Roth vs Traditional 401K

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Roth vs Traditional 401K

Postby EmergDoc » Wed Mar 05, 2008 1:42 am

An interesting article for those who actually have the opportunity to make this decision. More interesting than the article, is this comment posted afterward, which I believe is correct.


I do not agree with the statement that the Roth and the 401K are mathematically equivalent (assuming tax rates stay the same). The roth 401K is taxed at your current marginal tax rate, say 25%. The traditional 401K is taxed upon withdrawal and is likely to be the majority of your income during retirement (maybe some social security also). That means the tradional 401K will be essentially taxed at an effective tax rate. Under the current tax structure, the maringal tax rate for a single person earning up to $77100 is 25%. For that same person to have an effective tax rate of 25%, their income would have to increase to ~$165,000. Unless your income is going to increase drastically over your career, the traditional 401k is likely your best bet.
Posted By Jeff, Greensboro, Nc : March 4, 2008 9:51 am


What do you think?

I liked the idea of contributing YOUR contributions to the Roth and the match to the traditional (as is required) as a way of hedging your bets. Plus that allows you to put more after-tax money into a tax-protected investment, for those of us able to max it out. But I am hesitant when I think about the fact posted by Jeff above.

http://asktheexpert.blogs.money.cnn.com ... n=money_pf

Apologies if this has been posted already. Please post a link to that thread if it has.
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Roth vs. Traditional 401(k)

Postby Dan Kohn » Wed Mar 05, 2008 2:39 am

I can't figure this out. I've considered changing my company's 401(k) plan for 2009 so that all contributions would go to a Roth 401(k). Since we do 100% match, that would mean everyone's contributions were split between tax now and tax later, for effective diversification.

I don't want to just add a Roth 401(k) as an option, because if I can't figure out what to do (or even how to decide), I know the organization's employees will just be stressed out by the decision.

However, I'm also unclear whether the fact that I now pay 9.3% CA state tax, but may not live in CA forever, means that I should run screaming from anything Roth-related. It's just really hard to make good judgments about completely unknowable things like future tax rates. By comparison to the uncertainty of future rates, the difference between effective and marginal rates seem like a smaller issue.

My big question will come in 2010, when I'll need to decide whether to convert my SEP-IRA into a Roth IRA at the same time that I convert my non-deductible IRA. (Otherwise, I would first stash the SEP-IRA money in my 401(k)).

[political remark removed by Mod Mel] Roth IRAs would become completely worthless, with Traditional IRAs being the best deal around. Or imagine a future of 60% marginal tax rates, which would make pre-existing Roth IRAs nirvana.

[political link removed by Mod Mel]
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Postby Met Income » Wed Mar 05, 2008 8:02 am

I'm happy I've had the Roth 401K for my first three years of working. I know once I buy a house I'll probably switch to traditional for the cash flow, but it's good to have diversification.
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Re: Roth vs. Traditional 401(k)

Postby allenmickers » Wed Mar 05, 2008 8:21 am

howdy wrote:
Just imagine <POLITICAL> and implementing the Fair Tax. Roth IRAs would become completely worthless, with Traditional IRAs being the best deal around. Or imagine a future of 60% marginal tax rates, which would make pre-existing Roth IRAs nirvana.

http://en.wikipedia.org/wiki/Fair_tax


Or imagine the flat tax implemented and then a few years later a second 60% marginal income tax put on top of it to pay for other amazing government programs.

If you look at the national debt, theres no way taxes could go down.

Im betting that taxes will constantly go up and I am betting on the Roth 100%.

Also factor in that any equities in your traditional 401k are taxed at marginal tax rate instead of preferred long term capital gain tax.
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Postby livesoft » Wed Mar 05, 2008 9:00 am

If you use real math and model your retirement expenses and taxes, then you will see whether the Roth 401k makes sense. It seems that it works if you are in a low tax bracket and you aren't really paying any taxes anyways. And it works for folks who work until they begin taking SS benefits and who have a pension.

I don't think it works for most people reading this forum. My numbers show that I am in the 33% marginal income tax bracket now, but my average tax rate is around 15%. In my retirement, my average tax rate will drop even more as I do not have a pension and have many years before drawing on SS. My expenses will be paid by return of capital (not taxed), long term capital gains (tax favorably), and qualified dividends (also tax favorably). The first several thousand dollars of my income will be in the 0% tax bracket. I will be able to rollover my 401(k) to traditional IRA from where I will convert portions of it to a Roth IRA over decade or so. Modelling suggests that I will pay between 5% and 10% tax on that money.

So which tax rate would you rather pay 33% or 5%?

For folks who will have a pension that puts them in the 25% tax bracket from the first day they retire, then perhaps a Roth401k makes sense.
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Postby allenmickers » Wed Mar 05, 2008 9:44 am

livesoft wrote:If you use real math and model your retirement expenses and taxes, then you will see whether the Roth 401k makes sense. It seems that it works if you are in a low tax bracket and you aren't really paying any taxes anyways. And it works for folks who work until they begin taking SS benefits and who have a pension.

