Roth vs pre-tax with higher income in the future

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diverdoc
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Joined: Tue May 16, 2017 10:46 pm

Roth vs pre-tax with higher income in the future

Post by diverdoc » Wed May 17, 2017 5:48 pm

Greetings,

I'm new to the Bogleheads forum but wanted to see if anyone might have some advice to help my wife and I as we start planning for retirement. After reviewing the articles and forum posts I hadn't seen something quite similar to our situation. I'm currently active duty in the Navy as a doctor (pre-residency) and my wife is entering residency this coming July as a civilian. We have estimated expenses of about $66k a year with a take-home pay of $145k-$160k over the next three years but with a taxable income of $90k-$130k combined (due to Navy tax-free entitlements). We would like to have 3 months expenses for an emergency fund given our essentially stable jobs and save up for a 20% house down payment anywhere from $60k-$100k depending on where we end up moving in three years to continue our post-graduate training. We obviously know that we will significantly higher earners upon completing our training over the next 10 years. Typically the adage is the put Roth money away when your income taxes are low, however as I've been reading on the articles and forum posts here, there's a possibility of being in a lower tax bracket (especially for early retirees) or ideally in the same tax bracket as we currently are in at 25%.

Our current retirement savings are less than ideal at 4-figures (paying off student loans for him, still in school for her, financing our wedding on our own) but will change now that she will be receiving a paycheck. Our plan for paying down debt is to stay the course on my low interest loans which are currently going to be paid off in 2 years but to do income based repayment on her $200k as she is in a medical specialty that caters to academics and plan on public service loan forgiveness in 10 years. We are filing separately in our current financial situation because no matter how the math is worked out with pre-tax contributions or not, it comes out ahead: we save anywhere from $4k-$7k annually over the next three years filing separately accounting for any tax benefits on filing jointly.

I'm more primarily concerned over the next 3 years while my taxable income is at higher end of 25%/lower end of the 28% tax bracket as to whether to make Roth over pre-tax contributions for a retirement account. I see the pluses and minuses in both and have done simulations on doing a Roth conversion ladder later down the road, however with knowing that we'll likely contribute max with pre-tax dollars in our 401k when we become higher earners, I'm a little concerned about the sheer amount in that 401k upon retirement (paying similar taxes or higher taxes on Roth conversions and not making any headway, or worse a high tax bill when RMDs kick in). On the plus side, we free up $20k in taxes due/adjusted income based loan payments over the three year span which we could start contributing towards a taxable account vs savings account for our house down payment.

Question 1: The issue I'm debating is whether saving only the pre-tax dollars that would otherwise be taxed at 25% provides a clear advantage or is it safer to hedge on higher a tax bracket in retirement.

Question 2: Given the additional option of a O% down/No PMI VA loan should we face a bear market during time of a home purchase, is it worthwhile to put a house down payment into a taxable account?

Speculation on taxes especially 20+ years from now is always difficult and I understand this, but I was wondering if anyone could help provide some sound logic on how to move forward in a financially sound manner. It should be noted that we will have years 4-6 at a significantly lower income (55k salary each without any tax-free entitlements) because of residency/fellowship training.

Emergency funds: $16,500 (three months expenses, already saved)
Debt: His student loans ($46,000 at average 3.75% interest), Her student loans ($211,000 at 6.8% interest, on income based repayment)
Expenses: $5,500 monthly
Tax Filing Status: Married Filing Separately
Tax Rate: Federal: His 25%, Her 15% State: His 0%, Her 7.5%
State of Residence: His - Florida, Her California (we both technically live in California)
Age: 27
Desired Asset allocation: 80-100% equity allocation heavier on Large Cap and splitting the remainder between Small Cap, Total International, and REITs

Current retirement assets

His Backdoor Roth IRA at Vanguard
54% Vanguard Total Market ETF (VTI) (expense ratio 0.04%)
46% Vanguard Total International ETF (VXUS) (expense ratio 0.11%)

Asset allocation currently TBD though looking for more of a 80-100% equity allocation heavier on Large Cap and splitting the remainder between Small Cap, Total International, and REITs

Contributions

New annual Contributions
$18,000 his 401k (5% match)
$0 her 403b (no match) initially, then $6,492 and $7,961 in the following two years for income taxed at 25% tax rate
$5,500 his backdoor Roth IRA
$18,000 her Mega-backdoor Roth IRA (up to $59,500), then $16,471 and $12,888 in following two years
7.5% gross income (pre-tax) her defined contributions plan
$variable taxable - if any income remaining

*Mega-backdoor Roth IRA limit is actually her gross annual salary subtracted from her mandatory 7.5% pre-tax contribution and 403b contribution for each year but for the purpose of this argument we'll pretend like its an alternative to maxing out her 403b.

