Traditional vs Roth

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Hunter123
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Joined: Sat Dec 03, 2016 10:54 pm

Traditional vs Roth

Post by Hunter123 »

My employer just started offering Roth 401k in addition to traditional. I expect my tax bracket will be lower in retirement, which would make traditional more advantageous but a certain financial advisor has repeatedly lauded the tax-free growth aspect of Roth. If I keep growing my retirement accounts for another 20 years or so maxing out the 401k, would the tax free growth of Roth supersede the lower tax bracket savings of traditional in retirement? I would pay higher tax on principal now but growth would be free vs. paying lower tax rate on both growth and principal in traditional. So far I have been putting all into traditional - should I split it (50-50?) between Roth and traditional going forward for diversification? I can max out the 401k but can't make additional backdoor Roth contribution outside 401k at the moment so the question is - whether to split my 401 contribution between Roth and traditional or just keep it all in the traditional? Thank you!
enki
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Re: Traditional vs Roth

Post by enki »

The answer to this is both simple and complicated.

The simple answer is that it completely depends on your tax rate now and what you anticipate you will be paying during retirement. There are countless calculators out there that will allow you to enter both those variables with your balance, estimated rate of return, duration, contributions, etc. It will spit out a nice little graph with numbers showing what the two different end results COULD be.

And that is where it gets complicated. You can only guess what the tax rates will be when you retire. The longer out this timeline is, the less likely it is that you will be able to guess with much accuracy. Tax rates might go up substantially, or they could be the same (or go down). Or, god forbid, the tax rules change drastically and Roth withdrawals are made taxable anyway (extreme example, but still possible). So while you can make an educated guess, it is still just a guess.

In the end, my opinion is you should do what you feel comfortable doing. In my case, in the 25% current tax bracket, I put the vast majority of my 401k into the traditional option, while still putting 1% into a Roth 401k (mainly so it stays active on the books so the employer continues to offer it). I also max out my Roth IRA every year since this helps hedge the future as well as being disqualified from contributing to a tIRA. For me, this is a good mix. I know that I can get a tax break now on the bulk of my contributions while still having some flexibility when I retire.
rbaldini
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Re: Traditional vs Roth

Post by rbaldini »

I think it's important to realize that contributions to a Roth 401K are taxed now at your marginal tax rate. In contrast, when you pull out money as income from a traditional 401K, you are effectively applying the overall (average) tax rate, which is necessarily less than the marginal tax rate. So even if you are in, say, a 28% tax bracket in retirement, you probably still get to keep more money if you do a traditional 401K. Of course, no one knows what the tax situation will be in the future. It's entirely possible that you'll pay more in retirement. So some diversification is reasonable. I personally put all my 401k into traditional, but also max out a Roth every year.
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iceport
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Re: Traditional vs Roth

Post by iceport »

Hunter123 wrote:I expect my tax bracket will be lower in retirement, which would make traditional more advantageous but a certain financial advisor has repeatedly lauded the tax-free growth aspect of Roth. If I keep growing my retirement accounts for another 20 years or so maxing out the 401k, would the tax free growth of Roth supersede the lower tax bracket savings of traditional in retirement?
Your advisor is doing a poor job of explaining the issue, and it's possible he doesn't understand it well. (Once you grasp the essence of this concept, you might be disappointed in the advisor.)

The fact of the matter is, assuming a constant tax rate, the Roth and traditional options produce exactly the same result: tax-free growth.

ROTH Future Value = (PreTax$Invested) * (1-Tax1) * (1+Growth)

Trad Future Value = (PreTax$Invested) * (1+Growth) * (1-Tax2)

The future values are exactly the same if Tax1 = Tax2, and the traditional account has a tax advantage over the Roth if Tax1 > Tax2. In either case, the greater the growth in assets, the greater the tax break.

Here is a simple example to illustrate. Take the Roth first:

ROTH Future Value = (PreTax$Invested) * (1-Tax1) * (1+Growth)

Say you earn $1000, you're in the 25% tax bracket, and you put it in a Roth. So $750 goes in the Roth, and 10 years later it doubled to $1500. You get to withdraw it all tax-free: you end up with $1500. In this case, it's obvious that all growth was tax-free.

