Self employed- Roth vs. Traditional

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Topic Author
InquiringInvestor18
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Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Sun Apr 01, 2018 10:07 pm

Alright, guys, here goes. I’m working on figuring out Roth vs. Traditional. Feel free to direct me to a similar post. If there is one, I couldn’t find it. Also, let me know if there’s anything I left out that would help you better answer this question.

I’m:
• Around 30 years old.

• Currently in the 24% tax bracket ($165K-315K), effective was 18%.

• Self-employed with an S-Corp, and I have an individual 401(k), with the ability to invest up to 55,000 (obviously the max for Roth would be 18,500, with traditional making up the rest).

Other notes:
• Up to this point, I have mostly been investing in Roth accounts. (I currently have about 65K in Roth, 20K in Traditional.) With my individual 401(k), I have both the Traditional and the Roth option, so income limits on the Roth isn’t an issue.

• Until recently, I have planned to do a Roth conversion ladder upon partial retirement. I would like the option to retire early, but I really don’t know that I will stop working, or even slow down, before I hit 60, so I don’t know that I will have any low-income period. Because of this, is planning for this the best idea?

• I plan on my 1040 Schedule A deductions as a percentage of my taxable income increasing significantly over the next 30 years, which should lower my tax bracket, even if I don’t stop working. I plan on charitable giving being up to 50% of my income (it is currently at about 20%), which means my income would have to increase exponentially for me to have a higher tax bracket at retirement than right now.

I’ve studied and seen that many people recommend going all-out on traditional, to take the tax deductions now, and then investing an amount to cover taxes in a taxable account. This is generally the recommendation when someone has the normal limit of 18,500. Since I can contribute much more to my 401(k), should I put everything I save into traditional, and just know that I will take the tax hit on retirement?

With the information I’ve given, what would you suggest? Thank you in advance for your time.

NightFall
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Re: Self employed- Roth vs. Traditional

Post by NightFall » Mon Apr 02, 2018 6:18 am

I think most would suggest you go traditional at this level of income. The question is whether you think you tax bracket in retirement will be higher or lower than you current tax bracket. Keep in mind that you start at the 0% tax bracket in retirement (at least under current law). So it's useful to have traditional accounts to fill lower tax brackets. You can always fill low income years between retirement and the start of social security with roth conversions to take advantage of these lower tax brackets. If it is the case that your tax bracket in retirement is higher than your current tax bracket with all of those traditional contributions, ... well, it seems like you won the game anyway. There are some advantages (under current law) about making charitable contributions directly from retirement accounts as well. So that 50% giving rate can potentially go further in that case as well.

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FiveK
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Re: Self employed- Roth vs. Traditional

Post by FiveK » Mon Apr 02, 2018 9:40 am

InquiringInvestor18 wrote:
Sun Apr 01, 2018 10:07 pm
• Currently in the 24% tax bracket ($165K-315K), effective was 18%.
InquiringInvestor18, welcome to the forum!

First rule in Roth vs. traditional: ignore effective rates. It's all about marginal rates - see The reason to use marginal tax rates.
• Up to this point, I have mostly been investing in Roth accounts. (I currently have about 65K in Roth, 20K in Traditional.) With my individual 401(k), I have both the Traditional and the Roth option, so income limits on the Roth isn’t an issue.
• Until recently, I have planned to do a Roth conversion ladder upon partial retirement. I would like the option to retire early, but I really don’t know that I will stop working, or even slow down, before I hit 60, so I don’t know that I will have any low-income period. Because of this, is planning for this the best idea?
• I plan on my 1040 Schedule A deductions as a percentage of my taxable income increasing significantly over the next 30 years, which should lower my tax bracket, even if I don’t stop working. I plan on charitable giving being up to 50% of my income (it is currently at about 20%), which means my income would have to increase exponentially for me to have a higher tax bracket at retirement than right now.
If you expect to pay a lower marginal rate on withdrawals vs. the marginal tax saving rate you would get on contributions, then traditional is the logical conclusion.

If that assumption changes, then the conclusion might also change. Good luck!