I don't think it works for most people reading this forum. My numbers show that I am in the 33% marginal income tax bracket now, but my average tax rate is around 15%. In my retirement, my average tax rate will drop even more as I do not have a pension and have many years before drawing on SS. My expenses will be paid by return of capital (not taxed), long term capital gains (tax favorably), and qualified dividends (also tax favorably). The first several thousand dollars of my income will be in the 0% tax bracket. I will be able to rollover my 401(k) to traditional IRA from where I will convert portions of it to a Roth IRA over decade or so. Modelling suggests that I will pay between 5% and 10% tax on that money.

So which tax rate would you rather pay 33% or 5%?

For folks who will have a pension that puts them in the 25% tax bracket from the first day they retire, then perhaps a Roth401k makes sense.


This model works great if the 5,000 page IRS tax code which has historically changed every since since its inception almost 100 years ago, stays exactly the same for the next 100 years.
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Postby livesoft » Wed Mar 05, 2008 10:20 am

allenmickers wrote:This model works great if the 5,000 page IRS tax code which has historically changed every since since its inception almost 100 years ago, stays exactly the same for the next 100 years.

That's quite a bit of rhetoric. The tax code changes slowly. It would be highly unusual to change the tax code to raise the tax rate to 33% for folks in the 10% marginal income tax bracket.

This is not rhetoric: The Roth 401(k) serves to confuse folks and probably costs them real money in the long term.
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Postby gkaplan » Wed Mar 05, 2008 10:30 am

I'd be interested in the Roth 401(k) if my Thrift Savings Plan decides to offer it; however, the reality is that I would not be able, financially, to make use of it. Right now, I max out my contribution ($20,500), so my bi-weekly take-home pay is $420.
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Postby allenmickers » Wed Mar 05, 2008 10:35 am

livesoft wrote:This is not rhetoric: The Roth 401(k) serves to confuse folks and probably costs them real money in the long term.


Whats confusing about a Roth 401k? You contribute post-tax money instead of pre-tax money. When the money comes out, its entirely tax free versus entirely taxable. Doesnt seem too confusing to me.

In fact if you are maxing out your traditional 401k, you could theoretically contribute more to a Roth 401k, because if you are in the 25% tax bracket then contributing $15.5k in a Roth 401k would be the equivalent of contributing $20.7k to a Traditional 401k.
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Postby mptfan » Wed Mar 05, 2008 11:14 am

livesoft, I'm with you on this one. It seems clear to me. I know that tax rates may change in the future, and they may go up, but I am confident that my average tax rate in retirement will be less than my current marginal tax rate during the peak of my earning years.
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Postby livesoft » Wed Mar 05, 2008 11:22 am

allenmickers, it is with glee that I write the following: Your response at 9:35 am exactly demostrates your confusion with the Roth 401(k). The confusion is so complete, you do not even believe you are confused. :)
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Postby gvernon » Wed Mar 05, 2008 11:29 am

this is something i can't seem to make up my mind on. in fact, i've changed my contributions from traditional, to roth, and back now back to traditional again within the last 12 months.

here's my situation though, which i think might be a case that favors the roth...

i'm young - 23. wife is 22. this year our HHI will be ~120K. we live in tx (no state income tax). we don't really need the extra cash provided by the traditional, and it looks as though we'll be inelgible for Roth IRA contributions within 5 years or so.

i agree that taxes are likely to head northward, but we are also setting a goal of early retirement, so i'm guessing that we would not be living on large amounts of money in retirement.

what do the boglehead's suggest (sorry for the hijacking)?
Last edited by gvernon on Wed Mar 05, 2008 11:38 am, edited 1 time in total.
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Postby simplesimon » Wed Mar 05, 2008 11:36 am

Hi gvernon,

I was in the same state of mind when I first started working at my company which offers a Roth 401k and a traditional pre-tax 401k. I did tons of reading and thinking about which 401k plan would be best for me. I am also 23 years old and just starting out so what I was trying to aim for is the biggest nest egg possible (like everyone wants). I was going crazy.

What I've decided to do was to split my contributions like the Money article mentions. You won't get the biggest nest egg but you won't have the smallest if you bet incorrectly either. That's the best way to hedge against uncertainty.
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Postby gvernon » Wed Mar 05, 2008 11:43 am

simplesimon,

i think that's what i'll probably move to. for right now we're trying to stock up cash for a downpayment on a house so i'm in the traditional. i wish there was more clarity around this issue (like livesoft mentions).
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Postby Cloud » Wed Mar 05, 2008 11:45 am

The ROTH seems like a great way for us to pay more taxes now!