Now take the traditional:

Trad Future Value = (PreTax$Invested) * (1+Growth) * (1-Tax2)

You take the same $1000 earned and instead put it into a traditional ("tax-deferred") account, and invest it the same way as in the Roth above, so 10 years later the traditional account has also doubled. Now you have $2000 that will be taxed at 25% (that's the assumption for this example). So when you withdraw it, you end up with $1500. That's exactly the same ending value as the Roth, so you also got the benefit of tax-free growth in the traditional account. (If your tax rate in retirement is lower than the pre-retirement 25%, you make out even better in the traditional account. Essentially, you also permanently lowered the tax rate on the original earnings.)

Another fact is, because the comparison depends on assuming an unknown, you cannot know with absolute certainty right now which option is best for you. But that should not stop you from testing scenarios and making reasonable assumptions. In general, if your tax rate will be lower in retirement, you should favor the traditional account. Not only will you be getting better-than-tax-free growth there, but you will benefit from an additional subsidy in the form of reduced taxes on the dollars contributed as well.

Here is a good wiki article: Traditional versus Roth

At the bottom there is a link to a spreadsheet where you can test some scenarios.

Here are a couple of helpful articles from a forum member (which are also linked in the wiki):

https://thefinancebuff.com/case-against-roth-401k.html
https://thefinancebuff.com/the-forgotte ... e-ira.html
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
rbaldini
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Re: Traditional vs Roth

Post by rbaldini »

iceport wrote: The fact of the matter is, assuming a constant tax rate, the Roth and traditional options produce exactly the same result: tax-free growth.

ROTH Future Value = (PreTax$Invested) * (1-Tax1) * (1+Growth)

Trad Future Value = (PreTax$Invested) * (1+Growth) * (1-Tax2)

The future values are exactly the same if Tax1 = Tax2, and the traditional account has a tax advantage over the Roth if Tax1 > Tax2. In either case, the greater the growth in assets, the greater the tax break.

Another fact is, because the comparison depends on assuming an unknown, you cannot know with absolute certainty right now which option is best for you. But that should not stop you from testing scenarios and making reasonable assumptions. In general, if your tax rate will be lower in retirement, you should favor the traditional account. Not only will you be getting better-than-tax-free growth there, but you will benefit from an additional subsidy in the form of reduced taxes on the dollars contributed as well.
And, to repeat, Tax1 is your current marginal tax rate. Tax2 is your *average* retirement tax rate, which will be less than your marginal retirement tax rate (but not necessarily less than your current marginal tax rate).

OP, there are some other technical differences to keep in mind. If I understand correctly, you can withdraw from a Roth 401k early without paying a penalty - but you do have to pay tax on the earnings. For a traditional 401k, you have to pay a penalty + tax. You shouldn't plan on doing this, but it's still worth considering.
KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

Hunter123 wrote:My employer just started offering Roth 401k in addition to traditional. I expect my tax bracket will be lower in retirement, which would make traditional more advantageous but a certain financial advisor has repeatedly lauded the tax-free growth aspect of Roth. If I keep growing my retirement accounts for another 20 years or so maxing out the 401k, would the tax free growth of Roth supersede the lower tax bracket savings of traditional in retirement? I would pay higher tax on principal now but growth would be free vs. paying lower tax rate on both growth and principal in traditional. So far I have been putting all into traditional - should I split it (50-50?) between Roth and traditional going forward for diversification? I can max out the 401k but can't make additional backdoor Roth contribution outside 401k at the moment so the question is - whether to split my 401 contribution between Roth and traditional or just keep it all in the traditional? Thank you!
Hunter123,

What is your marginal tax rate?

1) If you contribute to Trad. 401K, you can contribute your tax savings to Roth IRA. You have more money enjoying tax-free growth and you get both: tax deferred (Trad. 401K) and Roth IRA.

2) If you contribute to Roth 401K, you pay more tax and less money for Roth IRA. You have less money enjoying tax-free growth.

So, why would you want to do (2) and have less money in your own pocket?

KlangFool
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rbaldini
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Re: Traditional vs Roth

Post by rbaldini »

KlangFool wrote: Hunter123,

What is your marginal tax rate?

1) If you contribute to Trad. 401K, you can contribute your tax savings to Roth IRA. You have more money enjoying tax-free growth and you get both: tax deferred (Trad. 401K) and Roth IRA.

