Bogleheads

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

Was looking for some feedback and/or advice on Roth vs traditional investing for retirement. As it stands now, I am 100% Roth and max out both the 401k at 16500 and IRA at 5000. There seems to be good arguments for both sides; however, to truly determine which one is the better choice you would need information which is not obtainable. Namely, you would need to know what your portfolio would be worth during retirement and what the tax code would be. This might be somewhat predictable, although not certain, for someone very close to retirement, but for someone at 27 (my age) largely an unknown. Despite the fact that I am single and in the 25% federal tax bracket and the 5.75% state bracket, I still feel that choosing the Roth option is the best choice. Here are my best reasons:

1.) While it would be nice to pay less tax now, I don't feel that paying taxes on my contributions hinders my quality of life. Who knows what retirement may hold? This is more of an emotional reason.

2.) The Roth 401k can be rolled over to a Roth IRA thereby not requiring RMDs. Mandatory distributions during a period of steep portfolio decline could have a profound effect on how long the portfolio could last. In effect, RMDs could force you to sell low. Here is my example and anyone correct me if I am wrong.

Kevin is 72 and the IRS determines his RMD from his portfolio worth on December 31, 2053. This RMD is significantly higher than Kevin determines he needs to withdraw in order to meet yearly living expenses. The market declines drastically leaving Kevin with a 20% loss in his well allocated portfolio. The RMD, calculated from portfolio worth 20% higher, forces Kevin to sell at a loss and to further add insult to injury he must pay taxes on the distributions. Even if Kevin takes the bulk of the RMD and reinvests it, he still has less capital to invest at the lower prices and that capital will no longer grow tax deferred. Avoiding the RMD seems to be a significant advantage for the Roth IRA.

3.) I have nine years total service between the active duty Air Force and the Air National Guard. I plan to stay in for at least twenty years so I will have a small pension beginning at 60 (actually slightly before that due to rule changes affecting how deployments get factored in). More than likely within the next couple of years I will probably seek employment with the FAA which will also add another pension although in my early fifties due to the air traffic controller retirement system. Being conservative, I would estimate the combined worth of these pensions in today's dollars would be around $50,000/yr and they are both COLAd. The pensions are taxed. If, and likely when, I go into the FAA I hope the Roth TSP. I do have some money in the TSP from the my active duty days as well as plan to contribute a little more on each deployment so as to put away more money for retirement than the combined $21,500 a year I do now.

I do have a couple of question though, particularly for those knowledgeable with tax rules and regulations.

Even if the tax structure remains the same and you withdraw the same amount in retirement per year as you earned working per year, you will pay less tax in retirement due to the effective tax rate being lower in retirement. How come the amount of taxes paid on an equal amount of income would not be the same in both retirement and during working years? Just to reemphasize, we are assuming the tax structure remains exact the same pre and post retirement. If this is true, it certainly is one of the strongest arguments for traditional over Roth in terms of tax efficiency. I still would feel that Roth is a better choice for me due mostly to anticipated pensions.

In terms of state income taxes, are you taxed again on Roth withdrawals? My understanding is you are.

Lastly, I suppose you could always split contributions between traditional and Roth. Anyone have any arguments in favor of making contributions to traditional rather than Roth that I'm missing.

YDNAL · Joined: 10 Apr 2007 Posts: 3812 Location: Biscayne Bay

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

That would be a risk, but the risk to the traditional investor is that income tax rates will be higher in retirement than during his working years. Two sides to every coin. Thanks for the reply.

wx27 · Joined: 10 Apr 2007 Posts: 97

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

noppenbd · Joined: 05 Nov 2009 Posts: 1

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

FoolishJumper · Joined: 05 Aug 2009 Posts: 23

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

I'm still a little lost. I completely see that 20% of 50000 is 10000, but I don't see how the entire amount of contributions get taxed at the marginal rate of 25%. With 401(k) contributions, you would be putting a certain percentage of each paycheck into the 401(k) account. I'm assuming that contributions would increasingly be taxed higher throughout the year as you moved into higher tax brackets; therefore, the effective tax rate on contributions should be lower than 25%.

I do agree that the assumption of a decent pension favors Roth contributions.

dbr · Joined: 04 Mar 2007 Posts: 3455

kaneohe · Joined: 22 Sep 2008 Posts: 556

I don't know if this will help or not. Try the situation w/ a tax calculator like this one: http://turbotax.intuit.com/tax-tools/
The one to use is Taxcaster in the middle of page.

1) Wages 40000
Interest 9350 (to compensate for std.deduction for single...assume)
Find from calculator:
Taxable income 40000
Tax(before credit) 6194
This is your situation when you are working, earning 50K and contributing
10K to 401K. You have an effective tax rate of 15.5%

2) Wages 50000
Interest 9350
Find from calculator:
Taxable income 50000
Tax(before credit) 8694
This is your situation when you are working, earning 50K and NOT contributing to 401K. You paid $2500 more in taxes because you didn't contribute to 401K or saying it the other way, if you did save 10K in 401K you saved $2.5K or 25% of that contribution.

3) When you withdraw the 40K in retirement, your tax situation is identical to 1) above and since all of the income (except the interest) came from the 401K, the effective tax rate on that income is the 15.5%.

4) You can use the calculator to see what happens if you have that pension stream in retirement and supplement with 401K. If your pension is very large and your 401K withdrawal is small, you may, in fact find that your effective tax rate on the 401K is also 25%......since the 15% bracket only goes to 34K (taxable) so if you had 34K in pension and 6K in 401K, you might think of the effective tax rate of the last 6K in income as 25%.

SpecialK22 · Joined: 01 Sep 2009 Posts: 19

Thanks dbr and kaneohe for both helping clear up the tax question. So, once the adjusted gross income is known at the end of the year it is taxed in accordance with the tax brackets. Therefore, it really wouldn't be an advantage to contribute Roth early in the year when yearly earned income is lower and then switch to traditional later in the year. That is, you wouldn't achieve any better tax efficiency than if you contributed Roth early on and traditional later, assuming the contribution amounts to each account were the same as in the first example. I've heard some people talking about a strategy of having the deductions from your first few dollars put into Roth while you are at a lower tax rate and then switch to traditional as you would enter 25% or higher bracket. If I understand correctly, this method would really not be any better than any other combination of when you contribute Roth vs traditional as the amount of taxes paid for the year would still be the same.

kaneohe · Joined: 22 Sep 2008 Posts: 556

SK22.......I think you understand correctly that the tax depends only on the yr end income and not their timing.