401k question [Change to Roth 401(k)?]

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401k question [Change to Roth 401(k)?]

Postby jon7417 » Mon Jul 01, 2013 12:23 pm

First time poster. Have really enjoyed reading so far. I apologize in advance if this question has been answered, but on my brief search couldn't find anything.

Question regarding my 401k that I’ve had for 1 year. Currently the balance is around 50k. Up to this point I have been doing pre-tax 401k contributions with maximum employer match.

I am considering going forward to change to a Roth 401-k (post-tax) as it is offered by my employer.

The option of an in-plan 401k-Roth 401k conversion is NOT an option (i already asked). This would have been my preference.

So my options now are to continue going forward with regular pre-tax 401k maxed annually, or make future contributions post-pax to Roth 401k.

My question is if anyone knows logistically how this would happen. Would they create two accounts in the 401k (one pre and one post?) It sounds like an accounting nightmare come retirement time because any pre-tax contributions and gains would be taxed, and post-tax would grow tax free. How to separate these seems difficult to figure out.

To make things more complicated (or not), I only have 1 fund in my 401k- a Vanguard Target Retirement Fund. Most other options are expensive, actively managed funds and this is the best choice.

Thanks for the help
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Re: 401k question

Postby linguini » Mon Jul 01, 2013 2:27 pm

I think you are overestimating the complexity. The account custodian keeps a record of both traditional and Roth contributions, which are basically treated as separate accounts with separate assets, but except on statements this process is basically transparent to you until you start withdrawing from it. When you withdraw, you can choose whether to withdraw from Roth or traditional, and you pay taxes accordingly. It's a simple enough process.

However, there are very few situations where a Roth 401k is a superior choice to a traditional 401k. Unless you expect to earn significantly more in retirement, which is rare for those without sizable defined benefit pensions, there isn't much reason to bother with the Roth 401k for most people.
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Re: 401k question

Postby JW Nearly Retired » Mon Jul 01, 2013 3:04 pm

As linguini says, you will just have 2 401k accounts : a Roth 401k account where none of the contributions/earnings withdrawals are taxed, and a traditional 401k account where everything taken out is taxed. You will be able to select different investments in these two accounts. You cannot avoid having some funds in a traditional 401k because the employer match on Roth contributions must go into a pretax account.

I am curious how you got $50k into your 401k in just one year? $17500/year is the limit for deductible contributions. Did you make sizable non-deductible contributions on top of that? If you did, then those contributions and the earnings they generate will be effectively held in a separate account too. The contributions won't be taxed again when you withdraw them.
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Re: 401k question

Postby jasc15 » Mon Jul 01, 2013 3:08 pm

linguini wrote:The account custodian keeps a record of both traditional and Roth contributions, which are basically treated as separate accounts with separate assets, but except on statements this process is basically transparent to you until you start withdrawing from it. When you withdraw, you can choose whether to withdraw from Roth or traditional, and you pay taxes accordingly. It's a simple enough process.

Thanks for that explanation. When I began my current job, I saw the option for a Roth 401 and jumped on it, thinking, "[holy cow --admin LadyGeek], I can pay tax on it now, and not have to pay tax on 5x that amount in 30 years?!" :oops:

The next year, I switched back, but there is no indication in my statements of a Roth balance. I would like to consolidate, but that would require tax refund (?). Not sure if you can do that, or if it would be worthwhile.

Sorry for the thread hijack.
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Re: 401k question

Postby pkcrafter » Mon Jul 01, 2013 3:20 pm

I agree with the first poster, having the two accounts won't be a problem--they are separate accounts. Since you are able to contribute 50k to your plan, you have high income. So the next questions is, what is your tax bracket? If it's high, the Roth is not attractive.

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Re: 401k question

Postby archbish99 » Mon Jul 01, 2013 3:51 pm

jasc15 wrote:The next year, I switched back, but there is no indication in my statements of a Roth balance. I would like to consolidate, but that would require tax refund (?). Not sure if you can do that, or if it would be worthwhile.

Nope -- you can't undo Roth 401k contributions, even within the same year and definitely not after the year has ended. This situation is exactly why I have a small Roth 401k balance that will flow with me more-or-less forever until I retire.