2) If you contribute to Roth 401K, you pay more tax and less money for Roth IRA. You have less money enjoying tax-free growth.

So, why would you want to do (2) and have less money in your own pocket?

KlangFool
He can contribute to Roth IRA either way. The question is whether the top 18k of his paycheck (or whatever he chooses) is better off going to trad 401k or roth 401k.
KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

rbaldini wrote:
KlangFool wrote: Hunter123,

What is your marginal tax rate?

1) If you contribute to Trad. 401K, you can contribute your tax savings to Roth IRA. You have more money enjoying tax-free growth and you get both: tax deferred (Trad. 401K) and Roth IRA.

2) If you contribute to Roth 401K, you pay more tax and less money for Roth IRA. You have less money enjoying tax-free growth.

So, why would you want to do (2) and have less money in your own pocket?

KlangFool
He can contribute to Roth IRA either way. The question is whether the top 18k of his paycheck (or whatever he chooses) is better off going to trad 401k or roth 401k.
rbaldini,

Who says so? The amount of money is different. Many people that I know cannot contribute Roth IRA if they do Roth 401K.

Assuming 25% marginal tax rate.

1) 18K Roth 401K cost 4.5K in tax. Another 5.5K in Roth IRA.

Total reduction in take-home pay = 18K + 4.5K + 5.5K = 28K

2) 18K Trad. 401K, 4.5K tax saving. 5.5K in Roth IRA

The total reduction in take-home pay = 18K + (5.5K - 4.5K) = 19K

The difference is 9K. It is substantial.

KlangFool
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TinkerPDX
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Re: Traditional vs Roth

Post by TinkerPDX »

From the Wiki:
Non-tax considerations (Traditional 401(k) vs. Roth IRA):

If your employer matches 401(k) contributions, put enough to get the maximum match in the 401(k) before contributing to any IRA.
If you have inferior options in the 401(k), prefer an IRA to unmatched 401(k) contributions.
Tax considerations:

If your current marginal tax rate is 15% or less, prefer a Roth.[note 1]
If you expect to have higher marginal rates than your current marginal rate for most of your career, prefer a Roth.
If you will have a traditional account or a pension large enough to meet your expected retirement expenses (and you expect to take that pension shortly after retiring), prefer a Roth.[3]
Otherwise, prefer a traditional account.
A complicating factor is that if you have some savings in Roth, then the withdrawals/income coming from that won't be taxed, so won't push you up tax bracket wise. The result is that the "higher taxes now or later?" argument is more complicated, and it's likely optimal to have some in trad and some in roth, and to plan on contributing trad during whatever the highest-tax portion of your earnings years are. That, in turn, could be impacted not just by your marginal rate based on bracket, but also certain tax credit/benefit phase-outs.
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iceport
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Re: Traditional vs Roth

Post by iceport »

rbaldini wrote:
iceport wrote: The fact of the matter is, assuming a constant tax rate, the Roth and traditional options produce exactly the same result: tax-free growth.

ROTH Future Value = (PreTax$Invested) * (1-Tax1) * (1+Growth)

Trad Future Value = (PreTax$Invested) * (1+Growth) * (1-Tax2)

The future values are exactly the same if Tax1 = Tax2, and the traditional account has a tax advantage over the Roth if Tax1 > Tax2. In either case, the greater the growth in assets, the greater the tax break.

Another fact is, because the comparison depends on assuming an unknown, you cannot know with absolute certainty right now which option is best for you. But that should not stop you from testing scenarios and making reasonable assumptions. In general, if your tax rate will be lower in retirement, you should favor the traditional account. Not only will you be getting better-than-tax-free growth there, but you will benefit from an additional subsidy in the form of reduced taxes on the dollars contributed as well.
And, to repeat, Tax1 is your current marginal tax rate. Tax2 is your *average* retirement tax rate, which will be less than your marginal retirement tax rate (but not necessarily less than your current marginal tax rate).

OP, there are some other technical differences to keep in mind. If I understand correctly, you can withdraw from a Roth 401k early without paying a penalty - but you do have to pay tax on the earnings. For a traditional 401k, you have to pay a penalty + tax. You shouldn't plan on doing this, but it's still worth considering.
Oh, there are a whole multitude of other considerations, agreed. That's why I provided links to articles that address most of them.