There's also more to consider in the math... Here in VT our property tax is so high many qualify for prop tax rebate. I would no longer receive property tax rebate if we were to use a ROTH because that $31,000 in ROTH contributions would no longer be tax deferred. VT looks at taxable household income so by going ROTH it would appear to the State of Vermont that my income just went up 31K... And extra 31K = no more property tax rebate for me. Go figure, my paycheck never changed..
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Postby allenmickers » Wed Mar 05, 2008 11:54 am

One large previously unmentioned advantage to the Roth for me personally, is that I know exactly how much money I have for retirement. The number in my account, is the number I have. I dont have to estimate tax costs or anything else. This is why I refuse to buy any funds that have an exit cost like VEIEX emerging markets. I want to know exactly how much I have.
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Postby gvernon » Wed Mar 05, 2008 12:01 pm

allenmickers wrote:One large previously unmentioned advantage to the Roth for me personally, is that I know exactly how much money I have for retirement. The number in my account, is the number I have. I dont have to estimate tax costs or anything else. This is why I refuse to buy any funds that have an exit cost like VEIEX emerging markets. I want to know exactly how much I have.


this is appealing. but i suppose i'm willing to live without that conveinence if a traditional would net me more money in the end.
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Postby dbr » Wed Mar 05, 2008 12:05 pm

The price of certainty is that you have to pay something (ie taxes) up front to buy the insurance.
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Postby Warner » Wed Mar 05, 2008 12:05 pm

there seemed to be agreement at the 2007 Diehards VI that conversion to a Roth is probably a smart thing to consider.
Audience Member: Do you foresee a change in tax policies and how do we prepare for them? Will 15% tax on dividends disappear in 2010? Will that cause an adverse impact on high-yielding stocks? Why didn’t the reduction in the dividend tax rate cause high-yielding stocks to move much higher?

A. Sue Stevens: Tax rates will go up. Do the Roth IRA conversion when you can. Currently, capital gains rates are low and they will go up.

A. Mel Lindauer: I agree. I expect that the rates will go up.

A. Rick Ferri: There will be innovations in financial markets to reflect what is happening in Washington. There are, for example, ETN, or Exchange Traded Notes. They guarantee market return, including dividends, but they do not distribute dividends; you only pay capital gains when you sell. Depending on what the Congress does, different vehicles will be more attractive. If dividends get taxed higher, people will be buying more ETNs. In fact, there will be different results, depending on whether capital gains or dividends (or both) will be taxed higher.

A. Dr. Bernstein: Roth conversion is one of the most painful and most useful things to do.

A. Taylor Larimore: A good time to convert to Roth is during the low-tax period after one retires and before one starts collecting Social Security or receiving Required Minimum Distributions (RMD).

A. Mel Lindauer: I retired early and have been converting from Traditional IRA to Roth for a number of years. I cannot say that I am in the lowest tax bracket, but at the age of 70.5, when my mandatory distributions start, my tax bracket will be even higher.

A. Laura: In 2008, there will be a special window where those in a low tax bracket (15%) will not be paying taxes on capital gains. One could sell equities, wait for 30 days and buy them right back. It is also a good way to get out of bad investments.
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Postby mptfan » Wed Mar 05, 2008 12:07 pm

For those in their peak earning years, it is usually better to maximize tax deductible plans (401k, 403b, SIMPLE IRA, SEP IRA, deductible traditional IRA) before investing in non-tax deductible plans (Roth IRA) because:

1) You get an immediate tax reduction equal to your marginal tax rate. If you are currently in your peak earning years, you are probably in a high marginal tax bracket, say 25% or higher, and you will save 25% or more of every dollar you invest in a tax deductible plan. Then, when you retire and begin withdrawing that money, you will pay taxes based on your lower AVERAGE tax rate (aka effective tax rate) in retirement, not your marginal tax rate in retirement. Your average tax rate is almost always lower than your marginal tax rate. If you pay state income tax, your savings are even more dramatic. People who suggest that a Roth IRA and a 401k are a wash if you will be in the same tax bracket in retirement simply don't understand this.

2) Your fixed expenses in retirement may be lower than they are now (no mortgage, no tuition bills or other child related expenses, no car payments, no work related expenses). You will also no longer need to save a chunk of your income for retirement. Therefore, when you retire, you will likely be able to maintain the same standard of living on less income, which means you will be in a lower marginal tax bracket in retirement. If you want to live a more extravagant lifestyle and withdraw money into the higher tax brackets, so be it, you will have that choice. To that extent, and to that extent only, the Roth may prove to be a better choice in the future, but that does not prove that a Roth is better choice as the first option for your investment money now.

3) By contributing to tax deferred plans, you can reduce your current adjusted gross income (AGI) below the threshold at which you can fully take advantage of certain tax credits or tax deductions, such as the child tax credit, or the earned income credit, or the student loan interest deduction, or other credits. If you did not fully take advantage of tax deductible investment plans (and instead contribute to a Roth IRA), your AGI would be correspondingly higher, and you would lose some tax credits, or, the amount of certain tax credits would be reduced. By contrast, investing in a Roth does not lower your AGI.

4) While I agree with the consensus that tax rates will likely be higher in the future, I think it's somewhat naive to have faith that congress will never tax Roth withdrawals, no matter how desperate our government may be in the future for tax revenue. There is a lot of tinkering that can be done in the future, such as reducing the eligibility to take tax free withdrawals, limiting the amount of annual tax free withdrawals, etc. It can (and I think it will) happen.