Available funds

Funds available in his 401(k) (TSP)
Common Stock Index (C fund) (expense ratio 0.025)
International Stock Index (I fund) (expense ratio 0.025)
Small Cap Stock Index (S fund) (expense ratio 0.025)
Fixed Income Index (F fund) (expense ratio 0.025)
Government Securities Index (G fund) (expense ratio 0.025)

Her 403b/457b at Fidelity (ER TBD--she hasn't started employment yet and fund performances aren't disclosed without a login)
UC Target Date 2055
UC Savings Fund
UC Bond Fund
UC Short Term TIPS Fund
UC TIPS Fund
UC Balanced Growth Fund
UC Domestic Equity Index Fund
Fidelity Growth Company Fund - Class K
Vanguard FTSE Social Index Fund - Institutional Shares
Vanguard Small-Cap Index Fund - Institutional Plus Shares
UC International Equity Index Fund
UC Global Equity Fund
Fidelity® Diversified International Fund - Class K
DFA Emerging Markets Portfolio
Vanguard REIT Index Fund - Institutional Shares
Last edited by diverdoc on Fri May 19, 2017 6:54 pm, edited 2 times in total.

lazylarry
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Re: Roth vs pre-tax with higher income in the future

Post by lazylarry » Wed May 17, 2017 7:12 pm

-Read White Coat Investor if you haven't already.
-I assume you are talking about Roth IRA vs 401k contributions
-also assume you are contributing up to match in 401k
-I think you will get differing opinions here. While you are still in the 25% tax bracket, it's slightly unclear whether you will be in a higher or lower tax bracket by retirement. I think you probably will be if you/wife do max out 401k continuously or even get SEP/SIMPLE IRA if working in private practice, and are converting from 401k to Roth in retirement. Given that, I think it's worth it to contribute to Roth IRA. However, some people would also contribute to 401k and then use the "saved" funds to contribute to the Roth IRA. It's probably a crapshoot and not predictable IMHO - you can't go super wrong either way also since it's a short period of time. But definitely if you are in the 28% tax bracket, then you would likely need to start focusing on 401k - I think it is much less likely you will make it up to that tax bracket in retirement.
Asking questions: https://www.bogleheads.org/forum/viewtopic.php?f=1&t=6212 | My profile: https://www.bogleheads.org/forum/memberlist.php?mode=viewprofile&u=86026

diverdoc
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Joined: Tue May 16, 2017 10:46 pm

Re: Roth vs pre-tax with higher income in the future

Post by diverdoc » Thu May 18, 2017 2:03 am

Thanks for your reply!

I was referring primarily for Roth vs "traditional" 401k (TSP) for myself. We file separately (at least for now) due to optimizing income-based loan payments w/ public service loan forgiveness in 10 years. We actually have multiple retirement account options which makes it difficult. Navy offers a Roth TSP option (new 5% match is rolling out in 2018 so no brainer there regardless of pre-tax or Roth contributions) so I can max out TSP in addition to a backdoor Roth IRA. My wife on the other hand has more retirement options than we have for contributions: defined contributions plan allowing after-tax contributions up to $54k with in-service transfers for a Roth IRA rollover (megaroth backdoor IRA), backdoor Roth IRA, and optional 403b as well as 457b plans. Therefore combined we have maximum of $83k we could put in Roth contributions or $54k in pre-tax contributions, however those are only theoretical as her actual gross salary wouldn't permit us to contribute up to those amounts. There would only be one year in which I personally would be in low 28% bracket/high end of 25% until 10 years from now. I think hedging on the future earnings throwing us into higher tax brackets in retirement makes sense to me, and in addition Roth opens more options for tax-free inheritance for children/grandchildren which is important to me. I've also explored just taking out pre-tax contributions on income that would otherwise be taxed at the 25% bracket which does free up some cash for Roth/taxable account. It does make it a little more difficult in prioritizing a house down payment but I'm exploring some increased income streams (moonlighting urgent care, etc.) so that may fill the gap.

lazylarry
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Re: Roth vs pre-tax with higher income in the future

Post by lazylarry » Thu May 18, 2017 5:33 pm

Thanks for your reply!