The marginal vs. effective or average rate is a valid point, but even that is less important for some than it is for others — those with pensions, for example. Future tax rates, future tax treatments, huge variations in income (necessitated by spending spikes, for example) all contribute to the uncertainty. That's why, despite advocating that people make some reasonable assumptions to make an informed choice, I also advocate the benefits of "tax diversification," having multiple types of accounts with different tax treatments that can be tapped advantageously during retirement.
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

TinkerPDX wrote:From the Wiki:
Non-tax considerations (Traditional 401(k) vs. Roth IRA):

If your employer matches 401(k) contributions, put enough to get the maximum match in the 401(k) before contributing to any IRA.
If you have inferior options in the 401(k), prefer an IRA to unmatched 401(k) contributions.
Tax considerations:

If your current marginal tax rate is 15% or less, prefer a Roth.[note 1]
If you expect to have higher marginal rates than your current marginal rate for most of your career, prefer a Roth.
If you will have a traditional account or a pension large enough to meet your expected retirement expenses (and you expect to take that pension shortly after retiring), prefer a Roth.[3]
Otherwise, prefer a traditional account.
A complicating factor is that if you have some savings in Roth, then the withdrawals/income coming from that won't be taxed, so won't push you up tax bracket wise. The result is that the "higher taxes now or later?" argument is more complicated, and it's likely optimal to have some in trad and some in roth, and to plan on contributing trad during whatever the highest-tax portion of your earnings years are. That, in turn, could be impacted not just by your marginal rate based on bracket, but also certain tax credit/benefit phase-outs.
TinkerPDX,

When in doubt, do Trad. 401K! Then, contribute your tax savings to Roth IRA and taxable account. It is not complicated. You will have money in all 3 pools: Trad. 401K, Roth IRA, and taxable account. You have maximum flexibility and tax diversity.

This is the right answer for 90+% of people.

KlangFool
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Evilmagus
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Re: Traditional vs Roth

Post by Evilmagus »

KlangFool wrote:
rbaldini wrote:
KlangFool wrote: Hunter123,

What is your marginal tax rate?

1) If you contribute to Trad. 401K, you can contribute your tax savings to Roth IRA. You have more money enjoying tax-free growth and you get both: tax deferred (Trad. 401K) and Roth IRA.

2) If you contribute to Roth 401K, you pay more tax and less money for Roth IRA. You have less money enjoying tax-free growth.

So, why would you want to do (2) and have less money in your own pocket?

KlangFool
He can contribute to Roth IRA either way. The question is whether the top 18k of his paycheck (or whatever he chooses) is better off going to trad 401k or roth 401k.
rbaldini,

Who says so? The amount of money is different. Many people that I know cannot contribute Roth IRA if they do Roth 401K.

Assuming 25% marginal tax rate.

1) 18K Roth 401K cost 4.5K in tax. Another 5.5K in Roth IRA.

Total reduction in take-home pay = 18K + 4.5K + 5.5K = 28K

2) 18K Trad. 401K, 4.5K tax saving. 5.5K in Roth IRA

The total reduction in take-home pay = 18K + (5.5K - 4.5K) = 19K

The difference is 9K. It is substantial.

KlangFool
Your math is wrong. #2 shoudl be 18k + 5.5 = 23.5k. The total reduction is 4.5k.
KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

Evilmagus wrote:
KlangFool wrote:
rbaldini wrote:
KlangFool wrote: Hunter123,

What is your marginal tax rate?

1) If you contribute to Trad. 401K, you can contribute your tax savings to Roth IRA. You have more money enjoying tax-free growth and you get both: tax deferred (Trad. 401K) and Roth IRA.

2) If you contribute to Roth 401K, you pay more tax and less money for Roth IRA. You have less money enjoying tax-free growth.

So, why would you want to do (2) and have less money in your own pocket?

KlangFool
He can contribute to Roth IRA either way. The question is whether the top 18k of his paycheck (or whatever he chooses) is better off going to trad 401k or roth 401k.
rbaldini,

Who says so? The amount of money is different. Many people that I know cannot contribute Roth IRA if they do Roth 401K.

Assuming 25% marginal tax rate.

1) 18K Roth 401K cost 4.5K in tax. Another 5.5K in Roth IRA.

