Roth 401k vs Traditional 401k

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inbox788
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Roth 401k vs Traditional 401k

Post by inbox788 » Tue Jul 10, 2018 2:05 pm

Saw this article today and got me thinking and confused.

Why a Roth 401(k) Is (Almost) Always Better Than a Traditional 401(k)
https://twocents.lifehacker.com/why-a-r ... 1827477812

I thought the baseline case of no tax change in retirement yielded no difference. But using their assumption (investing the $250 deduction into taxable), they get a substantial advantage to Roth WITHOUT tax rate change. But what if you didn't have the $250 deduction from taxable and only put $1000 in the tIRA and $750 (after tax) into the Roth and in retirement remained in same 25% tax bracket? Wouldn't the difference go away? And if so, isn't the difference simply the tax drag from $250 invested in taxable account?

A few years ago, my company started offering Roth 401k, and I passed up the opportunity to expand the tax advantaged space by paying the higher tax rates in Roth 401k and stuck with Traditional 401k. I'm wondering if that was a mistake now, but I'm still pretty sure my tax rate will go down quite a bit in retirement. I like the graph/table and seems to provide useful information IF the assumptions are correct.

mcraepat9
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Re: Roth 401k vs Traditional 401k

Post by mcraepat9 » Tue Jul 10, 2018 2:14 pm

This ignores any strategic Roth conversions between now and retirement. I think Roth 401k would be a mistake for most people.
Amateur investors are not cool-headed logicians.

FreemanB
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Re: Roth 401k vs Traditional 401k

Post by FreemanB » Tue Jul 10, 2018 2:23 pm

I saw that article earlier, and I thought they used some very suspect math. The biggest flaw in that article is that they assume that the Traditional 401k contributions would be taxed at the same rate as the withdrawals in retirement. That will only rarely be the case, since your contributions are taxed at your marginal rate, which will usually be much lower in retirement.(If not, then Roth conversions during the early retirement years can help offset that) It also assumes that the tax savings today aren't used to fund another tax-advantaged account(Or higher contributions to the 401k). For myself, the tax savings from my traditional 401k effectively fund my Roth IRA contributions. They also taxed the taxable account at 25%, even though LTCG rates are either 0%, 15%, or 20% currently, further slanting the numbers in favor of Roth.

I didn't bother checking the results of those things were accounted for, but I'd bet the results would be in line with standard guidance if they were.

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David Jay
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Re: Roth 401k vs Traditional 401k

Post by David Jay » Tue Jul 10, 2018 2:24 pm

Your understanding (tax rate now vs. tax rate at withdrawal) is correct if you are not "maxing-out" 100% your tax-advantaged space.

The article is playing a bit of a game where the deposit into either version is the same size and the immediate tax benefit goes into a taxable account where you have to pay taxes on the gains for the remainder of your working lifetime. This would only apply if you have no more space in your tax advantaged accounts (including a backdoor Roth) and you had no LTCG in your taxable account.

From the example, if you contribute the same amount of pre-tax money into either account (i.e. $1250 into traditional 401K before taxes, $1000 into Roth 401K after taxes) then the result will be as you understand it: the lower tax rate at time of contribution favors the Roth and lower tax rate at the time of withdrawal favors the traditional.
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FiveK
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Re: Roth 401k vs Traditional 401k

Post by FiveK » Tue Jul 10, 2018 3:56 pm

See the commutative property of multiplication and Maxing out your retirement accounts for the math behind the different situations.

Ben Mathew
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Re: Roth 401k vs Traditional 401k

Post by Ben Mathew » Tue Jul 10, 2018 4:48 pm

From the report referenced in the article:
“The benefits of tomorrow’s tax-free retirement withdrawals with a Roth IRA far outweigh the benefits of today’s tax-deduction
and other possible benefits with a Traditional IRA,” says T. Rowe Price senior financial planner Stuart Ritter. “Even though the Roth IRA contribution doesn’t qualify for an income tax deduction, decades of compounding tax-free money can generate more spendable income in retirement.
Millennials in particular stand to benefit from the tax-advantages of Roth IRAs, because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement.
These statements are incorrect in light of the Roth and traditional parity result which comes from the commutative property of multiplication (growth followed by tax = tax followed by growth). The reason they're getting Roth to come out ahead is that they're comparing $1000 in Roth vs. $1000 in Traditional + $250 in a taxable account. This is not the right comparison. The right comparison is $1,000 in Roth vs $1,333 in traditional. $1,333 in a traditional account results in a current consumption loss of $1,333*(1-.25)=$1,000, the same as that of $1,000 in Roth. So an apples to apples comparison should compare $1,333 in a traditional account vs $1,000 in a Roth account. There's no reason why someone saving $1,000 in traditional should save the $250K tax savings in a taxable account when they are not maxed out.