5) You will retain the option of converting some of your tax deductible funds to a Roth IRA at lower marginal tax rates in the future. For example, you may decide to retire before you are eligible for social security benefits, and withdraw taxable savings to pay your expenses until social security begins. By doing this, you will be using "return of capital" which is not taxed as income, and you may find yourself in a very low tax bracket for a period of time, maybe even a zero tax bracket, and you can use up your lower tax brackets during that time period to convert tax deferred IRAs to a Roth IRA and pay tax on that money at your then lower tax rates. By contrast, funds contributed to a Roth IRA can never be converted to a traditional deductible IRA.

6) Almost everyone will die with some money. Some will die with a great deal of money, especially those of us who plan carefully and consider safe withdrawal rates. I have even heard some suggest that they do not plan on touching their principal during retirement, and some have stated that they continue to be net savers even after retirement. Therefore, given the fact that we will likely die with some significant amount of money left over, we will never have to pay taxes on that chunk of money which was tax deferred. Our heirs will have to worry about paying the deferred taxes on that money. So, I much rather save the taxes now, allow my money to grow tax free, and defer a significant chunk of that tax liability beyond my grave to my heirs. I refuse to voluntarily pay more taxes now so that my heirs will enjoy the benefit of paying less taxes when I'm dead.
Last edited by mptfan on Mon Mar 10, 2008 6:15 pm, edited 16 times in total.
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Postby dphmd » Wed Mar 05, 2008 12:14 pm

One other advantage to Roth accounts (I assume this is the same for 401k's as it is for IRA's, anyway) is that there are no MRD's. With traditionnal accounts one is forced to begin withdrawals (and start paying taxes) at a certain age, and if I am still working I would prefer to have some retirement savings that I could leave alone.

It is pretty clear to me that there is not a "one-size-fits-all" solution. For myself, I feel that there is enough uncertainty in my own future income/tax bracket to warrant a diversified approach, much as I have with the individual investments within my accounts. Therefore, I hold both types of accounts.

After all, if we could really predict the future we wouldn't need this forum. :wink:

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Postby gvernon » Wed Mar 05, 2008 12:15 pm

mptfan,

i really hope your wrong about the government taxing roth contributions again on the back end. that would be wrong on so many levels. unfortunately, somehow, i could see it happening and it scares me.

because of that, it's very hard to leave a tax deduction on the table today by selecting the roth over the traditional.
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Postby livesoft » Wed Mar 05, 2008 12:27 pm

I want to re-iterate that I am not against Roth IRAs nor Roth 401ks even though I do not have either of them. I fully intend to convert my traditional 401(k) money to a Roth IRA when I can do so at a tax rate of less than 33% and hopefully a rate of 15% or less and before I begin receiving SS benefits.
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Postby CaptMidnight » Wed Mar 05, 2008 1:00 pm

dphmd wrote:One other advantage to Roth accounts (I assume this is the same for 401k's as it is for IRA's, anyway) is that there are no MRD's.


This is the crux of the matter for some of us. The value of a Roth IRA is a function of the expected life span of the Roth IRA. If that life span is your life span, then the tax-deferred accounts may be better. If one of your major concerns is to bequeath assets, then nothing beats the Roth IRA which can live for 50 years or more of tax-free earning.

As for the Fair tax or some other tax reform eliminating income taxes, I don't think there is any possibility. Politicians will be desperate for money, but they won't discontinue any existing tax, which already has acceptance however grudging. On the contrary they will add new taxes that will therefore seem small in size. A carbon tax is one likely candidate or a national VAT. Under these scenarios Roth IRAs will preserve their major advantages.
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Postby Yukon » Wed Mar 05, 2008 1:36 pm

"I think it's somewhat naive to have faith that congress will never tax Roth withdrawals, no matter how desperate our government may be in the future for tax revenue"

Absolutely. I'm nearly convinced Uncle Sam will eventually find a way to tax Roth withdrawals. I assume it'll be by taxing the "rich" re: people who actually have saved for retirement. I'm quite confident it'll assuredly happen albeit in an indirect manner. (People with $x in retirement will have increased RMDs and all will be taxed at X%, for example) Just another method to redistribute wealth:) There is no free lunch!

I'm skeptical on the 2010 Roth conversion/eliminating the roth contribution limits....as a classic bait and switch. If it sounds too good to be true.........

I guess thats why I agree with WSJ Jonathan Clements on diversifying your accounts in an attempt to decrease any unforseen tax risk. Fund taxable, fund tax deferred, and fund Roth.....and hope for the best.
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Postby markcoop » Wed Mar 05, 2008 2:00 pm

After reading this thread, I think I'm convinced to use a traditional 410k instead of a ROTH 401K. For me, there are 2 main considerations:

1) Even though I have thought about it before, for seem reason it was not so clear to me about comparing the average tax rate at retirement to the marginal rate today. I would think for many people, their current marginal rate is higher than what the average rate will be in retirement, even if taxes are raised.

