Traditional vs Roth IRA

[demps]

Hi all,

I'm sure this question is posed quite often. I can't decide between a traditional IRA and a Roth IRA. I've recently gotten my ducks in a row as far as debts are concerned so now I'm pivoting my finances towards retirement.

Info:
Age: 26
Martial Status: Single
Location: New York City, NY (High state income tax and city income tax)
Base salary: $90k
Bonus: $3-10k (Should be on the high end this year)
Other income: $120 travel, $40 phone, and $85 gym reimbursement per month (Gym one is paid directly to the gym, others to my check. I think all of these are taxable?)

401k: Employer pays a flat 3%, no match needed. (I'm currently putting in 4% regardless but will be upping this soon.)

Based off my tax bracket I assumed a traditional IRA but I've read that since I have a 401k with my employer I may not be eligible to deduct a traditional IRA? Also as far as an IRA goes, since my employer does not offer one, I figured I should just open one with Vanguard. How does this work since I would be paying into it with post tax dollars, it's just an end of year deductible?

Many thanks for any advice!

[EdwardMM]

Hi all,

I'm sure this question is posed quite often. I can't decide between a traditional IRA and a Roth IRA. I've recently gotten my ducks in a row as far as debts are concerned so now I'm pivoting my finances towards retirement.

Info:
Age: 26
Martial Status: Single
Location: New York City, NY (High state income tax and city income tax)
Base salary: $90k
Bonus: $3-10k (Should be on the high end this year)
Other income: $120 travel, $40 phone, and $85 gym reimbursement per month (Gym one is paid directly to the gym, others to my check. I think all of these are taxable?)

401k: Employer pays a flat 3%, no match needed. (I'm currently putting in 4% regardless but will be upping this soon.)

Based off my tax bracket I assumed a traditional IRA but I've read that since I have a 401k with my employer I may not be eligible to deduct a traditional IRA? Also as far as an IRA goes, since my employer does not offer one, I figured I should just open one with Vanguard. How does this work since I would be paying into it with post tax dollars, it's just an end of year deductible?

Many thanks for any advice!

Before you consider a traditional IRA, you should max out your employer provided 401K to the current limit of $18,000 per year. A traditional IRA and 401K have the same tax advantages, but they have a few practical differences:

1) You can borrow from most 401K plans. You cannot borrow from traditional IRAs as far as I know. (NOT that you should ever borrow, though.)
2) 401K's get better bankruptcy protection than traditional IRAs. Traditional IRAs have a $1 million protection, whereas 401K protections are unlimited.
3) A traditional IRA is going to give you more investing options, but most 401Ks have pretty good low-fee options these days. As long as your 401K plan offers anything decent, you should be going with that first.
4) I don't *think* you can deduct contributions to a traditional IRA if you are 401K eligible at work... I know that's true in upper-income brackets, but it might not be 100% true for you.

Your income makes you also eligible for a Roth IRA. I would begin investing in that Roth ASAP. You're 26 years old making $90K. I was there in my own life. You're probably on an upwardly mobile track, which means your income is eventually going to be too high to be Roth IRA eligible. The more you can stock away in that account, the better. Especially if you want to pursue an early retirement goal, the Roth is going to give you more options. (You can withdraw, tax and penalty free, the contributions you made to a Roth IRA at ANY time. But when you do, you lose the ability to put that money back in.

Hope this helps!
Edward

[respond2u]

You might enjoy the thinking of MadFientist: http://www.madfientist.com/archives/

Unless the tax situation changes, I'd invest in the Roth IRA first. When you retire you'll enjoy having the tax free assets available.

Plus, you may not be eligible for the Roth much longer  : )

[MDM]

Based off my tax bracket I assumed a traditional IRA but I've read that since I have a 401k with my employer I may not be eligible to deduct a traditional IRA? Also as far as an IRA goes, since my employer does not offer one, I figured I should just open one with Vanguard. How does this work since I would be paying into it with post tax dollars, it's just an end of year deductible?

Yes, you probably should want to deduct a tIRA (which you would on line 32 of Form 1040), but you may not be eligible, based on http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits.

You could do a Roth IRA, and might as well do so, if you have extra to invest after putting $18K into your 401k.  See https://forum.mrmoneymustache.com/investor-alley/investment-order/.

[Grande]

After the 401k (if that's what you feel is best) I am not so sure I would necessarily chose the Roth over the Traditional. It depends on a lot of other things. For example, after 401k max you may still be taxed at the 25% rate at the margin. If that's the case I'd chose the Traditional over the Roth until at least you reach the 15% rate. My reference is at 25% chose Traditional, 10% - Roth, 15% can go either way depending on situation and personal preference.

Read up on 'last dollar' principle as it relates to taxes

[Grande]

You might enjoy the thinking of MadFientist: http://www.madfientist.com/archives/

Unless the tax situation changes, I'd invest in the Roth IRA first. When you retire you'll enjoy having the tax free assets available.

