When is a Roth 401k the Better Option?
When is a Roth 401k the Better Option?
Hey all,
I have read a couple articles online on trying to figure out when it's okay to use a Roth vs. Traditional 401k. I am still having issues, and most of them just had me confused. My current job has me at around $32k/year gross, and within 3 years it will be up to about $39k (unless I get a management promotion to about 65k). My work offers both Roth and Traditional options, and they match 100% up to 5%. Currently I'm signed up for the Roth option at 5%, getting the full match.
I know a lot of it leads to the question of retirement income levels. I live a comfortable and high-savings (35%+ savings rate) life on my current income and would be happy with a 30k/year income level in retirement (todays dollars). but of course the more the merrier. I do anticipate higher incomes later on in life, as I am college educated - hopefully around the 65-70k/year range. So to answer the question of "do you plan to make more yearly while working or while in retirement" - the answer would hopefully be "while working", or else I'll be reeling in a pretty low salary for most of my life.
If it matters, I also have a Roth IRA with VG. Both accounts get about the same contribution/week (around 70 in IRA, and ~35+35 401k).
Main question: When is it okay to use Roth over Traditional 401k - and what should I be signed up for in my situation?
I have read a couple articles online on trying to figure out when it's okay to use a Roth vs. Traditional 401k. I am still having issues, and most of them just had me confused. My current job has me at around $32k/year gross, and within 3 years it will be up to about $39k (unless I get a management promotion to about 65k). My work offers both Roth and Traditional options, and they match 100% up to 5%. Currently I'm signed up for the Roth option at 5%, getting the full match.
I know a lot of it leads to the question of retirement income levels. I live a comfortable and high-savings (35%+ savings rate) life on my current income and would be happy with a 30k/year income level in retirement (todays dollars). but of course the more the merrier. I do anticipate higher incomes later on in life, as I am college educated - hopefully around the 65-70k/year range. So to answer the question of "do you plan to make more yearly while working or while in retirement" - the answer would hopefully be "while working", or else I'll be reeling in a pretty low salary for most of my life.
If it matters, I also have a Roth IRA with VG. Both accounts get about the same contribution/week (around 70 in IRA, and ~35+35 401k).
Main question: When is it okay to use Roth over Traditional 401k - and what should I be signed up for in my situation?
Re: When is a Roth 401k the Better Option?
People probably use the Roth way too often, but it may be appropriate here just to hedge against the risk of tax code changes and because you may be in the 15% bracket anyway in retirement. There may be a case for using the traditional even now, but if you are saving well as it is, I don't think there's much need to play the odds aggressively here for a small potential benefit.
I would use the traditional (and tax-deductible traditional IRA if possible) instead when incomes are higher to keep in the 15% tax bracket, though, when you're close to the 15%/25% breakpoint. Doesn't seem like you should willingly lock in the 25% tax rate with a Roth ever in your life unless things change drastically. It may or may not work in your favor in the long run, but I think it's swung clearer to the side of taking the current tax break if you get into this range.
I would use the traditional (and tax-deductible traditional IRA if possible) instead when incomes are higher to keep in the 15% tax bracket, though, when you're close to the 15%/25% breakpoint. Doesn't seem like you should willingly lock in the 25% tax rate with a Roth ever in your life unless things change drastically. It may or may not work in your favor in the long run, but I think it's swung clearer to the side of taking the current tax break if you get into this range.
Last edited by lack_ey on Tue Jun 23, 2015 12:10 pm, edited 1 time in total.
Re: When is a Roth 401k the Better Option?
While you are still earning in the 30-45k range, I'd go for the Roth 401k. This is assuming you are single and not taking into account your state income taxes. For federal income taxes, you can earn about 47k before transitioning from the 15% marginal tax bracket to the 25% marginal tax bracket (which is what matters when looking at Roth vs regular 401k) if you are taking the standard deduction and claiming only one exemption. Once you are in the 25% marginal tax bracket, it's no longer clear that 'prepaying' taxes on your Roth 401k will beat out paying taxes on a traditional 401k when withdrawing in retirement.
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Re: When is a Roth 401k the Better Option?