Total reduction in take-home pay = 18K + 4.5K + 5.5K = 28K

2) 18K Trad. 401K, 4.5K tax saving. 5.5K in Roth IRA

The total reduction in take-home pay = 18K + (5.5K - 4.5K) = 19K

The difference is 9K. It is substantial.

KlangFool
Your math is wrong. #2 shoudl be 18k + 5.5 = 23.5k. The total reduction is 4.5k.
Evilmagus,

No, I am correct. The 4.5K portion of the 5.5K is funded by the 4.5K tax savings.

KlangFool
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Miriam2
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Re: Traditional vs Roth

Post by Miriam2 »

iceport wrote:The marginal vs. effective or average rate is a valid point, but even that is less important for some than it is for others — those with pensions, for example. Future tax rates, future tax treatments, huge variations in income (necessitated by spending spikes, for example) all contribute to the uncertainty. That's why, despite advocating that people make some reasonable assumptions to make an informed choice, I also advocate the benefits of "tax diversification," having multiple types of accounts with different tax treatments that can be tapped advantageously during retirement.
Iceport, could you explain what you mean with this, how people with pensions (I assume you mean old-fashioned pensions) would be different for this?

Is it because they have a guaranteed future income so that diversifying the future tax treatment pots has a different factor to consider?
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Pranav
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Re: Traditional vs Roth

Post by Pranav »

Another benefit of Traditional contribution is that you can do Roth conversions at lower tax rate when you work less due to job-loss, illness, pregnancy, and/or early-retirement.
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avalpert
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Re: Traditional vs Roth

Post by avalpert »

Hunter123 wrote: If I keep growing my retirement accounts for another 20 years or so maxing out the 401k, would the tax free growth of Roth supersede the lower tax bracket savings of traditional in retirement?
No, mathematically this will never happen. If the tax rate is the same - whether you pay it now before investing or on the total including investment returns in the future is irrelevant, the result will be exactly the same. If the tax rate is lower in the future (and yes that means marginal rate on each dollar) it will always be better to defer taxes no matter how long it is growing.
Evilmagus
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Re: Traditional vs Roth

Post by Evilmagus »

KlangFool wrote:
Evilmagus wrote:
KlangFool wrote:
rbaldini wrote:
KlangFool wrote:
Assuming 25% marginal tax rate.

1) 18K Roth 401K cost 4.5K in tax. Another 5.5K in Roth IRA.

Total reduction in take-home pay = 18K + 4.5K + 5.5K = 28K

2) 18K Trad. 401K, 4.5K tax saving. 5.5K in Roth IRA

The total reduction in take-home pay = 18K + (5.5K - 4.5K) = 19K

The difference is 9K. It is substantial.

KlangFool
Your math is wrong. #2 shoudl be 18k + 5.5 = 23.5k. The total reduction is 4.5k.
Evilmagus,

No, I am correct. The 4.5K portion of the 5.5K is funded by the 4.5K tax savings.

KlangFool
It doesn't matter if they use their tax savings on the Roth IRA or on hookers and cocaine. Money doesn't magically double just because you double count it.
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iceport
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Re: Traditional vs Roth

Post by iceport »

Miriam2 wrote:
iceport wrote:The marginal vs. effective or average rate is a valid point, but even that is less important for some than it is for others — those with pensions, for example. Future tax rates, future tax treatments, huge variations in income (necessitated by spending spikes, for example) all contribute to the uncertainty. That's why, despite advocating that people make some reasonable assumptions to make an informed choice, I also advocate the benefits of "tax diversification," having multiple types of accounts with different tax treatments that can be tapped advantageously during retirement.
Iceport, could you explain what you mean with this, how people with pensions (I assume you mean old-fashioned pensions) would be different for this?
Hi Miriam2,

It's just that the pension income — and yes, I mean an old-fashioned defined benefit pension — might fill the lower tax bracket(s) during retirement. The pension income is guaranteed, not subject to change by the beneficiary. So any pre-tax retirement plan withdrawals on top of the pension income might be taxed at, or at least a whole lot closer to, the retiree's marginal tax bracket. Though smaller, the pension income during retirement is analogous to the worker's income used for living expenses during the accumulation phase. In such a case, it makes sense to me that the tax rate for the withdrawals should be assumed to be higher than the effective tax rate as we typically define it, quite possibly as high as the marginal tax rate.
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KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

Evilmagus wrote:
It doesn't matter if they use their tax savings on the Roth IRA. Money doesn't magically double just because you double count it.
Evilmagus,

Did you read the original question?

