New investor with NY State; needs advice

[sighchological]

Hello,

I'm extremely new to investing and need all the help I can get. Any information would be greatly appreciated.

Some stats: I'm 26, and have 6 months with New York State civil service. My salary is $37,000.

I plan to be contributing to deferred compensation until retirement (which will be in a long time and I intend to stay with NY state) and am not sure whether to pick the Roth 457b or the traditional 457b. What's confusing me is that I read in "mutual funds for dummies" that:

"for those in the four highest fed income tax brackets, the tax rate on stock dividends and long term capital gains is just 15 %."

Does this mean that everyone in the highest income tax brackets who has stock dividends and long term capital gains can take it out at 15%?

Therefore, does it mean that if I choose Roth, i'll be taxed first at 25% due to my income bracket and if I choose traditional I can let it grow tax deferred and take it out at 15%?

I know I'm missing something here. Please help. thanks

[linuxuser]

Hello,

I'm extremely new to investing and need all the help I can get. Any information would be greatly appreciated.

Some stats: I'm 26, and have 6 months with New York State civil service. My salary is $37,000.

I plan to be contributing to deferred compensation until retirement (which will be in a long time and I intend to stay with NY state) and am not sure whether to pick the Roth 457b or the traditional 457b. What's confusing me is that I read in "mutual funds for dummies" that:

"for those in the four highest fed income tax brackets, the tax rate on stock dividends and long term capital gains is just 15 %."

Does this mean that everyone in the highest income tax brackets who has stock dividends and long term capital gains can take it out at 15%?

Therefore, does it mean that if I choose Roth, i'll be taxed first at 25% due to my income bracket and if I choose traditional I can let it grow tax deferred and take it out at 15%?

I know I'm missing something here. Please help. thanks

You should read Forbes article about 2013 marginal tax rates http://www.forbes.com/sites/moneybuilde ... nal-rates/

You should be concerned with saving as much as you can pre-tax into a retirement account.

[JW Nearly Retired]

Firstly, unless you have a lot of income you didn't mention, your tax bracket is 15% not 25%. For a single filer the 25% marginal tax bracket starts at a taxable income of $36,250. That means what's left after the standard deduction and exemption ($9500 last year). So you could make about $9000 more before you get there.

Assuming you will move up in salary and will reach the 25% bracket eventually, it might be a good mix to use the Roth until you get that kind of salary and then switch to the traditional. It's generally thought to be good to have a mix of traditional and Roth retirement savings.
JW

[sighchological]

thanks guys.

That makes sense JW. Roth seems like the choice. I forgot about the standard deduction and exemption.

I read the article linuxuser. thanks. So since i'll be taxed at 15% due to my salary why do you recommend pre-tax?

[linuxuser]

If by pre-tax, you mean contribute to the state employee's equivalent of a 401K, the answer is a resounding YES.

[sighchological]

i'm sorry linuxuser, but could you clarify why the pre-tax is a better choice for me than after-tax if i'll only be taxed at 15% by choosing after-tax? Thanks

[linuxuser]

http://www.bogleheads.org/wiki/Getting_Started

[JW Nearly Retired]

thanks guys.

That makes sense JW. Roth seems like the choice. I forgot about the standard deduction and exemption.

I read the article linuxuser. thanks. So since i'll be taxed at 15% due to my salary why do you recommend pre-tax?

I should clarify. Roth is surely the choice for now if you expect you might be in the 25% bracket in retirement...... and you will have income other than the Roth 457 that will fill up your lower brackets. Like a pension of some sort that I'm guessing a NY state civil servant still has. Plus the Traditional 401k you will likely switch to eventually. Plus social security? or do state employees opt out of that? Also any state matching funds they make for your Roth 457 contributions are put in a traditional pre-tax account.

I'm making the assumption that you will have some of this and the Roth 457 will represent just one smallish part of your total retirement income. Probably linuxuser is making a different assumption.

Can you confirm you are not going to retire solely on the 457 money? If you were going to be living off the 457 only, then it would be better to compare your average taxation rate in retirement with the present 15%, rather than your marginal rate.
JW

[Duckie]

sighchological, check out these blog posts by tfb, a regular contributor on this forum. Just swap 457b for 401k.


The Case Against Roth 401(k)
Roth 401(k) for People Who Contribute the Max

[Epsilon Delta]

State taxes also have some effect.

In retirement any state pension is state tax free, as is SS. In addition $20,000 per year of withdrawals from the 457 is also state tax free. These factors mean that your state taxes are likely to be lower (probably zero) when you retire and tilt the balance towards the traditional 457.

[sighchological]

Thank you all for your help. Sorry it took so long to reply - I read everything that you guys suggested and gave it a lot of thought. Honestly, after all that reading I feel a lot more knowledgeable, but I admit that I am still confused. I have many questions; please forgive me if they are not in logical order.