Also depends on your age. The younger you are, the more advantageous the Roth option.
Re: When is a Roth 401k the Better Option?
My thought is if you are young and in a lower tax bracket than you expect to be in the future and until retirement, utilize a Roth 401K. Once you get over a certain tax bracket where you expect to stay for a long time, you can switch to a traditional and may lower yourself into the previous bracket.
Re: When is a Roth 401k the Better Option?
As your salary goes up, the IRS will increase your exemptions, deductions, and tax brackets, too. So when you are making $70K in the future, you will still be in the same tax bracket you are now.
I recommend you contribute to the traditional 401(k), but also figure out your tax savings from that and contribue to an individual Roth IRA as well. It appears that at $70 a week to a Roth IRA, you are no where near hitting a contribution limit.
I think in general, folks with lower incomes will not benefit from a Roth 401(k) because they will be able to convert a traditional 401(k) to a Roth IRA later on in life when they are in a lower tax bracket by virtue of being retired. Also folks with obscenely high incomes can benefit from a Roth 401(k) because they will not be in any lower tax bracket when they retire, so they might as well bite the bullet and pay taxes once on that income and not on the gains.
I recommend you contribute to the traditional 401(k), but also figure out your tax savings from that and contribue to an individual Roth IRA as well. It appears that at $70 a week to a Roth IRA, you are no where near hitting a contribution limit.
I think in general, folks with lower incomes will not benefit from a Roth 401(k) because they will be able to convert a traditional 401(k) to a Roth IRA later on in life when they are in a lower tax bracket by virtue of being retired. Also folks with obscenely high incomes can benefit from a Roth 401(k) because they will not be in any lower tax bracket when they retire, so they might as well bite the bullet and pay taxes once on that income and not on the gains.
Last edited by livesoft on Tue Jun 23, 2015 2:04 pm, edited 1 time in total.
Re: When is a Roth 401k the Better Option?
If that would be something like $15,000 in Social Security and $15,000 from your retirement savings then you would likely be paying almost no income taxes in retirement so you would be in a very low tax bracket then which would make the traditional deductible 401k a better choice. You can play with the numbers here but it will not show your state taxes.and would be happy with a 30k/year income level in retirement (todays dollars).....
https://turbotax.intuit.com/tax-tools/c ... taxcaster/
In your situation I would only use the Roth if you are below the 15% federal tax bracket but I would contribute a bit more to the deductible 401k. This is because your choice is either contributing $100 to a deductible 401K or contributing $85 to the Roth 401k and paying $15 in taxes.
If it turns out that a Roth would have been better then there will likely be times after you retire when you can do Roth conversions.
You may be able to get part of the retirement savings credit.
http://www.irs.gov/Retirement-Plans/Pla ... 9s-Credit)
The income numbers are after a bunch of adjustments so be sure to look at your actual numbers.
Re: When is a Roth 401k the Better Option?
If you are single, you seem to be in the 15% tax bracket. I think it is a good bet that you will never be in a lower bracket, so that would argue for using Roth 401k now in my book.
When your income goes up to $70k, you will probably be in the 25% bracket (if single) and at that point, I would switch to traditional.
I think one reason to use traditional now is to get the Saver's Credit because it lowers your income. Information on the Saver's Credit is available in the Wiki.
It would not be a mistake to use some of both.
Good job on saving so much of your income!
When your income goes up to $70k, you will probably be in the 25% bracket (if single) and at that point, I would switch to traditional.
I think one reason to use traditional now is to get the Saver's Credit because it lowers your income. Information on the Saver's Credit is available in the Wiki.
It would not be a mistake to use some of both.
Good job on saving so much of your income!
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Re: When is a Roth 401k the Better Option?
Certainly contribute enough to the traditional 401(k) to be in the 15% or lower marginal income tax bracket.
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Re: When is a Roth 401k the Better Option?
The savers credit if you are eligible is an interesting thought but if it does not apply the decision seems clear cut as noted by most respondents. You should be/are in Roth . When you are making 60k or more it would probably be right to go to traditional. being married will affect the calculation as will having a working spouse
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Re: When is a Roth 401k the Better Option?
