer matching.  But the employer match is always Traditional 401(k), so you wind up with a Roth contribution you make and an employer match in a Traditional 401(k).

I don't know how common this is, but "always" is certainly incorrect.  Where I last worked, the employer match went exactly where you designated it.  It could be 1% Roth/2% Traditional or all Roth or all Traditional.

Huh. I've never heard of that. If you chose Roth, did that matching money show up as wages on your W-2 or something else where you would have to pay tax on it that year? If not, why would anyone not choose the Roth option for their matching funds?

[Spork]

Note you can have both without trying.  At most employers when you take $21k, let it be taxed at 15%, and then stuff the resulting $18 into a Roth 401(k), you still get employer matching.  But the employer match is always Traditional 401(k), so you wind up with a Roth contribution you make and an employer match in a Traditional 401(k).

I don't know how common this is, but "always" is certainly incorrect.  Where I last worked, the employer match went exactly where you designated it.  It could be 1% Roth/2% Traditional or all Roth or all Traditional.

Huh. I've never heard of that. If you chose Roth, did that matching money show up as wages on your W-2 or something else where you would have to pay tax on it that year? If not, why would anyone not choose the Roth option for their matching funds?

I think so... though now you have me doubting myself.  I will have to dig up an old pay stub and see. 

[21runner]

It's all about using "income smoothing" to optimize your tax liability now, and in retirement.  A more consistent income has the benefit of lower taxes paid over the long term.  I'm sure there's a great write up on it here or on the web, but here's my abridged version of the retirement buckets method.

Savings buckets:
1.  SS / Pension / etc
Annuity style income you have little control over with varying tax liability.
2.  Tax advantaged - Pre-Tax (Traditional 401k, Traditional IRA)
This money is 100% taxable and subject to RMD.  You used this to optimize taxes while working.
3.  Taxable - (brokerage accounts, savings, other)
Only earnings are taxable and no RMD
4.  Tax advantaged - Post Tax (Roth 401k, Roth IRA)
Free money in retirement - does not affect taxable income!

Having these buckets allows for some control over your taxes in retirement.  Each year, you will fund your spending from these buckets.  It can be done in a tax efficient way by pouring some money out of each bucket to cover all your expenses, while keeping taxes over your entire retirement at a minimum.

The SS/Pension bucket generally gives a set amount each year, and you have little control over it, so that's your base.  Any RMD from your pre-tax bucket also contributes to the base.  (Ignoring rental income and dividends) The rest of your expenses you have control over what bucket to use.

A good strategy is to continue to draw from your pre-tax and taxable accounts until you max out a particular tax bracket (or a certain dollar amount you decide on).  This is flexible as you may have investments with varying unrealized gains/losses in your taxable bucket.  Then draw from your Roth bucket tax free for the rest of your expenses.

Some things to keep in mind when optimizing:
-Try to minimize taxes in the long term while working and in retirement.
-Income limit past where SS becomes 85% taxable (it's 85% past 34k, it may be hard to optimize taxable income so low).
-RMDs get larger as you age - if you only take the minimum every year, you may find your RMD is larger than all expenses in later years.
-Tax rates and laws may change - having assets in each bucket lets you change withdrawal strategies if that happens.

Awesome post!

[MDM]

I don't know how common this is, but "always" is certainly incorrect.  Where I last worked, the employer match went exactly where you designated it.  It could be 1% Roth/2% Traditional or all Roth or all Traditional.

That's a neat trick, but not what the IRS says is allowed:

Yes, your employer can make matching contributions on your designated Roth contributions. However, your employer can only allocate your designated Roth contributions to your designated Roth account. Your employer must allocate any contributions to match designated Roth contributions into a pre-tax account, just like matching contributions on traditional, pre-tax elective contributions.

Haven't found the US Code citation that supports this - maybe Cathy will chime in?

[Spork]

I don't know how common this is, but "always" is certainly incorrect.  Where I last worked, the employer match went exactly where you designated it.  It could be 1% Roth/2% Traditional or all Roth or all Traditional.