2) I happen to be one of those individuals that is on the border to receive a child tax credit. With 3 children, I get a $3,000 tax credit. It seems like a no-brainer to use a traditional 401k instead of a ROTH 401k if it means I will lose the $3,000 credit with a ROTH 401k.

thanks for the thread
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Postby dbr » Wed Mar 05, 2008 3:23 pm

In my estimation quick and dirty using either marginal or average is not as good or enlightening as running actual tax calculation models, as difficult at that may be. The reason is that the specific effects between two scenarios of tax rate brackets, exemptions, deductions, credits and phase outs thereof, of preferential tax treatments (cap gains and dividends), of AMT, of the tax treatment of social security, of the inflation indexing or not of various factors, and so on make it very difficult to apportion taxes to any specific source of income. This is not to mention the consideration as to whether the taxes are to be those of the original married couple, a single widow/widower/divorcee or perhaps the taxes of a remarried person, even with a new family. The kicker, of course, is to know the tax structure decades into the future, which is also totally speculative.

Personally, if I were starting the process at agr 20's and 30's today I would opt for maximum diversification respecting tax status without doing something that was obviously stupid. Probably paying in the 40-50% tax burden to opt for a Roth would be stupid and so would giving up a good 401K match, but short of that . . .
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Postby rob » Wed Mar 05, 2008 6:51 pm

It's all about unknowns... A few years ago I would never have said my income would have dropped as much as it has over the last 7-8 years....

To me the Roth 401K allows more of a balance between tax-deferred and tax-paid because of the years of only doing tax-deferred..... I am hitting a Roth hard so I have a decent amount in both sides... at least part of the $ will have the best call.

Once I get to more of a balance... It's a crap shoot with all the unknowns :shock: I will probably do some of each so as not to be wrong or right.
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Postby markcoop » Wed Mar 05, 2008 7:10 pm

Tax diversification makes sense. Putting money in both traditional and ROTH is a good idea, but one should still evaluate the situation. My question would be at what cost would you pay for such tax diversification? If one contributes the max to a ROTH401K for a year, it could cost you $800 if you would have received a child tax credit (Every $1000 of income reduces your credit by $50). The amount is even more if you live in a state that has a child tax credit too based on the federal, such as New York. If you ask me, it's not worth diversifying the tax risk at such a high cost. The child tax credit is just one consideration.
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Postby timid investor » Wed Mar 05, 2008 9:23 pm

I intend to make high roth returns make it at least a break even exercise with estate mgmt as icing on the cake.
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Re: Roth vs Traditional 401K

Postby redbeard » Thu Mar 06, 2008 3:59 pm

EmergDoc wrote:An interesting article for those who actually have the opportunity to make this decision. More interesting than the article, is this comment posted afterward, which I believe is correct.


I do not agree with the statement that the Roth and the 401K are mathematically equivalent (assuming tax rates stay the same). The roth 401K is taxed at your current marginal tax rate, say 25%. The traditional 401K is taxed upon withdrawal and is likely to be the majority of your income during retirement (maybe some social security also). That means the tradional 401K will be essentially taxed at an effective tax rate. Under the current tax structure, the maringal tax rate for a single person earning up to $77100 is 25%. For that same person to have an effective tax rate of 25%, their income would have to increase to ~$165,000. Unless your income is going to increase drastically over your career, the traditional 401k is likely your best bet.
Posted By Jeff, Greensboro, Nc : March 4, 2008 9:51 am


What do you think?

I liked the idea of contributing YOUR contributions to the Roth and the match to the traditional (as is required) as a way of hedging your bets. Plus that allows you to put more after-tax money into a tax-protected investment, for those of us able to max it out. But I am hesitant when I think about the fact posted by Jeff above.

http://asktheexpert.blogs.money.cnn.com ... n=money_pf

Apologies if this has been posted already. Please post a link to that thread if it has.


I had to think about this for a while, but I'm pretty sure the premise is wrong in comparing average tax rates in retirement to marginal tax rates during contribution years. The reason is we have the opportunity to make these decisions on the margin, so our tax comparison should be on the margin for both periods. For every 1% of your tax sheltered contribution you shift from IRA to Roth during the accumulation phase, one can expect to move 1% of your annual withdrawals during retirement from the Roth instead of the IRA. Those dollars withdrawn tax free from the Roth would have been taxed at your (future) marginal tax rate if they were taken from the IRA, not your average tax rate. I'm not sure I'm explaining this in the most clear way, but the essence is you should be comparing marginal tax rates on both ends, not comparing marginal to expected average rates.
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Postby mptfan » Thu Mar 06, 2008 6:25 pm

Redbeard, that is simply wrong. Let's assume you are currently retired, and you withdraw $50,000 this year from tax deferred accounts to fund your retirement. (This figure is close to the average household income) Let's also assume you have no other income sources, either because you retire before you are eligible for social security, or, you have elected to delay taking social security to get higher benefits in the future. Let's also assume that you are married, and you have no tax deductions or credits other than the standard deduction. Here is what your taxes would be:

Gross Income: 50k
Standard Deduction: 10.9k
Personal Exemptions: 7k
Taxable Income: 32k
Tax: $4,018
Effective (Avg) tax rate: 8%
Marginal Tax Rate: 15%

As you can see, the effective or average tax rate on the funds that you withdrew is 8% (4k/50k), even though you are in the 15% marginal tax bracket.