A couple thoughts...lack_ey wrote:People probably use the Roth way too often, but it may be appropriate here just to hedge against the risk of tax code changes and because you may be in the 15% bracket anyway in retirement.
1. A lot of high income earners elect to use a Backdoor Roth IRA. Would you argue there is no reason for them to do so?
2. Psychological benefit. For me, it feels better to pay taxes on X dollars now with a Roth and have peace of mind that you won't ever pay tax on any growth... versus have it grow tax-deferred for years but know you will eventually pay the piper on X income plus an increasingly larger "Y growth" at a future date.
Re: When is a Roth 401k the Better Option?
If you are not expecting a pension, you will want enough in traditional to fill the 0% and 10% brackets every year in retirement. No sense in paying 15% now, when you could be paying 0% in retirement.
Re: When is a Roth 401k the Better Option?
Wow, thanks for all of the helpful replies everyone! It sounds like the consensus is sticking with the Roth for now. Also, some additional info that may be helpful: I am single - hope to be married in about 2 years. I am 24 years old. $32k is my gross income. I am in the 15% federal bracket. I am not counting on Social Security or Pension as part of retirement income, so the aim of $30k/year would come from portfolio/rental property. My approximate 35% savings rate breaks down weekly like this: $35 to 401k, soon to be $70 into the IRA, and then $100/week into my $25k student loans @ 6.5%, then a bit into cash to build up my emergency fund.
If you think this strategy should be adjusted, let me know. Those loans are pretty nasty with the 6.5% interest. Only about $3k of that is a 3% loan. I currently have no required payments due to income-based repayment plan, but I am paying the above amount per week. Here is a link to my initial thread that does include all of the required information: viewtopic.php?f=1&t=164431&p=2469341#p2469341
If you think this strategy should be adjusted, let me know. Those loans are pretty nasty with the 6.5% interest. Only about $3k of that is a 3% loan. I currently have no required payments due to income-based repayment plan, but I am paying the above amount per week. Here is a link to my initial thread that does include all of the required information: viewtopic.php?f=1&t=164431&p=2469341#p2469341
Re: When is a Roth 401k the Better Option?
Would you suggest dedicating a certain amount in my early years to a Traditional 401k, and then switching back to Roth? Or should I wait until I hopefully gain that higher income later on, where I would switch to Traditional anyways?rkhusky wrote:If you are not expecting a pension, you will want enough in traditional to fill the 0% and 10% brackets every year in retirement. No sense in paying 15% now, when you could be paying 0% in retirement.
Re: When is a Roth 401k the Better Option?
1. Of course not. The context was Roth vs. traditional where the option is there. There are tradeoffs and different situations where one might be better or worse than the other, though I think people are doing themselves a mild disservice by picking the Roth option too frequently. You're bringing up Roth vs. taxable where one is virtually strictly better than the other.StormShadow wrote:A couple thoughts...lack_ey wrote:People probably use the Roth way too often, but it may be appropriate here just to hedge against the risk of tax code changes and because you may be in the 15% bracket anyway in retirement.
1. A lot of high income earners elect to use a Backdoor Roth IRA. Would you argue there is no reason for them to do so?
2. Psychological benefit. For me, it feels better to pay taxes on X dollars now with a Roth and have peace of mind that you won't ever pay tax on any growth... versus have it grow tax-deferred for years but know you will eventually pay the piper on X income plus an increasingly larger "Y growth" at a future date.
Never mind all the other stuff. I would pay the student loans more aggressively at the expense of retirement savings.jed2009 wrote:Wow, thanks for all of the helpful replies everyone! It sounds like the consensus is sticking with the Roth for now. Also, some additional info that may be helpful: I am single - hope to be married in about 2 years. I am 24 years old. $32k is my gross income. I am in the 15% federal bracket. I am not counting on Social Security or Pension as part of retirement income, so the aim of $30k/year would come from portfolio/rental property. My approximate 35% savings rate breaks down weekly like this: $35 to 401k, soon to be $70 into the IRA, and then $100/week into my $25k student loans @ 6.5%, then a bit into cash to build up my emergency fund.