The question was with 25% marginal tax rate, how much money do you need in order to

A) Contribute to Roth 401K and Roth IRA

versus

B) Contribute to Trad. 401K and Roth IRA.

In (A), you have to pay 4.5K in tax and come up additional 5.5K for Roth IRA.

In (B), you save 4.5K in tax and use that for the Roth IRA. So, you only need to come up 5.5K - 4.5K = 1K for Roth IRA.

So, the difference is 2 X 4.5K = 9K. Since the difference is huge aka 9K per year, many people that contribute to Roth 401K will not have the money to contribute 5.5K to Roth IRA.

KlangFool
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Re: Traditional vs Roth

Post by Miriam2 »

iceport wrote:The marginal vs. effective or average rate is a valid point, but even that is less important for some than it is for others — those with pensions, for example. . . .
It's just that the pension income — and yes, I mean an old-fashioned defined benefit pension — might fill the lower tax bracket(s) during retirement. The pension income is guaranteed, not subject to change by the beneficiary. So any pre-tax retirement plan withdrawals on top of the pension income might be taxed at, or at least a whole lot closer to, the retiree's marginal tax bracket. Though smaller, the pension income during retirement is analogous to the worker's income used for living expenses during the accumulation phase. In such a case, it makes sense to me that the tax rate for the withdrawals should be assumed to be higher than the effective tax rate as we typically define it, quite possibly as high as the marginal tax rate.
Thank you for the explanation.

And yes, now I see this - I believe this is kind of what happened to us. My husband retired with a full pension, began collecting social security, then missed his profession and co-workers so much he went back to work, almost full time. He has to take out RMDs from his employer plan rollover. We now have the "unfortunate" problem of earning more money now "in retirement" than when he "worked" full time and we are now in a higher tax bracket than when he was working full time. I see the value of diversifying future tax accounts because one never knows what will happen.
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Re: Traditional vs Roth

Post by grabiner »

iceport wrote:
Hunter123 wrote:I expect my tax bracket will be lower in retirement, which would make traditional more advantageous but a certain financial advisor has repeatedly lauded the tax-free growth aspect of Roth. If I keep growing my retirement accounts for another 20 years or so maxing out the 401k, would the tax free growth of Roth supersede the lower tax bracket savings of traditional in retirement?
Your advisor is doing a poor job of explaining the issue, and it's possible he doesn't understand it well. (Once you grasp the essence of this concept, you might be disappointed in the advisor.)
I would say that his statement is right for the wrong reason.

If you contribute $18,000 to a Roth, you will be better off in retirement than if you contribute $18,000 to a traditional account. This is right, but not a fair comparison; if you contribute $18,000 to a traditional account and are in a 25% tax bracket, you will have $4500 more to spend (or to invest somewhere else) this year.

The fair comparison is putting $18,000 into traditional or $13,500 into Roth; both cost the same $13,500 out of pocket. If you retire in a 15% tax bracket, the traditional account is better. If you retire in a 25% tax bracket, it is break-even.
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teen persuasion
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Re: Traditional vs Roth

Post by teen persuasion »

KlangFool wrote:
Evilmagus wrote:
It doesn't matter if they use their tax savings on the Roth IRA. Money doesn't magically double just because you double count it.
Evilmagus,

Did you read the original question?

The question was with 25% marginal tax rate, how much money do you need in order to

A) Contribute to Roth 401K and Roth IRA : 18,000 + 5500 + .25(23,500) = 23,500 + 5875 = 29,375

versus

B) Contribute to Trad. 401K and Roth IRA. : 18,000 + 5500 + .25(5500) = 23,500 + 1375 = 24,875

29,375 - 24,875 = 4500


In (A), you have to pay 4.5K in tax and come up additional 5.5K for Roth IRA.

In (B), you save 4.5K in tax and use that for the Roth IRA. So, you only need to come up 5.5K - 4.5K = 1K for Roth IRA.

