Roth 401K Option

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Topic Author
EMDW
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Joined: Thu Jul 04, 2013 11:18 am

Roth 401K Option

Post by EMDW » Sat Sep 21, 2013 11:37 am

Our retirement plan has an option for a Roth 401K. Would this make sense for me to consider? Have over 20 years before retirement. Tax bracket 39.6% (fed) 5.5% (state). No debt. Asset allocation: 70% stocks/30% bonds. Also, is a back door roth IRA part of the equation here? Thanks in advance for your help.

Tax advantage account: 401K maxed out yearly:
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Taxable account:
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stan1
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Re: Roth 401K Option

Post by stan1 » Sat Sep 21, 2013 11:47 am

At that tax rate I would stick with the Traditional 401K so you get the current year tax savings.

$17,500 x 2 = $35,000
$35,000 x (0.396 + 0.055) = $15,785 less tax paid per year, more than $300K in tax savings over the next 20 years.

This is a sure thing that does not require speculation about your future tax bracket or future rates of return.
Last edited by stan1 on Sat Sep 21, 2013 12:37 pm, edited 1 time in total.

less
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Re: Roth 401K Option

Post by less » Sat Sep 21, 2013 12:29 pm

1) When contributing at a higher tax rate, the probability of eventual withdrawal (of at least part) at a lower rate is high. That generates a additional 401k benefit equal to the $$ withdrawn multiplied by the difference in the tax rates.

2) Your income in retirement will come from the investment income of your taxable account, the income from any inheritance (lottery) you receive, the SS benefits and any pension. Make an estimate of those to see what tax bracket that leave you in.

3) Also consider you own POV regarding the possible increase of tax rates across the board as the US runs out of money for SS etc. You definitely do NOT want to be in a higher rate on withdrawal.

4) Contributing the same $$ to either a Roth of traditional 401k does not put the same capital in the tax shelter. $5,000 put in a 401k shelters only $3,000 of principal (at a 40% tax rate). $5,000 in a Roth shelters all $5,000.

5) So while the traditional 401k gives you the possible additional benefit from a lower rate on withdrawal, you miss out on the sheltering of income from that $2000 difference.

6) I disagree with your choice of Asset Location. Read this easy to understand paper http://papers.ssrn.com/sol3/papers.cfm? ... id=2317970

Topic Author
EMDW
Posts: 79
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Re: Roth 401K Option

Post by EMDW » Sat Sep 21, 2013 12:53 pm

stan1 wrote:At that tax rate I would stick with the Traditional 401K so you get the current year tax savings.

$17,500 x 2 = $35,000
$35,000 x (0.396 + 0.055) = $15,785 less tax paid per year, more than $300K in tax savings over the next 20 years.

This is a sure thing that does not require speculation about your future tax bracket or future rates of return.
The 401K max is 51K per year.

MooreBonds
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Re: Roth 401K Option

Post by MooreBonds » Sat Sep 21, 2013 1:35 pm

less wrote: 3) Also consider you own POV regarding the possible increase of tax rates across the board as the US runs out of money for SS etc. You definitely do NOT want to be in a higher rate on withdrawal.
I've always been a big believer in diversification in investments, not only in asset class/geography/country, but in taxes as well.

Just as the unthinkable double taxation of SS benefits came into being 2 decades ago (when your SS benefit received went from being 50% taxable on the "employer's portion" to as much as 85% taxable, which means your SS contribution that was taxed when you had it deducted is now possibly taxed again when you receive it), there's nothing to say that a future tax levied on ROTH accounts is entirely out of the question.

I would also suggest looking at your projected retirement income picture to see what it would look like. If it's pretty likely you'll have a substantially lower taxable income in retirement, then I would likely suggest a much stronger tilt (80% of your contributions) towards your traditional 401k for the guaranteed tax savings now. However, it wouldn't hurt to put a small amount into your ROTH 401k as a hedge now.

DSInvestor
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Re: Roth 401K Option

Post by DSInvestor » Sat Sep 21, 2013 1:40 pm

sari wrote:The 401K max is 51K per year.
51k is the total of all 401(k) contributions made by employee and employer. The rules do not permit 51k of Roth contributions. The employee salary deferral is limited to 17.5K if under age 50 can be designated Roth or traditional or a mix of both. Contributions above and beyond that 17.5K limit (employer match, profit share, non-Roth after tax) must go into traditional 401(k). 401(k) contributions made by the employer are deductible as an expense for the employer so those contributions must go into traditional. As such, the tax comparison for designated roth contributions should compare 17.5K of salary deferral contributions to either Roth or Traditional.
Wiki