If you think this strategy should be adjusted, let me know. Those loans are pretty nasty with the 6.5% interest. Only about $3k of that is a 3% loan. I currently have no required payments due to income-based repayment plan, but I am paying the above amount per week. Here is a link to my initial thread that does include all of the required information: viewtopic.php?f=1&t=164431&p=2469341#p2469341
You don't seem to have any problem with investing discipline, and you're not going to be running into yearly contribution limits for tax-advantaged space soon even with those gone, so this is more cleanly about the rate of return on the loans versus in the markets. 6.5% is too high for a guaranteed rate to pass up.
I would maybe make some retirement contributions (all stock) just for some liquidity as a last-level emergency fund that really shouldn't ever be tapped, but 6.5% is a lot and may readily be above what you get from stocks.
edit: the above is wrong if you can get the saver's credit. Better check; I didn't.
You'll have traditional 401k contributions eventually, hopefully when you hit the 25% tax bracket some day (or would hit the 25% if you didn't make traditional contributions). Or let's say you're 50 and you're pretty sure that's never going to happen—supposing everything about the tax code is the same then, you could use the traditional then.jed2009 wrote:Would you suggest dedicating a certain amount in my early years to a Traditional 401k, and then switching back to Roth? Or should I wait until I hopefully gain that higher income later on, where I would switch to Traditional anyways?rkhusky wrote:If you are not expecting a pension, you will want enough in traditional to fill the 0% and 10% brackets every year in retirement. No sense in paying 15% now, when you could be paying 0% in retirement.
Last edited by lack_ey on Wed Jun 24, 2015 12:37 am, edited 1 time in total.
Re: When is a Roth 401k the Better Option?
I couldn't get that link to work, but looked here: http://www.irs.gov/Retirement-Plans/Pla ... 9s-Credit) . It looks like my AGI is proper enough to hit the 10% credit (32k, take about 3k for IRA, leaves 29k), which I was able to claim last year as well. It doesn't look like 401k is included in the AGI, but an IRA is, correct?Watty wrote:
You may be able to get part of the retirement savings credit.
http://www.irs.gov/Retirement-Plans/Pla ... 9s-Credit)
The income numbers are after a bunch of adjustments so be sure to look at your actual numbers.
Re: When is a Roth 401k the Better Option?
It depends on how sure you are of the higher income and when that might occur. It is always good to run the numbers and see for yourself what you might be paying in taxes in retirement. You can probably tell whether you will have a $0.5M or $5M retirement account, based on your contribution rate and a rough estimate of annual return.jed2009 wrote:Would you suggest dedicating a certain amount in my early years to a Traditional 401k, and then switching back to Roth? Or should I wait until I hopefully gain that higher income later on, where I would switch to Traditional anyways?rkhusky wrote:If you are not expecting a pension, you will want enough in traditional to fill the 0% and 10% brackets every year in retirement. No sense in paying 15% now, when you could be paying 0% in retirement.
Re: When is a Roth 401k the Better Option?
Thanks for the input, lack_ey. I have thought about this. I feel like I would be missing out on some major growth in the future by stopping all contributions. The 401k can't be skipped, so I feel like the measly $35 to the IRA is worth putting in instead of completely missing out on potential growth by adding to the loan. The sad part is even with a big chunk of my income going to student loan, it will still take 5 or 6 years to pay it off. I do understand the guaranteed return of 6.5%, but it is more of a peace of mind thing for me knowing I am at least investing a little in my future in my early years, opposed to starting at 30 years old because of a silly loan.lack_ey wrote: Never mind all the other stuff. I would pay the student loans more aggressively at the expense of retirement savings.
You don't seem to have any problem with investing discipline, and you're not going to be running into yearly contribution limits for tax-advantaged space soon even with those gone, so this is more cleanly about the rate of return on the loans versus in the markets. 6.5% is too high for a guaranteed rate to pass up.
I would maybe make some retirement contributions (all stock) just for some liquidity as a last-level emergency fund that really shouldn't ever be tapped, but 6.5% is a lot and may readily be above what you get from stocks.
Re: When is a Roth 401k the Better Option?