That's a neat trick, but not what the IRS says is allowed:

Yes, your employer can make matching contributions on your designated Roth contributions. However, your employer can only allocate your designated Roth contributions to your designated Roth account. Your employer must allocate any contributions to match designated Roth contributions into a pre-tax account, just like matching contributions on traditional, pre-tax elective contributions.

Haven't found the US Code citation that supports this - maybe Cathy will chime in?

Yep, dug out old W2.  I clearly was a liar.  As originally stated, it went into standard 401k instead of Roth.  Carry on.  Nothing to see here.

[TomTX]

One other thing to think about: RMDs.  With a traditional IRA, you DAMN WILL start taking out minimal amounts of money and paying tax on it when you hit 70.5.  People don't really think much about that because it seems so far out on the horizon.  But with mustacian living, saving and compound interest: that amount just might be significant.  You are very likely to have to withdraw more than you need (assuming you were not able to convert it all to Roth).

And that RMD interacts negatively with the taxability of Social Security benefits. It's a fairly nasty trap.

I plan heavy Roth conversions between ER and drawing Social Security.

[Spork]

One other thing to think about: RMDs.  With a traditional IRA, you DAMN WILL start taking out minimal amounts of money and paying tax on it when you hit 70.5.  People don't really think much about that because it seems so far out on the horizon.  But with mustacian living, saving and compound interest: that amount just might be significant.  You are very likely to have to withdraw more than you need (assuming you were not able to convert it all to Roth).

And that RMD interacts negatively with the taxability of Social Security benefits. It's a fairly nasty trap.

I plan heavy Roth conversions between ER and drawing Social Security.

This was my plan as well, complete with spreadsheets planning each year from now until then.  But ... life happens.  I inherited a portion of an IRA already in the RMD phase.  First world problem, but it will likely change my plans.  I need to spend a few hours analyzing the difference in taxes/ACA of converting now vs paying taxes later.

[MoonShadow]

This is an excellent collection of advice.  I will add one additional point, which potentially conflicts with MDM's comment above.  In general, most people have an income curve that starts low then increases, often significantly.  It is possible that the optimal allocation of dollars involves contributing to a Roth IRA when you start at a low income—even if your marginal tax rate in retirement will be lower—and then switching your contributions to a traditional IRA when your income increases later.

This.  I have been teaching my teenagers to contribute the max, or as much as they can, to a roth for the first 9 years of their working lives, and the rest is up to debate.  Most people peak in their income in their 30's, and their first 10 years or so of working they are in a really low tax bracket anyway.  But even if they were not, long time periods of compounding favor the Roth, because a greater portion of the account balance will be tax free growth.

Also, keep in mind that a Roth has other benefits, that a traditional does not.  For example, it can be used as an emergency fund at any point in your life, because you can withdraw the contributions without penalty.  And once you are over 59.5 years old, and are withdrawing from your 401k and/or traditional for your base income, a sudden need for funds can be met by the Roth IRA without the withdrawal forcing you over your planned tax bracket like a large withdrawal from the 401k or traditional would.  In short, it would be wise to have a balance in both a pre-tax retirement account and a Roth IRA.  (a roth 401k is not the same, however)

[MoonShadow]

Note you can have both without trying.  At most employers when you take $21k, let it be taxed at 15%, and then stuff the resulting $18 into a Roth 401(k), you still get employer matching.  But the employer match is always Traditional 401(k), so you wind up with a Roth contribution you make and an employer match in a Traditional 401(k).

The problem with this, I have found personally, is that you have co-mingled funds.  When it's time to make a withdrawal or rollover, you cannot 'choose' one over the other, and you must withdraw those funds at the ratio that they exist in the account.  It is possible to rollover those funds into a "rollover IRA" and then separate them out, but the process is neither simple nor without pitfalls.  IMHO, most people would be better off just keeping their 401k as a straight pre-tax account, and opening a separate Roth IRA for the post-tax funds.