I was referring primarily for Roth vs "traditional" 401k (TSP) for myself.

I think most of what I said before applies.

We file separately (at least for now) due to optimizing income-based loan payments w/ public service loan forgiveness in 10 years.

Don't know a ton about filing separately, but would also consider loss of certain itemized deductions, and also that you are paying taxes on a higher tax bracket. I haven't heard of a ton of folks doing MFS and actually benefiting from that in situations similar to yours.

We actually have multiple retirement account options which makes it difficult. Navy offers a Roth TSP option (new 5% match is rolling out in 2018 so no brainer there regardless of pre-tax or Roth contributions) so I can max out TSP in addition to a backdoor Roth IRA.

Not sure if your MAGI exceeds Roth limits, you may be ok. But yes, matching Roth TSP, and contributing to either Roth TSP or traditional TSP makes sense.

My wife on the other hand has more retirement options than we have for contributions: defined contributions plan allowing after-tax contributions up to $54k with in-service transfers for a Roth IRA rollover (megaroth backdoor IRA), backdoor Roth IRA, and optional 403b as well as 457b plans. Therefore combined we have maximum of $83k we could put in Roth contributions or $54k in pre-tax contributions, however those are only theoretical as her actual gross salary wouldn't permit us to contribute up to those amounts. There would only be one year in which I personally would be in low 28% bracket/high end of 25% until 10 years from now. I think hedging on the future earnings throwing us into higher tax brackets in retirement makes sense to me, and in addition Roth opens more options for tax-free inheritance for children/grandchildren which is important to me. I've also explored just taking out pre-tax contributions on income that would otherwise be taxed at the 25% bracket which does free up some cash for Roth/taxable account. It does make it a little more difficult in prioritizing a house down payment but I'm exploring some increased income streams (moonlighting urgent care, etc.) so that may fill the gap.

Wow a lot of options. I think you'd need to post more info as per the sticky in my sig to give the clearest advice, along with fund choices in various a/cs. But from what you've told, if you are in the 28% tax bracket, I would match the Roth TSP and then contribute to TSP. If your wife is in the 25%, then she could contribute to the 403b and/or Roth IRA. If in the 28%, would contribute to the 403b.

The reason why you will likely never make it to the 28% tax bracket is because once you are MFJ in retirement, to make it to the 28% tax bracket, you will need to be withdrawing at least 151k yearly, not even including all the deductions that might apply then when you are itemizing (vs now you are just taking standard, I assume). That means your retirement account might have around 3.5 million when you hit retirement, given a 4% withdrawal rate. Do you think you will have that much? Using a rough guesstimate based on Portfolio Visualizer, you would probably have around 3 million if things are ok. Plus you have to consider state taxes.
Asking questions: https://www.bogleheads.org/forum/viewtopic.php?f=1&t=6212 | My profile: https://www.bogleheads.org/forum/memberlist.php?mode=viewprofile&u=86026

KlangFool
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Re: Roth vs pre-tax with higher income in the future

Post by KlangFool » Thu May 18, 2017 5:52 pm

OP,

Do you have the money to contribute to Roth IRA if you contribute to Roth TSP? If the answer is no, then, the answer is clear.

If you contribute to Trad. TSP, you have money to contribute to Roth IRA. Then, you have money in both tax buckets: Tax Deferred and Roth. You have tax diversity.

At 28% tax bracket, usually, it is the wrong decision to contribute to Roth TSP. You will pay more tax than necessary.

KlangFool

Fishing50
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Re: Roth vs pre-tax with higher income in the future

Post by Fishing50 » Fri May 19, 2017 12:14 am

Your current tax situation is unfamiliar territory.

Tax deferred TSP is better if you plan to actually retire when eligible. Roth is probably better if you plan a second career after military retirement because wages + retirement pay will move you into 33% tax bracket.