Of course, in my case, it's small enough that when I leave my employer, I could probably roll it to a Roth IRA, withdraw it (contributions, paying penalty on any earnings) and turn around and re-contribute it to a Traditional IRA if eligible. Or if not, I have a small Roth IRA floating around my balance sheet. Big deal.
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Re: 401k question

Postby Watty » Mon Jul 01, 2013 3:54 pm

If it's high, the Roth is not attractive.


+1

Reading way in between the lines I would guess that you are relatively young.

For a younger person unless it was a very special situation I would not do a Roth 401K instead of a deductable 401K above the 15% federal tax bracket. I might streach this to 25% if you are in a state with no income taxes.

There are just to many twists and turns that your life can take and lots of them lead to not being in an outragisuly high tax bracket when you retire. Not all of these are bad, you might decide to retire early on a more moderate income.

If you are 50+ then you might have a clearer view of what your retirment numbers will look like so there might be more times when a Roth might make sense with a higher income.
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Re: 401k question [Change to Roth 401(k)?]

Postby LadyGeek » Mon Jul 01, 2013 4:12 pm

This thread is now in the Personal Finance (Not Investing) forum (401(k) question).

I also retitled the thread.

To the OP: Welcome! This sub-forum is better focused to answer your question. It's not a big deal, I thought moving the thread would help.
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Re: 401k question [Change to Roth 401(k)?]

Postby jon7417 » Mon Jul 01, 2013 6:27 pm

thanks to everyone for the replies.

loving this forum and the wealth of information :)

For the technical details:
Thanks for the good point about non-deductible and deductible contributions. I didn't realize there were (already) both in the account as others mentioned...the deductible employee (my) contributions.... and other employer (non-deductible) contributions (matching, safe harbor, etc) to the max.
When I further looked into 401k account, it does show on the details page how it is all broken down by amount.
On my particular 401k webpage (Principal), it has them all under one account as a FYI. Like I said I only have 1 fund, but it does break down the various portions and percentages and shares under each sub-account. I assume if I did Roth 401k, it would just be another subaccount listing on this page.

Regarding the issue of should i move to 401k roth in future:
Age: 31 with estimated 25-30 years until full retirement.
Spouse: not working.
33% Bracket

I have read some on this topic. Intuitively, I am having a difficult time understanding why it is better NOT to do Roth 401k. Since majority of earnings would be interest down the road vs contributions, wouldn't it be advantageous to pay tax now on contributions while letting the returns (larger portion) grow tax free? I am an investing novice, so forgive me if I am totally off base. I'm just trying to understand the thought process/logic. Thanks
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Re: 401k question [Change to Roth 401(k)?]

Postby scubadiver » Mon Jul 01, 2013 6:42 pm

jon7417 wrote:Regarding the issue of should i move to 401k roth in future:
Age: 31 with estimated 25-30 years until full retirement.
Spouse: not working.
33% Bracket

I have read some on this topic. Intuitively, I am having a difficult time understanding why it is better NOT to do Roth 401k. Since majority of earnings would be interest down the road vs contributions, wouldn't it be advantageous to pay tax now on contributions while letting the returns (larger portion) grow tax free? I am an investing novice, so forgive me if I am totally off base. I'm just trying to understand the thought process/logic. Thanks


Take a simple example for yourself where you only have one year to retirement.

Option 1: Pre-tax invest 10K, earn 8% return and pay 33% tax rate upon withdraw the following year.

Option 2: Pay 33% tax on 10K and then post-tax invest for one year, earn 8% and withdraw tax free the following year.

Under Option 1 You Have: 10,000 x 1.08 x 0.67 = Do the math

Under Option 2 You Have: 10,000 x 0.67 x 1.08 = Do the math again or recall the commutative law of multiplication which says this amount is equal to Do the Math.

There are two main differences between this example and your reality. First, you have more years between the initial investment and subsequent withdrawal and second, it is difficult to know the actual tax rate you will have during the withdrawal phase. I'm struggling with this now ( viewtopic.php?f=2&t=119006 ). The difference between your current and future marginal tax rate is key to the whole decision.

EDIT: BTW, welcome to the forum!
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Re: 401k question [Change to Roth 401(k)?]

Postby Kalo » Mon Jul 01, 2013 7:02 pm

I also have both options through my employer, and I contribute roughly 2/3 to the traditional 401k and 1/3 to the Roth 401k. I say roughly because I've changed it slightly at times. My logic for doing this is:

1) I'm splitting the difference (not 50/50 but still hedging) between the two options. This allows me to get significant tax savings today (the traditional piece), while still putting some money toward future tax free withdrawals (the Roth piece). Someone on these forums has said, when faced with uncertainty, diversify. I don't know what my future tax burden will be, so I'm diversifying between the traditional and the Roth options.

