I've generally understood that determining whether to invest into a Roth 401(k) versus a traditional 401(k) is based on your current and future tax bracket.
So that:
(1) Roth 401(k) if current tax bracket < Future retirement tax bracket
(2) Traditional 401(k) if current tax bracket > Future retirement tax bracket
I was listening to a financial guru one day and he seemed to suggest that no matter what the Roth 401(k) is your best bet, because it you'll always put into it more than you take out of it. For example you put in $1000 and it grows to $11,000. So you'd be paying taxes on that $10,000 growth. But I feel like this logic is flawed, because you are not necessarily drawing all the earnings at the same time, but rather over years if not decades.
Thoughts?
Roth 401(k) v. traditional 401(k)
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Optimal_Solution
- Posts: 57
- Joined: Tue May 07, 2013 4:56 pm
My plan is as follows:
1. Put money in traditional 401(k) while working. No taxes paid on contributions.
2. Roll 401(k) into IRA upon ER. No taxes paid on rollover.
3. Start converting IRA into Roth IRA after ER. Since you aren't working, you pay little or no tax on the conversion. Stretch this out of many years to minimize taxes.
4. After contributions have been in the Roth IRA for 5 years, they can be withdrawn tax and penalty free. (Earnings are different)
5. Have enough savings or existing Roth IRA contributions to get through the first five years of ER.
This should minimize my tax bill. However future IRA law changes are a risk.
As far as the question about the financial guru, why would you be paying taxes on the earnings from the Roth 401(k)? Are we assuming that they are being withdrawn before age 59.5?
1. Put money in traditional 401(k) while working. No taxes paid on contributions.
2. Roll 401(k) into IRA upon ER. No taxes paid on rollover.
3. Start converting IRA into Roth IRA after ER. Since you aren't working, you pay little or no tax on the conversion. Stretch this out of many years to minimize taxes.
4. After contributions have been in the Roth IRA for 5 years, they can be withdrawn tax and penalty free. (Earnings are different)
5. Have enough savings or existing Roth IRA contributions to get through the first five years of ER.
This should minimize my tax bill. However future IRA law changes are a risk.
As far as the question about the financial guru, why would you be paying taxes on the earnings from the Roth 401(k)? Are we assuming that they are being withdrawn before age 59.5?
To the OP, what the "guru" was saying is that if you contribute the same amount into an account (Roth vs. Non-Roth), your net takeout at the end would be greater with the Roth since you don't pay taxes at the end, however you will have less money today since you are paying more taxes. The only time this would be a concern to me is if you are hitting the 401(k) limit and want to contribute more. By increasing the percentage of "Roth" funds, you are effectively putting more money into your account. Personally I split my contributions 50/50, but since I didn't have this option until two years ago, my current Roth % is about 10% of my 457 plan. Add in my Roth IRA, and the percentage rises to about 25%. Given the near certainty that taxes need to rise sometime in the future, I think having funds in both pools will give me the flexibility to minimize my overall taxes (going in + going out) on the money. YMMV however.
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RealPerson
- Posts: 875
- Joined: Thu Nov 22, 2012 4:33 pm
I have always been told that a Roth IRA is better than an IRA generally speaking. I guess most people feel that our tax rate in the future is likely to be much higher than it is today. The power of growing your stash tax free for as long as you live is just a huge gift. That, of course, assumes that you trust the politicians. Congress can change the rules any time it wants. Given the exponentially increasing public debt, I guess the rules may very well be changed over time. Uncle Sam needs money...
Beware gurus and "rules of thumb."
Karim, the advice you talk about contains both. Your guru is looking to sell something (his services, book, etc.) and doesn't want to complicate things so he uses the "rule of thumb" that you can put more in your Roth than traditional. This is true, but it only means you end up with more money if the Roth is looked at separately from the rest of your money. This is a terrible idea.
BennKar is correct, it is better to have some of both traditional and roth. Of course, you can't always do that.
This blog post outlines why many people would do better with a traditional 401k/IRA:
http://thefinancebuff.com/case-against-roth-401k.html
Plus, I'm not sold that they won't find a way to tax Roth again at some point. Say a sales tax.
I plan on having a mix of traditional, Roth, and taxable.
Karim, the advice you talk about contains both. Your guru is looking to sell something (his services, book, etc.) and doesn't want to complicate things so he uses the "rule of thumb" that you can put more in your Roth than traditional. This is true, but it only means you end up with more money if the Roth is looked at separately from the rest of your money. This is a terrible idea.
BennKar is correct, it is better to have some of both traditional and roth. Of course, you can't always do that.
This blog post outlines why many people would do better with a traditional 401k/IRA:
http://thefinancebuff.com/case-against-roth-401k.html
Plus, I'm not sold that they won't find a way to tax Roth again at some point. Say a sales tax.
I plan on having a mix of traditional, Roth, and taxable.
It isn't really based on current and future tax brackets. A 401k contribution saves you your current tax bracket, and then your withdrawal is taxed at your effective tax rate. So even if your tax bracket is the same, you'll save money on taxes, assuming no other income.
Right now my 401k contributions save me 29% with federal and state tax. To be taxed that high on withdrawal, I think I'd have to take out $200k in a year.
Right now my 401k contributions save me 29% with federal and state tax. To be taxed that high on withdrawal, I think I'd have to take out $200k in a year.