JW, I expect to have a pension when I retire since i'm currently contributing to it. I'm not sure how social security works for NYS employees. I don't receive any matching funds from NY state.

I am planning on living off my pension, (around 15K if I retire at 55, 40K if i retire at 63), my 457, and my spouse's 457. (i'm not married yet but should be in 1-2 years.. my spouse will be making 100K and we plan to max her 457 out.)

In regards to what you said about comparing my average taxation rate in retirement with the present 15%, rather than the marginal rate, The Finance Buff says:

"Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k)."

What does it mean the "lower brackets should be filled from the traditional 401k?" Does the 401k fill in from the bottom of the marginal tax bracket because it is my main source of income?

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So, wouldn't it make sense for me to contribute to Roth 457 until I get married as I am making so little?

TFB says: "If you have a defined benefit pension plan and/or you expect to have a large balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing to Roth makes some sense."

"A Roth 401(k) is good for people in low paying jobs now but expect to have high paying jobs later." (I don't expect to get a huge salary raise though, as I make $37k now and will max out at around $58k.)

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Duckie, what do you mean swap 457b for 401k? Exchange plans?

Epsilon Delta, so you're saying that in retirement, the state pension, SS, and 20k of withdrawals from the 457 are state tax free, but I will still have to pay a federal tax and it will count as income?

[Duckie]

I'm not sure how social security works for NYS employees. I don't receive any matching funds from NY state.

Do you pay into social security? Some government jobs don't. If you do pay into it you'll get benefits just like everyone else. If you don't pay into it at all you won't get benefits. If you don't pay into it for your main job that has a pension, but have 40 SS credits from other employment by the time you're 62, you will get benefits but they'll be reduced by the Windfall Elimination Provision (WEP).

What does it mean the "lower brackets should be filled from the traditional 401k?" Does the 401k fill in from the bottom of the marginal tax bracket because it is my main source of income?

It's not specifically the 401k, but all your taxable income. If you are currently in the 25% federal bracket (and you aren't), that means that every dollar of taxable income above $36,250 gets taxed at 25%. See here. When you retire and start taking your pension, SS, 401k, etc., the first $8,925 will be taxed at 10%, and up to 36,250 will be taxed at 15% (of course the dollars will change with inflation and the brackets with politics).

It looks like you are in the 15% bracket and the Roth 401k is suitable for you at this time.

Duckie, what do you mean swap 457b for 401k? Exchange plans?

No. I just meant replace the wording "401k" with the wording "457b". Some people are extremely literal and think that because it says "401k plan" it isn't relevant for a "457b plan".

[sometimesinvestor]

If you work for New York State you will almost certainly get social security (It does show up as a reduction on your paycheck) Your discussion of future prospects seems to suggest you anticipate no promotions to more responsible (and higher paying duties) If that is the case a Roth is probably best till late in your career. Because of the New York State tax break of 20,000k on withdrawals from a traditional IRA or your 457 traditional plan at some point it will be appropriate to switch to a traditional even if you don't get a promotion especially since it seems your likely spouse will earn a high salary.
I notice you have not asked the group which funds you should invest in and that can be the subject of a different thread if you have questions. I can safely predict the group will suggest a mix of some of the Vanguard funds offered in the plan .

[JW Nearly Retired]

JW, I expect to have a pension when I retire since i'm currently contributing to it. I'm not sure how social security works for NYS employees. I don't receive any matching funds from NY state.

I am planning on living off my pension, (around 15K if I retire at 55, 40K if i retire at 63), my 457, and my spouse's 457. (i'm not married yet but should be in 1-2 years.. my spouse will be making 100K and we plan to max her 457 out.)

In regards to what you said about comparing my average taxation rate in retirement with the present 15%, rather than the marginal rate, The Finance Buff says:

"Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k)."

What does it mean the "lower brackets should be filled from the traditional 401k?" Does the 401k fill in from the bottom of the marginal tax bracket because it is my main source of income?
So, wouldn't it make sense for me to contribute to Roth 457 until I get married as I am making so little?

TFB says: "If you have a defined benefit pension plan and/or you expect to have a large balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing to Roth makes some sense."

"A Roth 401(k) is good for people in low paying jobs now but expect to have high paying jobs later." (I don't expect to get a huge salary raise though, as I make $37k now and will max out at around $58k.)

I think the Roth 401k while you are in the 15% bracket would be a good choice. Switch to traditional as soon as you are married and spouse is making $100k. Your combined income is going to set your marginal tax bracket and it will be 25% with a $137k joint income.

As to fill up the lower brackets with the pension and/or TIRA RMDs. You pay different tax rates on different layers of your income. In rough numbers a couple can have a gross income up to $19k before they pay any federal taxes at all because the standard deduction and exemptions add to that much. The next $18k income layer is taxed at 10% (i.e. gets you up to $37k gross income), next $55k layer is taxed at 15% (now at $92k gross income), next $74k layer is taxed at 25% (to $166k gross income), an so on.