Plus, you may not be eligible for the Roth much longer  : )

Good reference. Remember long term gains capital gains and qualified dividends are not taxed when one is in the 10%-15% bracket. So you could chose Traditional IRA and 401k max (no Roth) to lower taxes now and draw from a taxable account (over a Roth) and still duck taxes.

<$75,900 (married filing jointly) is where the magic happens. Get to 15%.

Check it out:
http://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New

[Hargrove]

Am I missing something?

93-102k+ in income - 18k from 401k = Still well above deduction cap for tIRA.

[MustacheAndaHalf]

Yes, you probably should want to deduct a tIRA (which you would on line 32 of Form 1040), but you may not be eligible, based on http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits.

More people need to read MDM's post closely: given current information, the IRS does not allow OP to contribute to a Roth IRA.

For the first $5,500 OP can contribute after-tax dollars to a Traditional IRA.  Then wait days or hours, and convert it into a Roth IRA.  Any gains in those days or hours will be taxed (typically $0), and then it's a Roth IRA.  This does not work if OP has a pre-tax Traditional IRA sitting around, as the IRS would require proportional conversion ("pro rata rule") from all IRAs.

So much narrower options than most people realize for OP.  There's also the "mega backdoor Roth" if your employer supports that approach.

[Nothlit]

Am I missing something?

93-102k+ in income - 18k from 401k = Still well above deduction cap for tIRA.

Agreed, it doesn't sound to me like OP would be able to deduct tIRA contributions. I'm not aware of any situation where a non-deductible tIRA is better than a Roth.

More people need to read MDM's post closely: given current information, the IRS does not allow OP to contribute to a Roth IRA.

How so? Maybe I missed something, but I see nothing in OP's post that indicates s/he's above the phaseout for Roth IRA contributions, which begins at $118k MAGI for single filers.

[EdwardMM]

What Nothlit said (And I said at the top). He's out of range for tax-deductible tIRA contributions but not out of range for Roth IRA contributions. I don't know of a situation where it makes sense to contribute after-tax funds to a tIRA. And given the choice between tIRA and 401k, people sometimes ignore the loan/bankruptcy benefits of a 401K (though admittedly the bankruptcy protections typically don't come into play).

He's in the 25%-28% marginal tax bracket, which to me says he should max a 401K before contributing to a Roth at all - but people have varying opinions on this one and it depends somewhat on long term plans. Since there are a variety of ways to migrate pre-tax 401K money into a Roth in the long run (should he pursue FIRE and use a laddering technique popular on this forum), I say get $18K per year into that 401K as fast as possible. Every year that 18K isn't fully funded he's missing out on a big gift from the IRS. If he can manage a full 18K pre-tax contribution, I'd probably go next to the Roth, though if he's in a high deductible insurance plan there may be even more current year tax shielding possible in an HSA.  But taking the HSA out of it, Max the 401K, then fund the Roth.

[demps]

Thanks all. I'm glad to see that there was quite a bit of back and forth on this one, as it validated me not being able to figure it out on my own!

I was always under the impression that it was 401k match > IRA max > 401k max but it seems that at a minimum, the consensus is that I should max my 401k first which I'll setup this week. It looks like the discussion is leaning towards a Roth after that. I'll get on both of these. Thanks!

On a side note, my company recently moved to TransAmerica for our payroll/401k. Here is what's currently available to me and what I chose. A mix of types with low fees. Apologies if this isn't allowed in the tax section!

Short Bonds/Stable/MMkt
Transamerica Stable Value Account   0%

Interm./Long-Term Bonds
PIMCO Total Return Ret Acct      0%
SSgA U.S. Bond Index Ret Acct   0%

Large-Cap Stocks
RidgeWorth Large Cap Value Equity Ret Acct   0%
Transamerica Partners Stock Index Ret Acct   20%
Morgan Stanley Growth Ret Acct            5%

Small/Mid-Cap Stocks
American Century Mid Cap Value               0%
SSgA S&P Mid Cap Index Ret Acct               0%
Goldman Sachs Mid-Cap Opportunities Ret Acct   0%
Franklin Small Cap Value Ret Acct            0%
SSgA Russell Small Cap Index Ret Acct         15%
Janus Triton                           0%
Vanguard REIT Index Ret Acct               10%

International Stocks
American Funds New Perspective Ret Acct   0%
Invesco International Growth Ret Acct   0%
Oakmark International Ret Acct         0%
SSgA International Index Ret Acct      15%
SSgA Emerging Markets Index Ret Acct   10%

Multi-Asset/Other
TA Vanguard Instl Trgt Re Inc      0%
TA Vanguard Instl Trg Re 2010      0%
TA Vanguard Instl Trg Re 2015      0%
TA Vanguard Instl Trg Re 2020      0%
TA Vanguard Instl Trg Re 2025      0%
TA Vanguard Instl Trg Re 2030      0%
TA Vanguard Instl Trg Re 2035      0%
TA Vanguard Instl Trg Re 2040      0%
TA Vanguard Instl Trg Re 2045      20%
TA Vanguard Instl Trg Re 2050      5%
TA Vanguard Instl Trg Re 2055      0%
TA Vanguard Instl Trg Re 2060      0%

[MDM]

I was always under the impression that it was 401k match > IRA max > 401k max but it seems that at a minimum, the consensus is that I should max my 401k first which I'll setup this week.