So, the difference is 2 X 4.5K = 9K. Since the difference is huge aka 9K per year, many people that contribute to Roth 401K will not have the money to contribute 5.5K to Roth IRA.

KlangFool
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Re: Traditional vs Roth

Post by KlangFool »

teen persuasion wrote:
KlangFool wrote:
Evilmagus wrote:
It doesn't matter if they use their tax savings on the Roth IRA. Money doesn't magically double just because you double count it.
Evilmagus,

Did you read the original question?

The question was with 25% marginal tax rate, how much money do you need in order to

A) Contribute to Roth 401K and Roth IRA : 18,000 + 5500 + .25(23,500) = 23,500 + 5875 = 29,375

versus

B) Contribute to Trad. 401K and Roth IRA. : 18,000 + 5500 + .25(5500) = 23,500 + 1375 = 24,875

29,375 - 24,875 = 4500


In (A), you have to pay 4.5K in tax and come up additional 5.5K for Roth IRA.

In (B), you save 4.5K in tax and use that for the Roth IRA. So, you only need to come up 5.5K - 4.5K = 1K for Roth IRA.
,

So, the difference is 2 X 4.5K = 9K. Since the difference is huge aka 9K per year, many people that contribute to Roth 401K will not have the money to contribute 5.5K to Roth IRA.

KlangFool
teen persuasion,

Thanks for the correction. I made a mistake. I double counted. So, the difference is $4,500.

KlangFool
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teen persuasion
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Re: Traditional vs Roth

Post by teen persuasion »

KlangFool, you are welcome!

I believe your original point still holds true. Contributing to the traditional 401k is a way to create tax benefits that can then be contributed to a Roth IRA for greater savings and diversification. That is our path, despite spending many years nominally in the zero fed bracket.

Contributions to DH's traditional 401k lowered our AGI to where we could capture greater refundable tax credits. Those credits I turn around and plow into Roth IRAs for both of us.

Lowered AGI is important for FAFSA purposes, too, for us; we can qualify for the Simplified Needs Test that ignores assets.
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FiveK
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Re: Traditional vs Roth

Post by FiveK »

rbaldini wrote:And, to repeat, Tax1 is your current marginal tax rate. Tax2 is your *average* retirement tax rate....
iceport wrote:The marginal vs. effective or average rate is a valid point....
I'm guessing you heard that somewhere and it seemed reasonable.

It does seem reasonable, but it's actually not true. See Traditional versus Roth#Marginal_tax_rates, Fundamental Difference in Roth and Traditional 401k (read down to the "OMG I get it" part), etc.

Do you recall where you first heard that it should be marginal vs. average? That misinformation keeps popping up, and it would be good to understand where it comes from.
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iceport
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Re: Traditional vs Roth

Post by iceport »

FiveK wrote:
rbaldini wrote:And, to repeat, Tax1 is your current marginal tax rate. Tax2 is your *average* retirement tax rate....
iceport wrote:The marginal vs. effective or average rate is a valid point....
I'm guessing you heard that somewhere and it seemed reasonable.

It does seem reasonable, but it's actually not true. See Traditional versus Roth#Marginal_tax_rates, Fundamental Difference in Roth and Traditional 401k (read down to the "OMG I get it" part), etc.

Do you recall where you first heard that it should be marginal vs. average? That misinformation keeps popping up, and it would be good to understand where it comes from.
I'm not exactly sure where I heard it first, but it could very well have been here. That idea comes up here occasionally, and elsewhere. Even the white coat investor makes this claim:
But thanks to the fact that not only are you likely to have a lower marginal rate in retirement, but also the fact that you contribute at your marginal rate and withdraw at your effective tax rate, most doctors in their peak earning years are going to be better off deferring taxes whenever possible.
But as far as the explanation as to why it isn't true, I must admit it isn't clear at all to me. Tax brackets are big and discrete, not a continuous. What makes sense to me is that the more other retirement income you have, the more it makes sense to consider the marginal tax rate at withdrawal when evaluating the choice. Theoretically, if 100% of all retirement income will come from pre-tax accounts (this is not realistic, of course), wouldn't it be the correct to consider the effective tax rate at withdrawal?
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
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FiveK
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Re: Traditional vs Roth