2) I really can't afford to do more than 1/3 of my contribution to the Roth because it would leave me with too little net income (that is, the traditional contributions are easier to make because they are pretax).

It's not an all or nothing proposition. You can split your contribution between the two options, which is what I do.

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Re: 401k question [Change to Roth 401(k)?]

Postby retiredjg » Mon Jul 01, 2013 7:05 pm

jon7417 wrote:33% Bracket

I have read some on this topic. Intuitively, I am having a difficult time understanding why it is better NOT to do Roth 401k.

No - do not use Roth 401k now. There is no logic in paying 33% now when you could pay 25% or 15% or even less at some time in the future.

Instead, use traditional 401k to the max and use Roth IRA (via the back door) if you can. You might see if you have the opportunity to make after-tax employee contributions (this is not the same thing as Roth 401k) and then do inservice rollovers of those contributions to Roth IRA.

Don't worry about the different accounts - the paperwork people take care of that for you.
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Re: 401k question [Change to Roth 401(k)?]

Postby JW Nearly Retired » Mon Jul 01, 2013 8:01 pm

jon7417 wrote: I have read some on this topic. Intuitively, I am having a difficult time understanding why it is better NOT to do Roth 401k. Since majority of earnings would be interest down the road vs contributions, wouldn't it be advantageous to pay tax now on contributions while letting the returns (larger portion) grow tax free? I am an investing novice, so forgive me if I am totally off base. I'm just trying to understand the thought process/logic. Thanks

It's the non-intuitive logic of the math. If you are in the 33% bracket now, then for the same after-tax cost you can annually invest (e.g.) $15.5k in a trad 401k or 0.67*15.5k=$10.385k in a Roth 401k, the rest goes to pay the tax. In 25 years both 1-year contributions grow tax deferred (or tax free) to e.g., 10X = $155k for traditional and $103.85k for Roth. However, if you are in the same 33% tax bracket in retirement then, after taxes, the trad 401k money is worth only (1-0.33)*155k = $103.85k in real spending money. i.e., exactly the same amounts of after tax money if your saving and retirement tax rate is the same. If you are in a lower bracket in retirement then traditional grows to more spending money.

As a final nuance, if you are in the 33% bracket you can probably afford to save more than the above after-tax amounts. At the same cost, you could max out the Roth or, if going with the traditional 401k, put the same after tax amount in a taxable account at the same after tax cost. It's something of a close call but IMO if you are sure to be in the same bracket all through retirement there is a slight edge to going Roth. Others think there will be plenty of chances to be in a low tax bracket in early or late retirement when you can withdraw or convert IRA / 401k money at low tax cost.
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Re: 401k question [Change to Roth 401(k)?]

Postby Kalo » Mon Jul 01, 2013 9:54 pm

One other consideration between Roth & Traditional is that the Roth has no Minimum Required Distribution. If you go all Traditional you may find yourself after age 70.5 taking more in distributions than you would like to.

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Re: 401k question [Change to Roth 401(k)?]

Postby archbish99 » Mon Jul 01, 2013 11:28 pm

JW Nearly Retired wrote:Others think there will be plenty of chances to be in a low tax bracket in early or late retirement when you can withdraw or convert IRA / 401k money at low tax cost.

And this is the lynch pin of the opinion. While tax law can and will change over time, your sources of income in retirement will be:
  • Pension, possibly, but unlikely these days; SPIAs are the same, save that you control the timing and amount
  • Social Security, which gets some tax preference and you can control the timing of until age 70
  • 401k/IRA withdrawals, which you can control timing of entirely, until age 70.5
  • Taxable investments, which will be primarily the return of basis and only taxable to the amount of the capital gain
It's far from definite that far in the future, but certainly plausible to many of us, that by delaying SS and living off your taxable investments, your income will be low enough in the years from retirement to age 70 to do Roth conversions at substantially less than the 33% bracket (plus whatever state rate you have). Also, because of the weird way Social Security is taxed, you may find that your marginal rate goes down past a certain level of income in retirement, and you may be able to arbitrage that by doing conversions later in retirement if you're near or past that income level.