Target low taxable income years for Roth TSP.
-Residency/fellowship might be an opportunity. MFJ about $95K is the top of the 15% tax bracket. If expenses are low enough, you could save $18K in Roth TSP and $11K in Roth IRA paying only 15% taxes.
-Deployments will opportunities for Roth TSP contributions. Here's an extreme example:
https://www.bogleheads.org/forum/viewtopic.php?f=1&t=214218&p=3298149

White Coat Investor converted tax-exempt TSP contributions to Roth:
http://whitecoatinvestor.com/how-to-get-your-tax-exempt-tsp-money-in-to-a-roth-ira/
It's perfectly legal, go ask the IRS, they'll say the same thing. I actually feel stupid telling you this, I'm sure you would've investigated the matter yourself. Andy Dufresne

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celia
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Re: Roth vs pre-tax with higher income in the future

Post by celia » Fri May 19, 2017 3:58 am

diverdoc wrote:Speculation on taxes especially 20+ years from now is always difficult and I understand this, but I was wondering if anyone could help provide some sound logic on how to move forward in a financially sound manner. It should be noted that we will have years 4-6 at a significantly lower income (55k salary each without any tax-free entitlements) because of residency/fellowship training.

It looks like this is your implied question. It also looks like you've put a lot of thought into the traditional vs Roth trade-offs and understand them well.

You are correct in that it is better to contribute to Roth when your tax rate is lower. For you, that is now--lower pay while in the military and in training.
You are correct in that early retirees can take advantage of Roth conversions since their income is lower. But at that time, the amount to be converted is so much bigger because it had time to grow, that many cannot get it all converted. In your case, you are unlikely to "retire early" since doctors get such a late start in starting their careers (and usually enjoy what they do). You will have fewer working years even if you retire at a normal working age of 62 or 65.

You also seem to be aware of wanting tax diversity--some of the money in tax-deferred and some in Roth--at the time you retire. Since you will likely be putting fewer "absolute" dollars in Roth over your working career, it is best to get them in early and start them growing. Here's another thought regarding tax-diversity for the present:

You are already getting $30K to $55K tax-free while you have the Navy entitlements. If I had that, I wouldn't mind taking half of it and paying taxes on it while putting it in a Roth. (I would use some of the other half to pay for the taxes on that contribution.) Of course, if you contribute it to a Roth TSP, it has to be withheld from your paycheck.

By the time you decide to settle down and buy a house, you will be able to save that down payment easily, so don't worry about that for now.

I assume you are familiar (or can easily learn about) the "backdoor Roths". Both of you will want to keep money out of tax-deferred IRAs, except for the non-deductible contributions that you will convert the next day.
https://www.bogleheads.org/wiki/Backdoor_Roth_IRA
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

The Wizard
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Re: Roth vs pre-tax with higher income in the future

Post by The Wizard » Fri May 19, 2017 4:59 am

It's hard to predict future taxation, even if the bracket structure remains essentially the same.
I'm in the low part of 28% Federal bracket in retirement after being in upper part of 25% bracket much of my working years.
Had I retired five years earlier with less in tax deferred, I could have stayed in the 25% bracket in retirement. As it turned out, I had decently large tax deferred accumulation and negligible taxable account at start of retirement.

In the OP's case, I think you'll have a large taxable account accumulation once you exit the Navy and begin doctoring in private practice. This obviously because of limits on 401(k) contributions even with income four times higher.

So you might be able to retire early with only a modest amount in tax deferred accounts, thus 25% or lower marginal tax bracket in retirement. Hard to predict at this point what your mindset will be at age 45 or so...
Attempted new signature...

diverdoc
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Re: Roth vs pre-tax with higher income in the future

Post by diverdoc » Fri May 19, 2017 4:35 pm

Fishing50 wrote:Your current tax situation is unfamiliar territory.

Tax deferred TSP is better if you plan to actually retire when eligible. Roth is probably better if you plan a second career after military retirement because wages + retirement pay will move you into 33% tax bracket.