By contrast, if you earn the same income while working (50k), when you defer income into a tax deferred plan (401k, etc) while working, you save taxes at your marginal tax rate, which is 15%. So, you save 15% in taxes for every dollar that you contribute to a tax deductible account, and when you retire, you pay 8% in taxes for every dollar you withdraw from that same account. Seems like a good deal to me.
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Help with rates, mptfan

Postby Dan Kohn » Thu Mar 06, 2008 6:44 pm

mptfan, can you generalize your scenario at all? I'm paying 33% federal plus 9.3% state taxes. What would the combined marginal rates need to be in retirement for it to be a better deal now for me to convert to a Roth?
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Postby simplesimon » Thu Mar 06, 2008 6:55 pm

Aren't the taxes paid while working also effective?

Using mptfan's simple example, if the same $15.5k or $20.5k wasn't contributed towards a 401k but was instead part of take-home pay and thus taxed, wouldn't the total dollars taxed be the effective rate? I.E. the entire $15.5k/$20.5k isn't taxed at 15%.

This was my impression of how our Federal taxes are taken from our paychecks at the very least (excluding deductions, credits, witholding, etc.)
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Postby livesoft » Thu Mar 06, 2008 7:01 pm

Often cited as a complication to all this is the taxes you would pay on social security benefits. If you have the right income, you could shift your SS such that 25% is taxed to 85% is taxed. Some writers have suggested that this bumps your marginal income tax rate to more than 50%.

This extra complication is another reason that I will be converting my 401(k) and IRAs to a Roth IRA in the years before I begin SS benefits - when I am in a much lower tax bracket in retirement.
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Postby mptfan » Thu Mar 06, 2008 7:07 pm

simplesimon...... no, the taxes saved while working are not saved at the effective rate, they are saved at the marginal rate. In my simple example, if the worker contributed 10k to a 401k, the taxable income would be reduced by 10k, and the tax savings would be $1,500 (15% of $10,000). Thus, while working, you save taxes at your marginal tax rate.
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Postby simplesimon » Thu Mar 06, 2008 7:16 pm

Ahh...now that I think about it, you're saving taxes on the contribution which comes off "the top" of your earnings (I had to visualize it), therefore at the marginal tax rate (assuming the contribution doesn't knock you down a bracket if you were earning right at the threshold). Thanks for helping me learn that mptfan!
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Postby mptfan » Thu Mar 06, 2008 7:19 pm

You're welcome, simplesimon. You now know more about the benefits of tax deductible investing than most so called financial experts.
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Postby redbeard » Thu Mar 06, 2008 7:37 pm

mptfan wrote:Redbeard, that is simply wrong. Let's assume you are currently retired, and you withdraw $50,000 this year from tax deferred accounts to fund your retirement. (This figure is close to the average household income) Let's also assume you have no other income sources, either because you retire before you are eligible for social security, or, you have elected to delay taking social security to get higher benefits in the future. Let's also assume that you are married, and you have no tax deductions or credits other than the standard deduction. Here is what your taxes would be:

Gross Income: 50k
Standard Deduction: 10.9k
Personal Exemptions: 7k
Taxable Income: 32k
Tax: $4,018
Effective (Avg) tax rate: 8%
Marginal Tax Rate: 15%

As you can see, the effective or average tax rate on the funds that you withdrew is 8% (4k/50k), even though you are in the 15% marginal tax bracket.

By contrast, if you earn the same income while working (50k), when you defer income into a tax deferred plan (401k, etc) while working, you save taxes at your marginal tax rate, which is 15%. So, you save 15% in taxes for every dollar that you contribute to a tax deductible account, and when you retire, you pay 8% in taxes for every dollar you withdraw from that same account. Seems like a good deal to me.


You aren't understanding my point. This isn't an all or nothing choice of 100% of your money going to (and later coming from) a ROTH or Traditional IRA. Assuming the same $50k total annual withdraw and tax rates from your example, one could withdraw $49,999 from an IRA, and $1 from a Roth. This will reduce your taxes by $0.15, not $0.08. It really is the marginal tax rate you need to consider in the future, not the average one. At some point if you trade off enough from the IRA to the Roth, you will start to impact your future marginal tax rates. However, even then it is still the marginal tax rates you need to consider, not the new average tax rates.
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Postby mptfan » Thu Mar 06, 2008 7:44 pm

redbeard, I understand your point, but it is wrong.
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Postby simplesimon » Thu Mar 06, 2008 10:25 pm

Redbeard, this is what I thought as well. But the $49,999 that you withdraw from the 401k/TIRA...how much total tax do you pay on that withdrawal, an effective rate correct?

Now how much tax did you save by contributing that much into your 401k 20-something years ago? The marginal rate.
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Postby redbeard » Fri Mar 07, 2008 1:11 pm

Here's an example that should clear this up. In the previous scenario both the future average and marginal rates were higher than the marginal rates during the accumulation phase, so either way the best course of action would be to go with the traditional IRA. It would help to have a scenario where the different theories would predict different results and test which one is true. The key here is to have marginal rates during the accumulation phase lie somewhere in between average and marginal rates in the withdrawal phase. If it is true that Average rates matter, the correct answer then should be to put 100% of sheltered funds in a traditional IRA. If the marginal rate in retirement is the appropriate rate to consider, then some portion of the sheltered funds should be placed in a Roth.