Basically, contributing to a Roth account is irrevocable after the tax year plus filing period is up. You've paid your taxes and that's it. Contributing to a Traditional account, however, leaves the door open to convert to a Roth sometime in the future when the tax situation is favorable. The more time you have before retirement, the more years you have when such a period could arise; the closer you are to retirement, the more likely you'll be able to forecast exactly when those will be. All else being equal, contribute to a Roth if you think your rate is as low as you can reasonably expect it will ever be, or if you've already filled all the Traditional space you've got available. At 33%, I would bet the first is not the case for you.

Of course you might be wrong, which is why some people hedge their bets with contributions to both.
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Re: 401k question [Change to Roth 401(k)?]

Postby Default User BR » Tue Jul 02, 2013 12:49 pm

Most people have multiple accounts in the 401(k) and don't realize it. I often have four:

1. Employee elective deferrals.
2. Employer contributions.
3. Employee rollover contributions.
4. Employee after-tax (non-Roth) contributions. These don't stay.

It's the plan administration's job to keep track.


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Re: 401k question [Change to Roth 401(k)?]

Postby an_asker » Wed Jul 03, 2013 9:25 am

scubadiver wrote:
jon7417 wrote:Regarding the issue of should i move to 401k roth in future:
Age: 31 with estimated 25-30 years until full retirement.
Spouse: not working.
33% Bracket

I have read some on this topic. Intuitively, I am having a difficult time understanding why it is better NOT to do Roth 401k. Since majority of earnings would be interest down the road vs contributions, wouldn't it be advantageous to pay tax now on contributions while letting the returns (larger portion) grow tax free? I am an investing novice, so forgive me if I am totally off base. I'm just trying to understand the thought process/logic. Thanks


Take a simple example for yourself where you only have one year to retirement.

Option 1: Pre-tax invest 10K, earn 8% return and pay 33% tax rate upon withdraw the following year.

Option 2: Pay 33% tax on 10K and then post-tax invest for one year, earn 8% and withdraw tax free the following year.

Under Option 1 You Have: 10,000 x 1.08 x 0.67 = Do the math

Under Option 2 You Have: 10,000 x 0.67 x 1.08 = Do the math again or recall the commutative law of multiplication which says this amount is equal to Do the Math.

There are two main differences between this example and your reality. First, you have more years between the initial investment and subsequent withdrawal and second, it is difficult to know the actual tax rate you will have during the withdrawal phase. I'm struggling with this now ( viewtopic.php?f=2&t=119006 ). The difference between your current and future marginal tax rate is key to the whole decision.

EDIT: BTW, welcome to the forum!

scubadiver:

A slight correction is in order to your calculations. What you say would work well if OP had $17,500 (or less) to invest or his decision to pay taxes up front would bump him to a higher tax bracket. If not ... let's look at the following scenario using your assumptions of 8% growth in one year.

Let's say OP has $17,500/0.67, i.e., $26,120 left over pre-tax income to invest.

Option 1) the standard 401(k) path: Put $17,500 into tax-deferred investments growing at 8%; pay taxes on the remainder (i.e., $8,620) - he would be left with $5,775 to invest in a taxable account.
After a year, pay taxes and he is left with $17,500*1.08*0.67 + $5,775*1.08 - $5,775*0.08*0.33 = $18,747

Option 2) Pay taxes on the $26,120; put the $17,500 left into the Roth 401(k).
After a year (not logical as you have to leave it a minimum five years - but my point is that this calculation will hold true for five years as well), pay 0 taxes and he is left with $17,500*1.08 = $18,900

So, he is better off with the Roth 401(k).
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Re: 401k question [Change to Roth 401(k)?]

Postby retiredjg » Wed Jul 03, 2013 10:02 am

an_asker, your math might be right but in my opinion, your conclusion is faulty.

There is the question of "pay 33% now vs pay 33% later". That is what you are looking at. But that is not the only question to consider and that one question alone does not reflect reality.

Most people are in a lower tax bracket in retirement. People in the higher brackets (like 33%) are very likely to be in a lower bracket in retirement. In fact they might be in a much lower bracket in retirement. Some might even be in the 0% bracket for a few years.

If you go back to your math and compare 33% going in vs 25% coming out, I think you'll see that Roth 401k is not the better choice.

Even if a person does end up in the same tax bracket in retirement, money coming out of the 401k might not all be taxed at that highest rate. For example, some of it might be filling up the lower brackets (taxed at 0%, 10%, 25%, and 28%) before being taxed at the 33% rate. If you compare that to paying 33% on everything going into Roth 401k many years earlier (not certain, but highly likely), you'll see again that Roth 401k is not the better choice for someone in a higher bracket.