You should simulate your tax burden for 2015, and try to get your Adjusted Gross Income below $30,000 so that you can claim the saver's credit. At 10% of $2000 for an AGI between 19,500 and 30,000 it is a pretty good deal.
Without running the spreadsheets, my guess is that the optimal situation for you might be to contribute an amount to your traditional account that will get your AGI down to $30,000, and then contribute everything else (the majority of savings) to a Roth.
If I were in your position, I would prioritize the Roth 401k over the Traditional. Even with only the standard deduction, personal exemption and half of SE tax deduction, your effective tax rate is only 7.5% or so. If you have other possible deductions, that tax rate will be even lower. So definitely go for the Roth but also try to capture the Saver's Credit, which is valuable in your situation.
Without running the spreadsheets, my guess is that the optimal situation for you might be to contribute an amount to your traditional account that will get your AGI down to $30,000, and then contribute everything else (the majority of savings) to a Roth.
If I were in your position, I would prioritize the Roth 401k over the Traditional. Even with only the standard deduction, personal exemption and half of SE tax deduction, your effective tax rate is only 7.5% or so. If you have other possible deductions, that tax rate will be even lower. So definitely go for the Roth but also try to capture the Saver's Credit, which is valuable in your situation.
Re: When is a Roth 401k the Better Option?
It seems likely that there will be plenty of years to use traditional, after the income goes up. I'd continue paying 15% now (using Roth 401k) and accumulate the traditional later. This is if you don't need to use traditional to get more of the saver's credit.rkhusky wrote:If you are not expecting a pension, you will want enough in traditional to fill the 0% and 10% brackets every year in retirement. No sense in paying 15% now, when you could be paying 0% in retirement.
On the other hand, when you get married unless your spouse makes a lot of money you may continue to be in the 15% bracket for a long time. But if that happens, you could still start using traditional at a later day.
When you arrive in retirement, you do want some of both - traditional (tax-deferred) and Roth.
I would not worry about this too much. The amount you save and the fact that you save are more important than whether you go traditional or Roth. Just make a decision and get on with it. You can make adjustments later in life when things are more clear.
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Re: When is a Roth 401k the Better Option?
Yes, you'd still be using the 401k up to the match, but beyond that, it's less clear.jed2009 wrote:Thanks for the input, lack_ey. I have thought about this. I feel like I would be missing out on some major growth in the future by stopping all contributions. The 401k can't be skipped, so I feel like the measly $35 to the IRA is worth putting in instead of completely missing out on potential growth by adding to the loan. The sad part is even with a big chunk of my income going to student loan, it will still take 5 or 6 years to pay it off. I do understand the guaranteed return of 6.5%, but it is more of a peace of mind thing for me knowing I am at least investing a little in my future in my early years, opposed to starting at 30 years old because of a silly loan.lack_ey wrote: Never mind all the other stuff. I would pay the student loans more aggressively at the expense of retirement savings.
You don't seem to have any problem with investing discipline, and you're not going to be running into yearly contribution limits for tax-advantaged space soon even with those gone, so this is more cleanly about the rate of return on the loans versus in the markets. 6.5% is too high for a guaranteed rate to pass up.
I would maybe make some retirement contributions (all stock) just for some liquidity as a last-level emergency fund that really shouldn't ever be tapped, but 6.5% is a lot and may readily be above what you get from stocks.
Many people expect less than 6.5% from stocks going forward, and paying down debt is investing for the future, even if you don't internalize it that way.
If the market drops 50% next year, I'd suggest holding off on the loan, but as we are now, there's less room to run up and the guaranteed return looks relatively strong.
In any case, that's what I would recommend thinking about, if you're going to the trouble to do all the calculations for the saver's credit and thinking hard about traditional/Roth contributions and who knows what else to optimize contributions here.
Re: When is a Roth 401k the Better Option?
Thanks, Caduc. I was reading and it looked like 401k's weren't included in bringing down your AGI? It looks like only IRA's. Was I reading this wrong? If so, if my Gross is around 32k, would a minimum 2000 to my IRA work to bring it down to the 30k level to get the 10% bonus? Would I even need to use part Traditional 401k each year if my IRA contribution is large enough to bring it to the 30k level?Caduceus wrote:You should simulate your tax burden for 2015, and try to get your Adjusted Gross Income below $30,000 so that you can claim the saver's credit. At 10% of $2000 for an AGI between 19,500 and 30,000 it is a pretty good deal.