This is a simple two period model, where contributions and withdrawals occur in lump sums, separated by 20 years. I've made the assumptions simple to keep the math easy.

Pre tax funds to invest in the present (accumulation phase): $7,432.18 (lets assume both accounts are 401ks and this isn't over any legal annual limits)
Marginal tax rate in present: 20%
Annual rate of return on invested funds: 10%

Future tax rates:
$0 to $25,000 : 0%
$25,001 and up: 30%
Average rate on $50k: 15%

Scenario A: Invest 100% of available funds in a traditional IRA.
Upfront Taxes Paid: $0
Amount invested in IRA: $7,432.18
Amount Invested in Roth: $0
Value in 20 years: $50,000
Taxes due on withdrawal: $7,500
After tax amount in retirement: $42,500

Scenario B: Invest 50% of available funds in a traditional IRA, 50% in a Roth.
Upfront Taxes Paid: $743.22
Amount invested in IRA: $3,716.09
Amount Invested in Roth: $2,972.87 (once taxes paid)
IRA Value in 20 years: $25,000
ROTH value in 20 years: $20,000
Taxes due on withdrawal: $0
After tax amount in retirement: $45,000

This proves that marginal rates in retirement, and not average tax rates, are what one should consider when deciding on putting money in a traditional IRA or a ROTH. If average rates were what mattered, one should put 100% of the funds in the traditional IRA because the average future rate of 15% is less than your present marginal rate of 20%. However, if you followed this logic, you would be poorer after tax by $2,500 in the future.
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Postby mptfan » Fri Mar 07, 2008 2:05 pm

redbeard, I don't know where to begin. You are so confused that you don't realize that you are confused.

First, my scenario did NOT assume a higher marginal rate in retirement. I explicitly assumed that someone had the same income (50k) before and after retirement, and I explicitly assumed that the current tax rates apply and used 15% as the marginal tax rate in both cases.

Second, in your example you assume a present marginal tax rate of 20%, and yet no such marginal tax rate exists. The current tax brackets are 0%, 10%, 15%, 25%, 28%, 33%, and 35%.

Third, the annual rate of return on invested funds is irrelevant to this analysis. We are comparing the taxes saved while working to the taxes paid in retirement.

Fourth, you "assume" a future average tax rate of 15%, but you don't explain how you came up with this number. In my example, I showed exactly how I came up with the average tax rate of 8% in retirement, and you haven't disputed it.

Your examples are hoplelessly flawed and prove nothing.
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Postby simplesimon » Fri Mar 07, 2008 2:17 pm

I think taxes will be more complicated in the future and therefore splitting contributions (as I previously mentioned) will help anyone hedge against uncertainty.
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Postby redbeard » Fri Mar 07, 2008 5:06 pm

mptfan wrote:redbeard, I don't know where to begin. You are so confused that you don't realize that you are confused.
Your examples are hoplelessly flawed and prove nothing.

This really doesn't help the discussion.

First, my scenario did NOT assume a higher marginal rate in retirement. I explicitly assumed that someone had the same income (50k) before and after retirement, and I explicitly assumed that the current tax rates apply and used 15% as the marginal tax rate in both cases.

You are right. I'm not sure why I had that wrong. What I should have said is if average rates matter in retirement, then one is clearly better off in that model using 100% traditional IRA, and if marginal rates are what count in retirement then adding some funds to a ROTH would be a wash (until the point where future marginal rates would be lowered by adding more). My numbers were intended to make the math simpler, but I'll show the scenario below using your tax rates to show that it really is a wash to add some ROTH (as marginal rates predict), and not a loss after taxes.

Second, in your example you assume a present marginal tax rate of 20%, and yet no such marginal tax rate exists. The current tax brackets are 0%, 10%, 15%, 25%, 28%, 33%, and 35%.

If the logic is right the prediction will work, regardless of whether the marginal rates assumed exist today or not. This is just a simple math problem. I chose the numbers I did to keep things simple. I'll use yours below to prove it doesn't change the fact that average rates don't assist in the decision making process.

Third, the annual rate of return on invested funds is irrelevant to this analysis. We are comparing the taxes saved while working to the taxes paid in retirement.

Agreed, but if I hadn't put that in someone would have said that was a problem with the model... You can replace the expected rate of return with any number and re run the numbers. The fundamental answer of which future tax rate (marginal or average) should be used for decision making won't change.


Fourth, you "assume" a future average tax rate of 15%, but you don't explain how you came up with this number. In my example, I showed exactly how I came up with the average tax rate of 8% in retirement, and you haven't disputed it.