Topic Author
InquiringInvestor18
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Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 11:57 am

NightFall wrote:
Mon Apr 02, 2018 6:18 am
The question is whether you think you tax bracket in retirement will be higher or lower than you current tax bracket.

Keep in mind that you start at the 0% tax bracket in retirement (at least under current law). So it's useful to have traditional accounts to fill lower tax brackets.
Thank you for the response. Can you elaborate on these two sections?

The first parts seems to be anyone's guess -- with no real knowledge of what my tax bracket will be, only a guess, is there any "best" choice?

The second part, I don't understand exactly what you're getting at.

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InquiringInvestor18
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Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 11:59 am

FiveK wrote:
Mon Apr 02, 2018 9:40 am

If you expect to pay a lower marginal rate on withdrawals vs. the marginal tax saving rate you would get on contributions, then traditional is the logical conclusion.

If that assumption changes, then the conclusion might also change. Good luck!

Seems like an educated guess is as good as it gets -- am I wrong?

Also -- when you say traditional, should I save ALL in traditional, or some in traditional, and some in taxable?

Thanks.

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FiveK
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Re: Self employed- Roth vs. Traditional

Post by FiveK » Mon Apr 02, 2018 12:21 pm

InquiringInvestor18 wrote:
Mon Apr 02, 2018 11:59 am
Seems like an educated guess is as good as it gets -- am I wrong?
Nope. As implied, it shouldn't be a pure guess but there aren't guarantees. In many cases (e.g., very early retirees, lottery winners, etc.) the answer will be "likely obvious". In other cases it might be a close call - but in those situations it probably doesn't matter much. See the part about Estimating withdrawal tax rates is not an exact science, but here is one approach.
Also -- when you say traditional, should I save ALL in traditional, or some in traditional, and some in taxable?
If the choice of traditional is correct (in the sense of traditional vs. Roth), then traditional will also be better than taxable.

Topic Author
InquiringInvestor18
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Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 1:19 pm

Ok -- Thank you everyone for the input!

NightFall
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Re: Self employed- Roth vs. Traditional

Post by NightFall » Mon Apr 02, 2018 3:42 pm

InquiringInvestor18 wrote:
Mon Apr 02, 2018 11:57 am
NightFall wrote:
Mon Apr 02, 2018 6:18 am
The question is whether you think you tax bracket in retirement will be higher or lower than you current tax bracket.

Keep in mind that you start at the 0% tax bracket in retirement (at least under current law). So it's useful to have traditional accounts to fill lower tax brackets.
Thank you for the response. Can you elaborate on these two sections?

The first parts seems to be anyone's guess -- with no real knowledge of what my tax bracket will be, only a guess, is there any "best" choice?

The second part, I don't understand exactly what you're getting at.
We have graduated tax brackets. For example, the first $24K with MFJ currently is taxed at 0%. If all of your income is Roth in retirement, you're effectively giving away free money unless your marginal tax bracket was 0% when you contributed the money to your Roth account. I typically assume a constant function when predicting future tax rates (current tax law is future tax law). I know that won't be true, but I consider it more likely than the infinite set of possibilities that exist if I throw out that assumption.

niceguy7376
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Re: Self employed- Roth vs. Traditional

Post by niceguy7376 » Mon Apr 02, 2018 3:54 pm

InquiringInvestor18 wrote:
Sun Apr 01, 2018 10:07 pm
• Self-employed with an S-Corp, and I have an individual 401(k), with the ability to invest up to 55,000 (obviously the max for Roth would be 18,500, with traditional making up the rest).

Other notes:
• Up to this point, I have mostly been investing in Roth accounts. (I currently have about 65K in Roth, 20K in Traditional.) With my individual 401(k), I have both the Traditional and the Roth option, so income limits on the Roth isn’t an issue.
Ability to invest upto 55K in a solo 401k would only be possible based on wage run to you by the S Corp. Not roth 18K and traditional the remaining.

I am confused of what you mean by "Income limits on roth isn't an issue". Your W2 income determines the ability to contribute to a Roth IRA or not.

Where do you have your solo 401k that gives roth 401k option? I know there are some providers that do it but want to let you provide that answer to clear off any ambiguities.

