401-k (Traditional v Roth)

[TheContinentalOp]

I am on schedule to FIRE in March 2021. I estimate that I'll earn U$30,000 from my employer in 2021. I won't need the cash (I've already got enough stocked away to go 2-3 years without selling any stocks or bonds). My question is should I take my entire paycheck (minus withholding) and put it in a Trad 401-k or a Roth 401-k?

At first glance Roth looks like the answer.

Roth: The first U$12,500 or so will be taxed at zero percent, the next U$10,000 or so at 10% and the remaining U$7500 or so at 12%. Or a total of U$1,900 in taxes up front and then never again as the money grows in the Roth.

Traditional: No upfront taxes, but when I make withdraws the marginal rate will be 10%. So maybe I'll pay an additional $2,500 in taxes. But those taxes paid out over time, so the dollars won't be worth as much.

A wild card is future tax law. I'd say it's more likely that the tax rate for withdrawals from Trad 401-k will go up, than a new tax on Roths or Roth distribution is passed.

Finally I need to worry about  the ACA. Having a MAGI in the range of U$30-35,000 will get me a Bronze plan with a $0 monthly premium premium, or Silver plan at U$75-140/mo. It will be much easier to manipulate my income if I go trad 401-k. I can always sell stocks to increase my income.

Is there anything I've overlooked? Has anyone else done this in their last year of employment?

[rantk81]

At first pass, I'd say Roth is probably better.
However, I think there's a good case to be made to put it in Traditional, at least initially -- if you can choose later in the year, exactly how much income you want to "manufacture" by converting that amount from Trad to Roth  (if your plan allows it, or if it's going to end up in a Rollover IRA anyway which you fully control.)

[Sanitary Stache]

Why will the first $12,500 be taxed at 0%?

[YttriumNitrate]

Why will the first $12,500 be taxed at 0%?

Standard deduction?

[terran]

I'm inclined to say traditional. Once you retire you can roll it over into an IRA and convert as much as you want to Roth in December once you have final income numbers (including projected dividends and/or capital gains distributions) so you'll be able to target a specific income target.

You could contribute to Roth an amount that you know for certain you want to have in income. The advantage of this over converting is that the amount you contribute can come out any time tax and penalty free instead of having to wait 5 years on the conversion.

Unless you have very small tax deferred accounts or a very large taxable account (dividends on which would push you over acceptable ACA limits) I would plan to convert at least up to the standard deduction every year as that means that money will never be taxed, while the 0% qualified dividend and long term capital gain bracket is much larger.

[seattlecyclone]

At first pass, I'd say Roth is probably better.
However, I think there's a good case to be made to put it in Traditional, at least initially -- if you can choose later in the year, exactly how much income you want to "manufacture" by converting that amount from Trad to Roth  (if your plan allows it, or if it's going to end up in a Rollover IRA anyway which you fully control.)

This. I think you can't go too wrong by contributing most or all of it to Roth, but if you want to play it safe you can contribute to traditional, convert to Roth later in the year, and it's not too different from if you had contributed to Roth in the first place.

[TheContinentalOp]

I'll probably have to withdraw/convert more than the standard deduction from my IRA rollover accounts, so some of that money is going to get taxed at 10%

But, traditional 401-k is now looking better for 2021.  If I dump my whole paycheck into it I'll have about U$3,000 in taxable earnings (withholding for FICA, state and local taxes) which will allow me to realize approx U$34,000 in pent up capital gains at 0%. (bought AMZN at U$200) and still get the ACA subsidy.

[MDM]

I'll probably have to withdraw/convert more than the standard deduction from my IRA rollover accounts, so some of that money is going to get taxed at 10%

But, traditional 401-k is now looking better for 2021.  If I dump my whole paycheck into it I'll have about U$3,000 in taxable earnings (withholding for FICA, state and local taxes) which will allow me to realize approx U$34,000 in pent up capital gains at 0%. (bought AMZN at U$200) and still get the ACA subsidy.

When the number of moving pieces increases (e.g., income, t vs R, capital gains, ACA tax credits, etc.) it might be helpful to use tax software.  E.g., there are the "what if?" worksheets of TurboTax, TaxAct, etc., the case study spreadsheet and others.

[Paul der Krake]

Another thing that’s funny about IRAs and 401(k)s at low earned income levels: you can contribute more than you earned in the year!

For IRA contributions you need to have at least that much earned income for the year... but not 401(k)s. So you could earn, say, 22k at the job, contribute 19.5k to the 401(k), and another 6k to the IRA. This can be helpful come year end when trying to hit just the right spot of AGI. If you realized to much income with capital gains or whatever, just shove some right back into a tIRA.