Post by FiveK »

iceport wrote:I'm not exactly sure where I heard it first, but it could very well have been here. That idea comes up here occasionally, and elsewhere. Even the white coat investor makes this claim:
But thanks to the fact that not only are you likely to have a lower marginal rate in retirement, but also the fact that you contribute at your marginal rate and withdraw at your effective tax rate, most doctors in their peak earning years are going to be better off deferring taxes whenever possible.
Thanks. Seems there are a few bloggers who aren't communicating correctly. There was a similar discussion in the MMM forum that mentioned WCI's post.
But as far as the explanation as to why it isn't true, I must admit it isn't clear at all to me. Tax brackets are big and discrete, not a continuous. What makes sense to me is that the more other retirement income you have, the more it makes sense to consider the marginal tax rate at withdrawal when evaluating the choice. Theoretically, if 100% of all retirement income will come from pre-tax accounts (this is not realistic, of course), wouldn't it be the correct to consider the effective tax rate at withdrawal?
Even if 100% of retirement income will come from pre-tax accounts, one should compare marginal vs. marginal for each new year's contribution.

One way WCI and others err is by comparing all contributions and withdrawals as if made in big lump sums. If one had to make a career-long decision on Roth vs. traditional, that comparison might be valid. But that's now how things work. We get to make this decision anew each year - for that matter, with each dollar we contribute, but let's stick with "yearly" for now.

It's relatively easy to see that "other" retirement income (e.g., a pension) pushes tIRA withdrawals into higher brackets, and that alone is enough to show that "marginal vs. average" is incorrect for years in which one will receive a pension.

It takes a closer look to see that previous traditional contributions, by themselves, also establish a base for retirement income above which withdrawals due to any new traditional contributions will be taken. Ok, that's a mouthful, so let's try an example.

Take a single person contributing $23.5K/yr for 26 years, earning 5%/yr. That gives a $1.2MM balance. If they were to retire and withdraw 4%/yr that would be $48K/yr. After subtracting $10,350/yr for standard deduction and exemption, that's $37,650/yr. The tax on $37,650 is ~$5,184 or 10.8%. But, $37,650 is also the start of the 25% bracket, so any additional income will be taxed at 25%.

Instead of retiring, in year 27 the person continues to work and again has a choice of traditional or Roth. Assume they are now in the 15% bracket. Using marginal vs. average the comparison would be 15% vs. 10.8% and the choice would be traditional. Using marginal vs. marginal the comparison would be 15% vs. 25% and the choice would be Roth. Because an additional year's traditional contribution would cause (again, assuming a 4% WR) taxable income to increase above $37,650, the marginal rate applies and the year 27 contribution should be Roth.

A few points:
* 26 years of maximum contributions is a lot. Many people won't do that and, lacking a pension, traditional will always be better for them
* For those who do have a significant pension, it becomes easier to justify using Roth
* This is the quantitative comparison. Qualitative issues (e.g., no penalty for early withdrawal of Roth contributions; less downside if one chooses traditional but retirement income isn't as high as expected) can be used to argue either way.

Back to the WCI post: down in the comments he does say "Technically it is marginal to marginal, but it’s marginal to marginal for every dollar" but then goes on to say that for someone saving 39.6% traditional will probably be better no matter how one looks at it....

Does all that make sense?
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Re: Traditional vs Roth

Post by iceport »

FiveK wrote:Does all that make sense?
Yes, it does (mostly) FiveK. Thanks for the explanation. I certainly understand the issues you described above. But I am also struck by the enormous uncertainty inherent in almost all of the assumptions made in the example(s). So the whole notion that the analysis is precise enough to vary from year to year seems unrealistic, until very close to retirement.

But you have made your point. I will no longer give the "effective tax rate at withdrawal" advice tacit approval. But it is important for everyone struggling with this question to consider not only the *anticipated* tax conditions in retirement, but also the *enormous uncertainty* in approximating them.
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Re: Traditional vs Roth

Post by FiveK »

iceport wrote:... it is important for everyone struggling with this question to consider not only the *anticipated* tax conditions in retirement, but also the *enormous uncertainty* in approximating them.
No argument there!

The "less bad result" of choosing traditional when Roth would have been better, compared with the opposite situation, is enough for me to have "use traditional" as a knee-jerk response to a generic "what should I do?" question. But for someone who is far enough along to have reduced uncertainty, at least we can help them use the proper analysis technique.
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