Looking back at your math, I'm not sure you have option 1 correct. It appears you have taxed the taxable part at .33 when it should be at the capital gains rate of .15? But I'm not sure I followed your math right so I might be seeing it wrong.
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Re: 401k question [Change to Roth 401(k)?]

Postby an_asker » Wed Jul 03, 2013 10:18 am

retiredjg wrote:an_asker, your math might be right but in my opinion, your conclusion is faulty.
[...]
Looking back at your math, I'm not sure you have option 1 correct. It appears you have taxed the taxable part at .33 when it should be at the capital gains rate of .15? But I'm not sure I followed your math right so I might be seeing it wrong.

You are right, I should have used 0.15 instead of 0.33; and of course, for someone with the 33% marginal tax rate, you are right about their tax rate likely being lower at retirement. I was just trying to be the devil's advocate in response to scubadiver.
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Re: 401k question [Change to Roth 401(k)?]

Postby scubadiver » Wed Jul 03, 2013 5:34 pm

an_asker wrote:
retiredjg wrote:an_asker, your math might be right but in my opinion, your conclusion is faulty.
[...]
Looking back at your math, I'm not sure you have option 1 correct. It appears you have taxed the taxable part at .33 when it should be at the capital gains rate of .15? But I'm not sure I followed your math right so I might be seeing it wrong.

You are right, I should have used 0.15 instead of 0.33; and of course, for someone with the 33% marginal tax rate, you are right about their tax rate likely being lower at retirement. I was just trying to be the devil's advocate in response to scubadiver.


@an_asker: I agree with your correction. Indeed, the Roth does yield advantages once the OP has more than 17,500 pretax to invest....unless of course the market yields negative annualized returns over the investing period. In that case, it is actually disadvantageous. :wink:

My whole challenge with the pre vice post tax 401k investment decision has been trying to assess my effective tax rate in retirement. retiredjg makes a good point concerning the fact that portions of the 401k withdrawals may be at a rate which is lower than your marginal rate. The problem I have is that none of this accounts for the effects of various benefit phaseouts which may be unique to retirement. For example, isn't it true that portions of medicare have income based payments and, if so, isn't that effectively a tax on your income, at least for the purposes of assessing the pre vice post tax 401k investments?
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Re: 401k question [Change to Roth 401(k)?]

Postby Alan S. » Wed Jul 03, 2013 6:53 pm

Yes, for calculating your post retirement marginal rates, you would generally add the IRMAA surcharge in dollars to your taxes due and convert the total into a higher marginal tax rate. Note that IRMAA is not inflation adjusted and I believe it is slated for additional premium increases in the future.

That said, estimating your retirement tax rate is difficult since for most people this rate will vary considerably from year to year. For those delaying SS benefits to 70, those higher benefits included in your income @ 85% will spike your MAGI in the same year that your RMDs generally begin. While RMDs start out around 3.7% of the prior YE balance, there is opportunity for the balance to continue to grow as long as the total return exceeds the RMD %. In addition the RMD %s increase slowly at first and really take off after age 80. Therefore, many retirees may see their position in their bracket continue to increase each year until you eventually spill over into the next bracket. Higher income people are additionally affected by the Obamacare surtax on net investment income over the threshold and higher qualified dividend and LTCG rates over a different threshold triggered by other higher income. Sooner or later you might end up in a pretty high marginal rate for all or part of the income you still have because you did not convert to a Roth or make various Roth contributions. And if your RMDs are high enough, you will not spend them, the funds will be reinvested in taxable accounts and accumulate thereby generating additional income.

Another factor is significant inheritances where they are probable. These will be invested and kick off additional income and maybe their own RMDs.

However, perhaps the largest driver of higher marginal rates in retirement occurs after the death of a spouse when the deceased spouse's assets pass to the survivor who then must file using single status. This situation is most severe when one spouse is much older or sicker than the other spouse, and when the survivor does not remarry for a long period of time if ever. Finally, there is the continuing trend toward higher tax rates driven by the national debt, and some retirees might actually retire to a higher taxed state to be near family.

Not suggesting overly aggressive Roth accumulation, but once your pre tax assets reach a certain level, the number of years where your retirement rates will higher are more likely, even if those years come later in retirement.
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