JBTX
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Re: Self employed- Roth vs. Traditional

Post by JBTX » Mon Apr 02, 2018 4:20 pm

There’s not enough info given to really give a good answer.

Is there state income tax? Will you retire in state with income tax?
How long until retirement?
Do you plan to retire early? (Maybe not per OP)
Will you have other sources of income in retirement?
If you went 100% traditional for 401k would that lower your income enough to allow you to contribute to an individual Roth IRA?
What do you want to assume happens to income tax rates in 2026 after the current rates sunset?

I’m am going to guess you will have a substantial traditional balance either way at retirement, if you keep having such a large employer match.

At 24% with the little bit of info given I think you could go either way. I’d probably lean Roth, given you are so young and are thinking you may not retire early, but it depends on the answers to the above questions.

Topic Author
InquiringInvestor18
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Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 8:20 pm

niceguy7376 wrote:
Mon Apr 02, 2018 3:54 pm
InquiringInvestor18 wrote:
Sun Apr 01, 2018 10:07 pm
• Self-employed with an S-Corp, and I have an individual 401(k), with the ability to invest up to 55,000 (obviously the max for Roth would be 18,500, with traditional making up the rest).

Other notes:
• Up to this point, I have mostly been investing in Roth accounts. (I currently have about 65K in Roth, 20K in Traditional.) With my individual 401(k), I have both the Traditional and the Roth option, so income limits on the Roth isn’t an issue.
Ability to invest upto 55K in a solo 401k would only be possible based on wage run to you by the S Corp. Not roth 18K and traditional the remaining.

I am confused of what you mean by "Income limits on roth isn't an issue". Your W2 income determines the ability to contribute to a Roth IRA or not.

Where do you have your solo 401k that gives roth 401k option? I know there are some providers that do it but want to let you provide that answer to clear off any ambiguities.
The solo 401k is through vanguard.
Income limits isn't an issue on the Roth, because I am using a 401k, not an IRA.
Maximum Employee Deferral is 18,500, but there is an overall maximum of 55,000.

Topic Author
InquiringInvestor18
Posts: 7
Joined: Fri Mar 30, 2018 10:56 pm

Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 8:22 pm

NightFall wrote:
Mon Apr 02, 2018 3:42 pm
We have graduated tax brackets. For example, the first $24K with MFJ currently is taxed at 0%. If all of your income is Roth in retirement, you're effectively giving away free money unless your marginal tax bracket was 0% when you contributed the money to your Roth account. I typically assume a constant function when predicting future tax rates (current tax law is future tax law). I know that won't be true, but I consider it more likely than the infinite set of possibilities that exist if I throw out that assumption.
Great point, and great explanation. Does that mean you wouldn't use the Roth Conversion ladder for ALL of your income in retirement -- you would leave some in a traditional account to make sure you were taking advantage of the 0% tax bracket?

Topic Author
InquiringInvestor18
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Re: Self employed- Roth vs. Traditional

Post by InquiringInvestor18 » Mon Apr 02, 2018 8:33 pm

JBTX wrote:
Mon Apr 02, 2018 4:20 pm
There’s not enough info given to really give a good answer.

Is there state income tax? Will you retire in state with income tax?
How long until retirement?
Do you plan to retire early? (Maybe not per OP)
Will you have other sources of income in retirement?
If you went 100% traditional for 401k would that lower your income enough to allow you to contribute to an individual Roth IRA?
What do you want to assume happens to income tax rates in 2026 after the current rates sunset?

I’m am going to guess you will have a substantial traditional balance either way at retirement, if you keep having such a large employer match.

At 24% with the little bit of info given I think you could go either way. I’d probably lean Roth, given you are so young and are thinking you may not retire early, but it depends on the answers to the above questions.
I live in PA, and I plan to retire in PA -- current tax rate is 3.06%.
Retirement would be, at the earliest, probably another 20 years, at 50. I'm not sure if I plan to retire early or not.
I will probably have other sources of income -- I've been giving some thought to starting rentals. I also don't know that I will ever fully retire, which means I may have some earned income as well.
If I went 100% traditional for the 401k, it would not lower my income enough for me to contribute to an individual Roth IRA, although I'm not sure that's relevant. If Roth is a good option -- I could just do a backdoor.
What do I want to assume happens in 2026? To borrow from one of the other posters, let's assume they stay where they are. It's anyone's guess what's going to happen.