There is no "one size fits all" conclusion regarding 401k vs. IRA and/or traditional vs. Roth.

There is a "one size fits all (or close enough...)" strategy one can follow to reach a conclusion:
- With 401k vs. IRA, favor the one offering the best annual return to you.  Consider employer match (if any) and investment fees.
- With traditional vs. Roth, favor the one that has you paying the lower marginal tax rate.

More details in the Investment Order thread and links therein.

[EdwardMM]

Demps -- One thing to also look at is an HSA. If you're healthy, HSA and high-deductible health plans are the way to go as it will reduce your premiums and give you an opportunity to invest the HSA funds. HSA's have the advantage of being permanently tax-free if used for medical expenses, and then at retirement age they become basically a tIRA... There are limited circumstances where an HSA shouldn't be a part of your strategy--basically if for some reason a non-HSA plan would be cheaper (extremely unusual today).  Does your employer offer an HSA?

[Nothlit]

On a side note, my company recently moved to TransAmerica for our payroll/401k. Here is what's currently available to me and what I chose. A mix of types with low fees. Apologies if this isn't allowed in the tax section!

I don't understand the logic in choosing individual index funds (large, mid, small cap, international, REITs) and also choosing two target date funds as well. The target date funds are themselves just containers of large, mid, small cap, international, and bonds. You've basically said "I want to manually manage 75% of my investments, but the other 25% I'm going to let Vanguard automatically manage for me". One or the other would be fine, but it doesn't make sense to me to do both. Given your options, I'd personally go 100% in one of the Vanguard target date funds (whichever one most closely matches your desired asset allocation, regardless of what year is in its name). That keeps it simple and you never have to think about manually rebalancing. Just check every couple of years to make sure that your chosen fund is still in line with your desired allocation and make adjustments as necessary (e.g., by exchanging some or all of the balance into a different target date fund).

[demps]

I was always under the impression that it was 401k match > IRA max > 401k max but it seems that at a minimum, the consensus is that I should max my 401k first which I'll setup this week.

There is no "one size fits all" conclusion regarding 401k vs. IRA and/or traditional vs. Roth.

There is a "one size fits all (or close enough...)" strategy one can follow to reach a conclusion:
- With 401k vs. IRA, favor the one offering the best annual return to you.  Consider employer match (if any) and investment fees.
- With traditional vs. Roth, favor the one that has you paying the lower marginal tax rate.

More details in the Investment Order thread and links therein.

I'll have to crunch the numbers but it seems like 401k and Roth IRA are going to be the way to go for me.

Demps -- One thing to also look at is an HSA. If you're healthy, HSA and high-deductible health plans are the way to go as it will reduce your premiums and give you an opportunity to invest the HSA funds. HSA's have the advantage of being permanently tax-free if used for medical expenses, and then at retirement age they become basically a tIRA... There are limited circumstances where an HSA shouldn't be a part of your strategy--basically if for some reason a non-HSA plan would be cheaper (extremely unusual today).  Does your employer offer an HSA?

My current employer covers 100% of my premium with a $0 deductible.

On a side note, my company recently moved to TransAmerica for our payroll/401k. Here is what's currently available to me and what I chose. A mix of types with low fees. Apologies if this isn't allowed in the tax section!

I don't understand the logic in choosing individual index funds (large, mid, small cap, international, REITs) and also choosing two target date funds as well. The target date funds are themselves just containers of large, mid, small cap, international, and bonds. You've basically said "I want to manually manage 75% of my investments, but the other 25% I'm going to let Vanguard automatically manage for me". One or the other would be fine, but it doesn't make sense to me to do both. Given your options, I'd personally go 100% in one of the Vanguard target date funds (whichever one most closely matches your desired asset allocation, regardless of what year is in its name). That keeps it simple and you never have to think about manually rebalancing. Just check every couple of years to make sure that your chosen fund is still in line with your desired allocation and make adjustments as necessary (e.g., by exchanging some or all of the balance into a different target date fund).

Yea I wasn't really sure. I just new I needed to diversify a bit with low fee funds so I went with that selection. Would there be an issue with letting it ride for a bit and re-balancing later?

[MDM]

I'll have to crunch the numbers but it seems like 401k and Roth IRA are going to be the way to go for me.

From what has been presented, that seems likely.  Good luck!