[MDM]

...long time periods of compounding favor the Roth, because a greater portion of the account balance will be tax free growth.

No argument with the rest of the post, and this part isn't wrong as much as it may be misleading.

A longer time compounding might increase the account balance enough so the "standard" 4% withdrawals (or RMDs) put one in a higher tax bracket, and that would favor Roth.  It is the marginal tax on withdrawal, however, not the compounding time itself, that matters.

Roth = Contribution * (1 - tax_now) * Growth
Trad = Contribution * Growth * (1 - tax_later)

The only difference is "tax_now" vs. "tax_later" because Contribution and Growth (where Growth is (1+i)^n or similar) are the same for each option.

Roth does indeed have the advantages mentioned.

Traditional has the advantage that, if life doesn't go as well as planned and retirement income is low, the fraction paid in taxes will be lower than if one assumed good results and chose Roth.

Either way, you pays your money and you takes your chances.

[Hadilly]

If you earn too much to deduct a traditional IRA contributions, then you might as well do a Roth. I think the backdoor Roth is a completely awesome way to shelter money for high income folks. If you are paying taxes anyway on income, it's nice to to know earnings will be tax free. And that sheltered money doesn't count as an asset on the FAFSA.

+1 to all the folks who mentioned a Roth's withdrawal flexibility.

[MoonShadow]

...long time periods of compounding favor the Roth, because a greater portion of the account balance will be tax free growth.

No argument with the rest of the post, and this part isn't wrong as much as it may be misleading.

A longer time compounding might increase the account balance enough so the "standard" 4% withdrawals (or RMDs) put one in a higher tax bracket, and that would favor Roth. It is the marginal tax on withdrawal, however, not the compounding time itself, that matters.

Either way, you pays your money and you takes your chances.

Perhaps, but I do think that favoring a Roth IRA early in your career is a wise bet for most people.  My daughter, for example, is 16.  With her new part time job at Arby's, I will be opening a Roth for her later this year.  I will be funding it on her behalf for 2 years, then it's up to her.  (This is what I'm doing instead of helping with college, because I consider traditional higher education to be in a bubble near to bursting.  There are too many modern ways to get an education.)  Assuming that she can actually manage to hit the annual max, she will have just about $50K in contributions, which makes for a hell of an emergency fund.  I told her (and her brother) that of the kinds of emergencies for which money can help, there are not many for which $50K will not go a long way towards solving.  For the first two years, at least, her income will be so low that her marginal tax rate will be either zero or near zero.  As her career progresses, her income will increase, but odds are high that those first 9 years will be the lowest earning years of her entire working career.  Unless you are the kind of person to fall into a high income occupation very young, which is a fine problem to have, even your typical doctor or lawyer doesn't make much until they actually graduate, which can't happen before 25 unless you are Doogie Houser, MD.  In this scenario, the tax rates in retirement are irrelevant, because so long as they are above zero, you are better off with the Roth in those first 9 years, as much of those contributions & gains are effectively never taxed, plus you have a lot of time for gains to accrue.

[MDM]

In this scenario, the tax rates in retirement are irrelevant, because so long as they are above zero, you are better off with the Roth in those first 9 years, as much of those contributions & gains are effectively never taxed....

Sure, if your marginal tax savings rate is 0%, Roth is always the better option - no argument there.

Also won't argue with the approach you are using with your daughter's Roth, as it's essentially the same as we are doing for ours. :)

A full time student 25 or younger is ineligible for both saver's and earned income credits, but once free of the age or student status prohibitions those credits can provide a high marginal tax savings rate even in the 10% bracket.  E.g., for a non-full-time student, filing single with $21K gross income a $2500 traditional contribution saves ~45%, likely making that a much better option than Roth for that amount for that year.

There are unfortunately many exceptions to the traditional vs. Roth rules of thumb, so doing some calculations using one's own situation seems worthwhile.