JBTX
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Re: Self employed- Roth vs. Traditional

Post by JBTX » Mon Apr 02, 2018 8:48 pm

InquiringInvestor18 wrote:
Mon Apr 02, 2018 8:33 pm
JBTX wrote:
Mon Apr 02, 2018 4:20 pm
There’s not enough info given to really give a good answer.

Is there state income tax? Will you retire in state with income tax?
How long until retirement?
Do you plan to retire early? (Maybe not per OP)
Will you have other sources of income in retirement?
If you went 100% traditional for 401k would that lower your income enough to allow you to contribute to an individual Roth IRA?
What do you want to assume happens to income tax rates in 2026 after the current rates sunset?

I’m am going to guess you will have a substantial traditional balance either way at retirement, if you keep having such a large employer match.

At 24% with the little bit of info given I think you could go either way. I’d probably lean Roth, given you are so young and are thinking you may not retire early, but it depends on the answers to the above questions.
I live in PA, and I plan to retire in PA -- current tax rate is 3.06%.
Retirement would be, at the earliest, probably another 20 years, at 50. I'm not sure if I plan to retire early or not.
I will probably have other sources of income -- I've been giving some thought to starting rentals. I also don't know that I will ever fully retire, which means I may have some earned income as well.
If I went 100% traditional for the 401k, it would not lower my income enough for me to contribute to an individual Roth IRA, although I'm not sure that's relevant. If Roth is a good option -- I could just do a backdoor.
What do I want to assume happens in 2026? To borrow from one of the other posters, let's assume they stay where they are. It's anyone's guess what's going to happen.
As to 2026 and beyond, how one views the future does tend ultimately inform ones decision. One point of view is that it is impossible to foresee the future, so don’t even try, just assume everything stays he way it is now. Another is to come to your own conclusions as the likelihood over decades whether rates will go up or down, based upon lots of macroeconomic and demographic and other factors. Neither is right or wrong, but they definitely play into our decision making.

So you are at 27% between federal and state. But you see yourself as potentially not an early retiree and maybe having modest other income in retirement. And if you keep saving as much company match as you do, you will likely have substantial traditional savings, such that you will have RMD income.

If your assumption is nothing will change (or it’s just as likely rates will go down vs up) the numbers for you probably modestly favor traditional. If you think rates will creep up over the next 20-30 years even a few points, I’d say they modestly favor Roth.

Keep in mind if you do Traditional, the assumption is you will take your traditional tax savings and reinvest them, in your case a taxable account, and hold that until retirement.

Whatever you do, I think it makes sense to have a good bit in both traditional and Roth. Hedging your bets if you will. Diversifying your retirement holdings in tax status as well as portfolio composition.

NightFall
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Re: Self employed- Roth vs. Traditional

Post by NightFall » Tue Apr 03, 2018 10:37 am

InquiringInvestor18 wrote:
Mon Apr 02, 2018 8:22 pm
NightFall wrote:
Mon Apr 02, 2018 3:42 pm
We have graduated tax brackets. For example, the first $24K with MFJ currently is taxed at 0%. If all of your income is Roth in retirement, you're effectively giving away free money unless your marginal tax bracket was 0% when you contributed the money to your Roth account. I typically assume a constant function when predicting future tax rates (current tax law is future tax law). I know that won't be true, but I consider it more likely than the infinite set of possibilities that exist if I throw out that assumption.
Great point, and great explanation. Does that mean you wouldn't use the Roth Conversion ladder for ALL of your income in retirement -- you would leave some in a traditional account to make sure you were taking advantage of the 0% tax bracket?
Depends. Roth conversions are great ways of moving traditional to Roth with low tax liability to take advantage of the progressive tax brackets. I'm not planning on converting everything before age 70 though. Most will try to convert over time to make RMDs to be small or manageable. Overall, the goal is for you to be able to determine when your income becomes taxable since you can help control the tax rate.

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