[cool7hand]

If you can do a roth conversion in FI year one, I'd do a traditional and then convert.

[terran]

Another thing that’s funny about IRAs and 401(k)s at low earned income levels: you can contribute more than you earned in the year!

For IRA contributions you need to have at least that much earned income for the year... but not 401(k)s. So you could earn, say, 22k at the job, contribute 19.5k to the 401(k), and another 6k to the IRA. This can be helpful come year end when trying to hit just the right spot of AGI. If you realized to much income with capital gains or whatever, just shove some right back into a tIRA.

That's a great point I hadn't thought of. Definitely worth contributing enough to Roth 401(k) so it will still show up as income on your W2 and count as earned income for IRA contributions.

[MDM]

Once the marginal tax rate for traditional 401k contributions goes to 0% (e.g., due to the saver's credit) - and assuming it doesn't pop back up due to the earned income credit - one should switch to Roth for any further 401k contributions.

[TheContinentalOp]

Another thing that’s funny about IRAs and 401(k)s at low earned income levels: you can contribute more than you earned in the year!

For IRA contributions you need to have at least that much earned income for the year... but not 401(k)s. So you could earn, say, 22k at the job, contribute 19.5k to the 401(k), and another 6k to the IRA. This can be helpful come year end when trying to hit just the right spot of AGI. If you realized to much income with capital gains or whatever, just shove some right back into a tIRA.

That's a great point I hadn't thought of. Definitely worth contributing enough to Roth 401(k) so it will still show up as income on your W2 and count as earned income for IRA contributions.

Just so I am clear. If my employer pays me U$30,000, and I put U$27,000 of it in a trad 401-k, Can I contribute only U$3,000 to a Roth IRA or can I do the max?

[seattlecyclone]

Another thing that’s funny about IRAs and 401(k)s at low earned income levels: you can contribute more than you earned in the year!

For IRA contributions you need to have at least that much earned income for the year... but not 401(k)s. So you could earn, say, 22k at the job, contribute 19.5k to the 401(k), and another 6k to the IRA. This can be helpful come year end when trying to hit just the right spot of AGI. If you realized to much income with capital gains or whatever, just shove some right back into a tIRA.

That's a great point I hadn't thought of. Definitely worth contributing enough to Roth 401(k) so it will still show up as income on your W2 and count as earned income for IRA contributions.

Just so I am clear. If my employer pays me U$30,000, and I put U$27,000 of it in a trad 401-k, Can I contribute only U$3,000 to a Roth IRA or can I do the max?

@Paul der Krake brings up an excellent point about low earners being able to put more than their earnings into retirement accounts. I am planning to make use of that ability this year to get more of our net worth out of taxable and into retirement accounts. With a spouse you can potentially shelter $12,000 in IRAs above and beyond what you put into a workplace retirement account.

Your IRA contribution is limited to your "taxable compensation" as defined in this IRS publication. Per Table 1-1 there, this figure includes "wages, salaries, etc.", but does not include "any amounts you exclude from income." Pre-tax 401(k) contributions are excluded from income. Roth 401(k) contributions are not.

[RedmondStash]

Tax strategy is big and complex, as you've already alluded to, OP.

Traditional IRAs are just deferred income. So if regular income is high in a given year, contributing to a traditional IRA can lower the amount you're taxed on -- but only for that year. You have to pay taxes on it eventually; you just try to plan so that you're taxed at as low a rate as possible on that money. For me, that's up to 12%, at least until 2026, when I believe the 12% bracket reverts to 15%.

If regular income is low in a given year, you probably don't want to dump it all into a traditional IRA, because there's less or no tax benefit. It all depends on the bigger picture.

And yeah, ACA subsidies factor in too, based on taxable income for the year. But remember to compare the subsidy against any higher taxes you might have to pay when you take that money out of the traditional IRA. If you'd get $10k in subsidies, but it ultimately costs you more than $10k extra in taxes, the subsidies aren't really worth it. Right now, the bracket after 12% is 22%, so you could pay a whopping 10% extra in taxes if that money ends up being taxed in that higher bracket. Tax planning, including for subsidies, is a very long-term process.

I see Roth as the promised land, where I want to shepherd all my money to eventually. Once it's in, it never gets taxed again.

[Runrooster]

Just so I am clear. If my employer pays me U$30,000, and I put U$27,000 of it in a trad 401-k, Can I contribute only U$3,000 to a Roth IRA or can I do the max?

Not to nitpick, but I think the 401K max for 2020 (age 50 or older)  is $26K.