less
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Re: Roth 401K Option

Post by less » Sat Sep 21, 2013 1:45 pm

less wrote:1) When contributing at a higher tax rate, the probability of eventual withdrawal (of at least part) at a lower rate is high. That generates a additional 401k benefit equal to the $$ withdrawn multiplied by the difference in the tax rates.
4) Contributing the same $$ to either a Roth of traditional 401k does not put the same capital in the tax shelter. $5,000 put in a 401k shelters only $3,000 of principal (at a 40% tax rate). $5,000 in a Roth shelters all $5,000.
5) So while the traditional 401k gives you the possible additional benefit from a lower rate on withdrawal, you miss out on the sheltering of income from that $2000 difference.
To give you the math for comparison assuming a 7% rate of return, an effective 15% tax rate if in a taxable account, and 30 years in the plan (not just until retirement) .....
a) The future value of $5,000 at 7% for 30 years = $38,061. A 10% lower tax rate on withdrawal creates a $3,806 benefit.
b) The lost shelter of $2,000 at 7% taxed at 15% for 30 years equals the difference between the future value compounded at 7% and the future value compounded after tax at 5.95%.
$15,225 less $11,326 = $3,899 lost benefits.

So the trade off is equal. So the withdrawal tax rate would have to be lower by more than a 10% to make up for the lost sheltering of the $2,000 principal. With the risk of a higher withdrawal tax rate still possible for the 401k.

Topic Author
EMDW
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Re: Roth 401K Option

Post by EMDW » Sat Sep 21, 2013 3:30 pm

6) I disagree with your choice of Asset Location. Read this easy to understand paper http://papers.ssrn.com/sol3/papers.cfm? ... id=2317970[/quote]

May you please expand on this? I read the article, but need help understanding which asset locations will be more suitable in my case. Thanks.

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Ketawa
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Re: Roth 401K Option

Post by Ketawa » Sat Sep 21, 2013 3:51 pm

At that tax rate, there is no way you should be using the Roth 401(k) option.

The Roth option would allow you to tax shelter more income, but your tax rate is likely to be much lower in retirement. In addition, the vast majority of your withdrawals will be taxed far below your marginal tax rate in retirement, since they fill up the lower brackets. Read this article for an explanation: The Case Against Roth 401(k)

At what point would Roth make sense? This article has a link to a spreadsheet where you can estimate the point of indifference between your current marginal tax rate and your future marginal tax rate: Roth 401(k) for People Who Contribute the Max.

My estimate is that the Roth option only makes sense if your marginal tax rate will be below 30% in retirement. Remember, this is only for the portion of retirement dollars that would actually be taxed at that rate, not the dollars filling up the lower bracket. Do you expect to pay a top marginal rate of 30% in retirement? Probably not. Do you have plans for early retirement? Then you definitely shouldn't be using the Roth option. Can you live off your taxable account during the early retirement years, and convert from Traditional to Roth during those years? Another reason not to use Roth.

Re: the asset location question. Yields on bond funds are starting to rise high enough that it probably makes sense again to have bond funds in tax-advantaged, or to use munis. Munis have historically high rates relative to Treasuries right now. Does this reflect greater risk or an irrational market? Impossible to say. I didn't bother to read the linked paper, but the wiki entry on tax-adjusted asset allocation covers the other issues it looks like it was discussing.

livesoft
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Re: Roth 401K Option

Post by livesoft » Sat Sep 21, 2013 4:31 pm

less wrote:6) I disagree with your choice of Asset Location. Read this easy to understand paper http://papers.ssrn.com/sol3/papers.cfm? ... id=2317970
a) The paper is not "easy to understand".
b) The paper is freshly posted for comments, so it is not really reviewed and updated by the author.
c) The paper as I read it appears to contain flaws.
d) But no worries, thanks for posting the link ... maybe we can discuss the paper in a new thread.
e) @less, You wouldn't happen to be connected to this paper somehow? Author? Friend or Spouse of Author?
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Watty
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Re: Roth 401K Option

Post by Watty » Sat Sep 21, 2013 5:31 pm

Ketawa wrote:At that tax rate, there is no way you should be using the Roth 401(k) option.

+1

In all the questions about if you will be in a higher tax bracket when you retire there seems to be an assumption that you will keep working and retire at the normal retirement age. There is also a significant chance that you could have career or health setbacks and not work until the normal retirement age. You might also decide to retire much earlier than normal too when you see you can.

The back door Roth is an entirely different question and would likely be a good choice.

Being in that tax bracket the estate planning aspects of selecting the Roth or Deductible 401k is likely as important as the tax issue. If the money will be left to a charity or to someone in a lower tax bracket then that would make the deductible 401k preferable.

If you are likely to retire in a state with higher or lower income taxes that should also be factored into your calculations.

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