Bottom line is if you are at the top of the 15% bracket with a $92k gross income, you will pay just 0 x 19000 + 0.10 x 18000 + 0.15 x 55000 = $10050 in taxes. Note that is an average tax rate of just 11% on the gross income. But really the marginal rates should control your decision. If you add say another $20k to your taxable income it's all in the layer taxed at 25%. You have already filled the 15% bracket so taxes will go up by 0.25 x 20000 = $5000.
If that extra income came a traditional 401k withdrawel you would pay that extra tax. If it came from a Roth it isn't taxable income and you would pay nothing on it.

Conclusion is if you expect to be in the 25% marginal bracket in retirement it will pay to do the Roth 401k while you are in the 15% marginal bracket now. If you are in the 15% marginal bracket in retirement then using the Roth now does no good but no harm either. If you end up lower than the 15% bracket in retirement then using the Roth would have been a mistake. Using some Roth now is a hedge against getting up into the 25% bracket in retirement. Also a hedge against tax rates going up.
JW

[sighchological]

Thanks again for everyone's help and clarification!

Duckie, I do pay into social security.

Sometimesinvestor, I do have some questions about the group of funds, and i'll post that later on. Yes, I have several Vanguard options and I'm happy about that.

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JW, isn't an important question how much I would be content on living on in retirement?

I would be content living with my spouse on $92k a year during retirement, which, if using the traditional 457b and assuming that tax rates will be the same, I would have an average tax rate of 11%. Even if I did make $20K more, with a salary of $112,000, the average tax rate would only increase to 13.4375%.

So, if Roth 457 is 15% now and Traditional 457 is 13.4375% later (for my desired income) wouldn't Traditional still be better?

Well.....I do realize that tax rates may likely go up. Am I missing something here?

[JW Nearly Retired]

JW, isn't an important question how much I would be content on living on in retirement?

I would be content living with my spouse on $92k a year during retirement, which, if using the traditional 457b and assuming that tax rates will be the same, I would have an average tax rate of 11%. Even if I did make $20K more, with a salary of $112,000, the average tax rate would only increase to 13.4375%.

So, if Roth 457 is 15% now and Traditional 457 is 13.4375% later (for my desired income) wouldn't Traditional still be better?

Well.....I do realize that tax rates may likely go up. Am I missing something here?

You will be taxed on the total income you get in retirement, whether you are content with less or not. That income is pension, social security, anything else, and traditional 401k/457/403b/TIRA RMDS (required minimum distributions) which start at age 70. The income will be what it is. One of the few things you have control over that will effect this is the Roth/traditional IRA or 401k choice.

Per your comment above, traditional would not be better if you stayed in the 15% bracket, it would be the same. The math says contributed money taxed now or grown money taxed later at the same rate makes no difference. If you get $20k into the 25% bracket, your average tax rate would only increase to 13.4375% but the tax on the "$20k more" would be $5000. That layer of income would be taxed at 25%. Getting that extra income from a Roth instead of a TIRA would save you that much tax. If you don't get into the 25% bracket but stay in 15% then you have not lost anything. So hedge your bets. More in Roths reduces your RMDs.

Personally, I regret not getting more into Roth accounts when I had a brief chance. I've ended up in a higher retirement bracket than I expected to. But I wouldn't worry too much about it. It isn't going to make a big difference either way.
JW

[slimshady]

Hello

I will shortly be entering my 18th year of service with NYS and have been contributing to the Deferred Compensation plan since. Started with 3% in 1996 and am currently at 25% for past 6 years. I use a 4 fund indexed approach and rebalance twice per year.

Aside from the knowledgeable advice received on this forum, you can also peruse the NYSDCP plan website. On the bottom left of the site under the "Latest Headlines"column, highlight "Roth Contributions" and you will be linked to the Roth Analyzer Tool. (The Roth option became effective in July of 2011). Going forth, you will be asked a series of questions and your answers will help determine if the 457 Roth option will be in your best interests. Used in conjunction with the Bogleheads advice you should be in a position where you will be able to make a sound decision as to whether or not the Roth option will be best for you. Good luck with both your employment and investments.

Rich

[sighchological]

JW, thank you for your advice and for clarifying my errors.

In a sense, can't I control my income because I don't have to take out more than the RMD requires. Even if I had $1 million in my 457b I would only have to take out around $36.5K a year (1 million/ 27.4 (the distribution period for age 70.5 ) )

Would $36.5 k + pension + social security definitely put me in the high tax brackets? I would have to factor in my wife's 401k as well.

Did I calculate anything wrong?

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Rich,

I appreciate the advice. I used the Roth Analyzer tool and the only problem is that I don't know what my expected tax bracket at retirement will be.