I am also low income, but am allowed to contribute $26K this year.  I alloted my entire income to Roth, but my company takes taxes out first, so I have about $4500 that won't be allocated to my 401K. 
I also have a side-gig that will only net 2500 this year, due to covid.  I also got two weeks of unemployment which I can't count towards the IRA as it is unearned.
I think, between furloughs and shortened hours, I will be down to putting only $20k this year.
I debate decreasing my tax withholding and pay the taxes myself, but I'm not sure that's legal.

[MDM]

I debate decreasing my tax withholding and pay the taxes myself, but I'm not sure that's legal.

It's legal for people to do that if they owe less than $1,000 in tax after filing their return or if they paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is less. There are special rules for farmers and fishermen and Higher Income Taxpayers.

[TheContinentalOp]

NJ.com answered my question about how much I can contribute to my Roth.

https://www.nj.com/news/2020/12/can-i-save-in-an-ira-if-most-of-my-salary-goes-in-a-401k.html

Q. I am planning on retiring early next year. I don’t need my salary so for 2021 I plan to have my employer deposit my entire check into my traditional 401(k) but they will still withhold taxes. I estimate that I’ll earn $30,000 and $3,000 will be withheld for taxes. Can I still make the maximum $7,000 contribution to my 2021 Roth IRA?

— Still working

A. Congratulations on your retirement.

Given your cash flow, it’s great to be thinking ahead to how you can maximize your savings in the short period of time you will be earning a salary.

In terms of IRA contributions, when it comes to wages and your ability to contribute to an IRA, it’s the amount that shows up in Box 1 of your Form W-2 that matters, said Joseph Sarnecki, a certified financial planner with U.S. Financial Services in Fairfield.

He said it’s important to note this amount is reduced by any pre-tax traditional 401(k) contributions that you make at work.

Therefore, if your numbers are accurate, you would only be able to contribute $3,000, Sarnecki said.

“One option you may want to consider is funding your contributions into the Roth 401(k) if available within the plan,” Sarnecki said. “Roth contributions do not reduce the amount in Box 1, so by utilizing this, you would be able to max out your IRA.”

He said you wouldn’t receive a tax deduction for Roth contributions so this could impact your overall tax liability.

Before you make any moves, you should talk it over with a tax advisor who knows your entire financial situation.

[Paul der Krake]

Another thing that’s funny about IRAs and 401(k)s at low earned income levels: you can contribute more than you earned in the year!

For IRA contributions you need to have at least that much earned income for the year... but not 401(k)s. So you could earn, say, 22k at the job, contribute 19.5k to the 401(k), and another 6k to the IRA. This can be helpful come year end when trying to hit just the right spot of AGI. If you realized to much income with capital gains or whatever, just shove some right back into a tIRA.

That's a great point I hadn't thought of. Definitely worth contributing enough to Roth 401(k) so it will still show up as income on your W2 and count as earned income for IRA contributions.

Yeah so I was wrong on this.

From Pub 590-A:

You can open and make contributions to a traditional IRA if:
* You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
* You weren’t age 70½ by the end of the year.

[snip]

If you are self-employed (a sole proprietor or a partner), compensation is the net earnings from your trade or business (provided your personal services are a material income-producing factor) reduced by the total of:
* The deduction for contributions made on your behalf to retirement plans, and
* The deduction allowed for the deductible part of your self-employment taxes.

So I don't get to "use up" earned income twice. Just once. Sad.

[seattlecyclone]

Yeah so I was wrong on this.

From Pub 590-A:

You can open and make contributions to a traditional IRA if:
* You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
* You weren’t age 70½ by the end of the year.

[snip]

If you are self-employed (a sole proprietor or a partner), compensation is the net earnings from your trade or business (provided your personal services are a material income-producing factor) reduced by the total of:
* The deduction for contributions made on your behalf to retirement plans, and
* The deduction allowed for the deductible part of your self-employment taxes.

So I don't get to "use up" earned income twice. Just once. Sad.

If you contribute Roth dollars to your solo 401(k) you don't claim a deduction for contributions to retirement plans on that money.

[Paul der Krake]

Yeah so I was wrong on this.

From Pub 590-A:

You can open and make contributions to a traditional IRA if:
* You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
* You weren’t age 70½ by the end of the year.

[snip]

If you are self-employed (a sole proprietor or a partner), compensation is the net earnings from your trade or business (provided your personal services are a material income-producing factor) reduced by the total of:
* The deduction for contributions made on your behalf to retirement plans, and
* The deduction allowed for the deductible part of your self-employment taxes.

So I don't get to "use up" earned income twice. Just once. Sad.

If you contribute Roth dollars to your solo 401(k) you don't claim a deduction for contributions to retirement plans on that money.

Right, it still works for that.

[seattlecyclone]

A loophole that I'm gladly using. The ability to have negative MAGI from profitable self-employment would be nice, but alas that's a bridge to far.