Without running the spreadsheets, my guess is that the optimal situation for you might be to contribute an amount to your traditional account that will get your AGI down to $30,000, and then contribute everything else (the majority of savings) to a Roth.
If I were in your position, I would prioritize the Roth 401k over the Traditional. Even with only the standard deduction, personal exemption and half of SE tax deduction, your effective tax rate is only 7.5% or so. If you have other possible deductions, that tax rate will be even lower. So definitely go for the Roth but also try to capture the Saver's Credit, which is valuable in your situation.
I also pay at least the $2,500/year in student loan interest, which would bring it down to around $27.5k.
Re: When is a Roth 401k the Better Option?
Thanks, lack_ey. What you say makes sense. What I may end up doing is picking up a part-time job and throwing the extra onto my student loan. Even an extra 50 bucks a week income would help quite a bit!lack_ey wrote:Many people expect less than 6.5% from stocks going forward, and paying down debt is investing for the future, even if you don't internalize it that way.
If the market drops 50% next year, I'd suggest holding off on the loan, but as we are now, there's less room to run up and the guaranteed return looks relatively strong.
In any case, that's what I would recommend thinking about, if you're going to the trouble to do all the calculations for the saver's credit and thinking hard about traditional/Roth contributions and who knows what else to optimize contributions here.
Re: When is a Roth 401k the Better Option?
Good point on wanting both in the future. I hope that my income does go up substantially, if not by a promotion then by perhaps going back to college to get a second degree to get a better job, etc. Appreciate the thoughts!retiredjg wrote:It seems likely that there will be plenty of years to use traditional, after the income goes up. I'd continue paying 15% now (using Roth 401k) and accumulate the traditional later. This is if you don't need to use traditional to get more of the saver's credit.
On the other hand, when you get married unless your spouse makes a lot of money you may continue to be in the 15% bracket for a long time. But if that happens, you could still start using traditional at a later day.
When you arrive in retirement, you do want some of both - traditional (tax-deferred) and Roth.
I would not worry about this too much. The amount you save and the fact that you save are more important than whether you go traditional or Roth. Just make a decision and get on with it. You can make adjustments later in life when things are more clear.
Re: When is a Roth 401k the Better Option?
The Wiki page indicates that both deductible IRA and (traditional) 401k will reduce your AGI. https://www.bogleheads.org/wiki/Saver%27s_creditjed2009 wrote:Thanks, Caduc. I was reading and it looked like 401k's weren't included in bringing down your AGI? It looks like only IRA's. Was I reading this wrong?
These things happen in different places on your tax form, so that may be why you misunderstood.
When you enter wages and salaries from your W2 on line 7 of Form 1040, the traditional contributions to 401k are already excluded from what you put in that line. So those contributions are never considered part of your income. If you make Roth contributions to your 401k, it is not excluded from what you put in that line - Roth contributions are part of your income. Check out your W2 to see how that is done.
Your AGI is the last line on the first page of Form 1040 (line 37). The IRA is subtracted out at line 32 and the student loan is subtracted out at line 33.
As I see it, all you need to do is get line 37 to less than $30,500 to get the 10% credit on your tax. I would get $1k to $2k below it if you can - just in case your income is higher than you think.
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Re: When is a Roth 401k the Better Option?
Excellent - thanks for clearing it up for me! I'll get it as low as I can while keeping my priorities in line.retiredjg wrote:The Wiki page indicates that both deductible IRA and (traditional) 401k will reduce your AGI. https://www.bogleheads.org/wiki/Saver%27s_credit
These things happen in different places on your tax form, so that may be why you misunderstood.
When you enter wages and salaries from your W2 on line 7 of Form 1040, the traditional contributions to 401k are already excluded from what you put in that line. So those contributions are never considered part of your income. If you make Roth contributions to your 401k, it is not excluded from what you put in that line - Roth contributions are part of your income. Check out your W2 to see how that is done.