Man, you are a tough grader! I assumed you understood this since you did the same calculation in your own scenario. Ok, I'll show my work!
Assuming $50k in IRA withdrawal, 0% marginal rate on the first $25K, 30% marginal rate on anything over $25k. 30% * ($50k - $25k) = 30% * $25k = $7,500. $7,500 / 50,000 = .15


As promised, here is the workup of the two period model using the tax details from your own model. If average rates in retirement are correct, 100% traditional IRA should be superior to using any amount of ROTH; the average rate of 8% in retirement is less than marginal rate of 15% in accumulation, while the marginal rates in accumulation and retirement are both 15%.

Keeping my two period model, separated by 20 years and an expected return of 10% annually. All tax assumptions from your model.

Scenario 1: 100% IRA
Initial investment of $7,432.18 into the IRA grows to $50,000 over 20 years at 10% growth rate.
Gross Income: 50k
Standard Deduction: 10.9k
Personal Exemptions: 7k
Taxable Income: $32,100 (you rounded this to $32k in your example)
Tax: $4,815 (you have this as $4,018, but I assume that is a typo)
Effective (Avg) tax rate: 9.63% (you have 8%, but we are close and this doesn't change the prediction of your model since it is still lower than current marginal tax rates of 15%)
Marginal Tax Rate: 15%
After tax Income during retirement: $50k - $4,815 = $45,185.00

Scenario 2: 35.80% IRA 64.20% Roth*
Initial investment of $2,660.72 into the IRA grows to $17,900.00 over 20 years at 10% growth rate.
Initial investment of $4,055.74 into the Roth grows to $27,285.00 over 20 years at 10% growth rate. [$7,432.18- $2,660.72 =4771.46 pre tax available to the Roth. Subtract 15% of this ($715.72) for taxes paid and you get $4,055.74]
Gross Income: $17,900.00
Standard Deduction: 10.9k
Personal Exemptions: 7k
Taxable Income: 0
Tax: $0
Marginal Tax Rate: 15%
After tax Income during retirement: $17,900.00 + $27,285.00 = $45,185.00

* I picked 35.8% and 64.2% for the IRA and Roth respectively because this is the point where the future marginal tax rate changes to 0% (17,900 / 50,000 = 35.8%). If you put more in the IRA and less in the ROTH, the end results will be the same. If you do the opposite, you will be worse off after taxes.

The "decide using average future tax rates" argument predicts that moving some contributions to a ROTH in this case would make one worse off, while the "decide using future marginal tax rates" model predicts adding some ROTH will be a wash. As you can see, the correct prediction is made by using future marginal tax rates, not average ones.
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Postby mptfan » Fri Mar 07, 2008 5:33 pm

redbeard, you are getting lost in your own calculations, and you have overlooked a very important point....

In your Scenario 1, you forgot that the initial investment of $7,432.18 into the IRA is tax deductible at the marginal tax rate of 15%. Therefore, when you make the intial investment, you immediately save $1,114.82 off of your income tax liability (15% of $7,432.18 ). You failed to account for this tax savings in any of your calculations. You also failed to account for how much that money would grow over 20 years. So, you save 15% when you make the contribution, then you only pay 8 or 9% tax on the money withdrawn from the very same account when you make the withdrawal. Pretty good deal, huh?
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Postby redbeard » Fri Mar 07, 2008 5:39 pm

mptfan wrote:redbeard, you are getting lost in your own calculations, and you have overlooked a very important point....

In your Scenario 1, you forgot that the initial investment of $7,432.18 into the IRA is tax deductible at the marginal tax rate of 15%. Therefore, when you make the intial investment, you immediately save $1,114.82 off of your income tax liability (15% of $7,432.18 ). You failed to account for this tax savings in any of your calculations. So, you save 15% when you make the contribution, then you only pay 8 or 9% tax on the money withdrawn from the very same account when you make the withdrawal. Pretty good deal, huh?


All contributions in Scenario 1 and 2 use pre tax dollars. This is why I subtract taxes from the amount going into the Roth first. You are trying to count tax savings twice.
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Postby mptfan » Fri Mar 07, 2008 5:40 pm

Not true. Contributions to a Roth are not tax deductible, and come from after tax dollars. Therefore, the immediate tax savings in Scenario 2 is much less than Scenario 1.
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Postby MWCA » Fri Mar 07, 2008 5:41 pm

I don't even have the option. I'm nearing ER and theres not enough time left for me to switch anyways. Besides I live in a high tax state which I plan on moving out of into a cheaper tax state. But not even having the option sure makes things easier :D
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Postby mptfan » Fri Mar 07, 2008 5:51 pm

redbeard wrote:Tax: $4,815 (you have this as $4,018, but I assume that is a typo)


That was not a typo, it was correct, based on 2008 tax rates. Rather than spend the time to do the calcuation for 2008, I will refer you to the 2007 IRS tax tables, which have very similar numbers, but the tax is slightly higher because the standard deduction and personal exemptions in 2007 were just a bit lower than 2008. According to the IRS tax table for 2007, the actual tax for a married filing jointly return in 2007 with a taxable income of $32,100 is $4,036 (only $18 different than my number for 2008). Take a look for yourself....

http://www.irs.gov/pub/irs-pdf/i1040tt.pdf
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