Target low taxable income years for Roth TSP.
-Residency/fellowship might be an opportunity. MFJ about $95K is the top of the 15% tax bracket. If expenses are low enough, you could save $18K in Roth TSP and $11K in Roth IRA paying only 15% taxes.
-Deployments will opportunities for Roth TSP contributions. Here's an extreme example:
https://www.bogleheads.org/forum/viewtopic.php?f=1&t=214218&p=3298149

White Coat Investor converted tax-exempt TSP contributions to Roth:
http://whitecoatinvestor.com/how-to-get-your-tax-exempt-tsp-money-in-to-a-roth-ira/


Thanks for your reply! I've been following WCI since I was an undergraduate student. I am actually more likely to separate from the military once my current obligation is due in 3 years so not depending on retirement pay other than our retirement/taxable accounts.Expenses are low enough that we are able to max out TSP and do backdoor Roth IRAs for both of us (can't go normal route because MFS) and also put any remainder into Megabackdoor Roth option through after-tax DCP vs a taxable account. I think because of how diverse the options are, we're considering contributing to pre-tax retirement accounts up only the amount of income that would otherwise be taxed at 25% (frees up $20k extra in cash on taxes which can then be contributed to Roth accounts), but weren't certain if we could match or be in a lower tax bracket upon retirement.

diverdoc
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Re: Roth vs pre-tax with higher income in the future

Post by diverdoc » Fri May 19, 2017 4:49 pm

celia wrote:You are correct in that it is better to contribute to Roth when your tax rate is lower. For you, that is now--lower pay while in the military and in training.
You are correct in that early retirees can take advantage of Roth conversions since their income is lower. But at that time, the amount to be converted is so much bigger because it had time to grow, that many cannot get it all converted. In your case, you are unlikely to "retire early" since doctors get such a late start in starting their careers (and usually enjoy what they do). You will have fewer working years even if you retire at a normal working age of 62 or 65.


I've run some initial simulations on this. There is a possibility that once RMDs kick in that I could theoretically remain below the exemption/deductions amount on the RMDs but assuming that our pre-tax contributions were limited to $36k/year once we became full staff physicians and starting to work part time at age 55...an option I might consider but as you say, I love my current job.

celia wrote:By the time you decide to settle down and buy a house, you will be able to save that down payment easily, so don't worry about that for now.


This is actually a little bit of concern for us. We intend to purchase a home once we begin years 4-6 (55k salary each during this time frame) because it is the most logical time where we are guaranteed 5 years in one particular area (I suppose also dependent on housing market at the time as well). Saving up for a down payment will definitely come into play here. One option we've considered is to put in into taxable account with the option of the 0% down/no PMI VA loan if the stock market was low during that time frame. Or play it safe and store cash away in a 1% savings account.

celia wrote:I assume you are familiar (or can easily learn about) the "backdoor Roths". Both of you will want to keep money out of tax-deferred IRAs, except for the non-deductible contributions that you will convert the next day.
https://www.bogleheads.org/wiki/Backdoor_Roth_IRA


Very familiar and plan to implement it with Vanguard and through Fidelity through my wife's after-tax DCP (in-service withdrawals). I think overall it does make sense to move forward with primarily Roth contributions given higher earnings coming our way during working years. But I'm curious the argument for putting away pre-tax dollars that would otherwise be taxed at 25%.
Last edited by diverdoc on Fri May 19, 2017 6:52 pm, edited 1 time in total.

diverdoc
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Re: Roth vs pre-tax with higher income in the future

Post by diverdoc » Fri May 19, 2017 4:52 pm

The Wizard wrote:It's hard to predict future taxation, even if the bracket structure remains essentially the same.
I'm in the low part of 28% Federal bracket in retirement after being in upper part of 25% bracket much of my working years.
Had I retired five years earlier with less in tax deferred, I could have stayed in the 25% bracket in retirement. As it turned out, I had decently large tax deferred accumulation and negligible taxable account at start of retirement.

In the OP's case, I think you'll have a large taxable account accumulation once you exit the Navy and begin doctoring in private practice. This obviously because of limits on 401(k) contributions even with income four times higher.

So you might be able to retire early with only a modest amount in tax deferred accounts, thus 25% or lower marginal tax bracket in retirement. Hard to predict at this point what your mindset will be at age 45 or so...


I don't think true early retirement will be in my future. I will have only been practicing for maybe 7-8 years as a staff physician by age 45. What is more likely is scaling back to something part time (potentially Roth conversions if it keeps me in the 25% bracket). But as you say, I may still be desiring to practice up to retirement which can cause some issues with RMDs at age 70. 1st world problems...

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