Your AGI is the last line on the first page of Form 1040 (line 37). The IRA is subtracted out at line 32 and the student loan is subtracted out at line 33.
As I see it, all you need to do is get line 37 to less than $30,500 to get the 10% credit on your tax. I would get $1k to $2k below it if you can - just in case your income is higher than you think.
Re: When is a Roth 401k the Better Option?
Well, do your own research and pencil in a 1040 form - I just did some quick research and might have overlooked something.jed2009 wrote:Excellent - thanks for clearing it up for me! I'll get it as low as I can while keeping my priorities in line.
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Re: When is a Roth 401k the Better Option?
Why do you say this? Age, length of time, etc. have no impact on if it is better to chose the traditional or the Roth. The primary factor is if you expect your tax rate in retirement to be higher or lower. Secondary factors are technical aspects of the tax code - such as your maximum contribution limits. Time is not a factor.anonenigma wrote:Also depends on your age. The younger you are, the more advantageous the Roth option.
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Re: When is a Roth 401k the Better Option?
Sorry - just saw this. Age matters because of compounding. People at the beginning of their careers are more likely to be at lower marginal tax rates, making it less beneficial to make pretax contributions. Since earnings in the Roth are not taxed, a younger person has many more years for compounding to work its magic.alex_686 wrote:Why do you say this? Age, length of time, etc. have no impact on if it is better to chose the traditional or the Roth. The primary factor is if you expect your tax rate in retirement to be higher or lower. Secondary factors are technical aspects of the tax code - such as your maximum contribution limits. Time is not a factor.anonenigma wrote:Also depends on your age. The younger you are, the more advantageous the Roth option.
Consider a 25 year old whose last $5,000 of income might be in the 15% IRS bracket compared with a 45 year old whose last $5,000 of income is in the 25% IRS bracket. For the 25 year old, taxes on that $5K would be $750. For the 45 year old, taxes would be $1,250.
The 25 year old would have almost 35 years (in most cases) before penalty-free withdrawals, during which time investment earnings would compound without taxes ever having to be paid. For the 45 year old, the time horizon is only 15 years. All withdrawals (contributions and earnings) from a non-Roth 401(k), 403(b) and 457b are taxed.
I heard a very compelling case for adding a Roth option to a defined contribution plan. The guy said that he could have paid the 15% federal tax years earlier whereas, when he takes the money out, he'll likely have to pay 25% federal tax on it (plus the earnings and state taxes).
Re: When is a Roth 401k the Better Option?
The first statement is false, compound has zero effect. Let's assume you want to save $1,000 for 35 years at 5%. You could invest in a Roth, pay the $150 in tax, and at the end of 35 years you would have $4,688.61. Or you could invest $1,000 in a IRA, have $5,688.61, than pay the 15% tax, and wind up with $4,688.61. Or exactly the same amount. This always holds true. Here is the math below. As you can see they are equivalent statements.anonenigma wrote:Sorry - just saw this. Age matters because of compounding. People at the beginning of their careers are more likely to be at lower marginal tax rates, making it less beneficial to make pretax contributions. Since earnings in the Roth are not taxed, a younger person has many more years for compounding to work its magic.
The future value of a IRA is: ((1+r)^n)*(1-t)
The future value of a Roth IRA is: (1-t)*((1+r)^n)
Where
r = annual return
t = tax rate
n = # of years
Your second statement may be true - people at the beginning of their careers may be true. Or may not. You have to forecast future income and tax policies for the next 35 years.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: When is a Roth 401k the Better Option?
alex_686 is correct age does not matter because the compounding applies equally in both circumstances.
However, there is a case where age can matter. This is when the amount of accumulation is so large that the estimate of the tax rate in retirement is wrong. For example, you could, never exceed the 25% marginal bracket in your working life, but because you have been maxing out your pre-tax accounts all along, RMDs could push you into the 33% bracket in retirement.
However, there is a case where age can matter. This is when the amount of accumulation is so large that the estimate of the tax rate in retirement is wrong. For example, you could, never exceed the 25% marginal bracket in your working life, but because you have been maxing out your pre-tax accounts all along, RMDs could push you into the 33% bracket in retirement.