Roth does have some advantages: If you are maxed out in traditional, then Roth lets you shield more (because $5,500 in Roth is effectively more money than $5,500 in traditional as it is post-tax). Or, if you have saved a lot and expect to be in a higher tax bracket in retirement, then you might want to go with Roth. Or if you want to leave your IRA as an inheritance, the Roth is better. But neither the article nor the report cited in the article make the mechanics of any of this clear.

megabad
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Re: Roth 401k vs Traditional 401k

Post by megabad » Tue Jul 10, 2018 5:14 pm

Ben Mathew wrote:
Tue Jul 10, 2018 4:48 pm
These statements are incorrect...
I mostly agree, but the actual T Rowe Price Report discusses a study that analyzed the portfolio sizes of those who chose Roth vs those who chose traditional accounts. In other words, it is possible that folks that chose Roth statistically had "more money" in retirement but it is not an obvious conclusion to me that this was because they chose Roth.

I do not find the second comment necessarily incorrect, but it would be more to my liking if it was stated something like:

"If in a higher marginal tax bracket in retirement, Millennials in particular stand to benefit from the tax-advantages of Roth IRAs, because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement."

edit:fixed lower to higher, ty FiveK.
Last edited by megabad on Tue Jul 10, 2018 6:27 pm, edited 1 time in total.

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FiveK
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Re: Roth 401k vs Traditional 401k

Post by FiveK » Tue Jul 10, 2018 5:27 pm

megabad wrote:
Tue Jul 10, 2018 5:14 pm
I do not find the second comment necessarily incorrect, but it would be more to my liking if it was stated something like:

"If in a lower marginal tax bracket in retirement, Millennials in particular stand to benefit from the tax-advantages of Roth IRAs, because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement."
But if they do have a lower marginal rate in retirement, traditional would have been a better choice.

The more one contributes to Roth, the more likely traditional would have been better.
The more one contributes to traditional, the more likely Roth would have been better.

02nz
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Re: Roth 401k vs Traditional 401k

Post by 02nz » Tue Jul 10, 2018 5:47 pm

For many people it would be wise to do a mix of both traditional and Roth, but in most cases the traditional should be in the 401(k) or its equivalents, while the Roth should be in an IRA. The Roth IRA has two big advantages - no RMDs and penalty-free withdrawal of contributions at any time - that beat out the Roth 401(k).

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ruralavalon
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Re: Roth 401k vs Traditional 401k

Post by ruralavalon » Tue Jul 10, 2018 5:56 pm

The article goes off the rails as soon as it starts talking about most people maxing their 401ks, which most people cannot do. In the U.S. median annual household income is about $57k, median annual individual income is about $31k.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started

megabad
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Re: Roth 401k vs Traditional 401k

Post by megabad » Tue Jul 10, 2018 6:26 pm

FiveK wrote:
Tue Jul 10, 2018 5:27 pm
megabad wrote:
Tue Jul 10, 2018 5:14 pm
I do not find the second comment necessarily incorrect, but it would be more to my liking if it was stated something like:

"If in a lower marginal tax bracket in retirement, Millennials in particular stand to benefit from the tax-advantages of Roth IRAs, because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement."
But if they do have a lower marginal rate in retirement, traditional would have been a better choice.

The more one contributes to Roth, the more likely traditional would have been better.
The more one contributes to traditional, the more likely Roth would have been better.
Oops! I guess it has been a long day. You are very much correct. I will edit for good measure.

Ben Mathew
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Re: Roth 401k vs Traditional 401k

Post by Ben Mathew » Tue Jul 10, 2018 8:15 pm

megabad wrote:
Tue Jul 10, 2018 5:14 pm
I do not find the second comment necessarily incorrect, but it would be more to my liking if it was stated something like:

"If in a higher marginal tax bracket in retirement, Millennials in particular stand to benefit from the tax-advantages of Roth IRAs, because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement."
But wouldn't it be better as:

"If in higher marginal tax bracket in retirement, anyone--millenial or not--stands to benefit from using a Roth IRA over a traditional IRA"

It doesn't have anything directly to do with being millenials or how long their contributions will compound tax-free. So saying it's because of how long contributions get to compound seems misleading to me. Yes, it's true that the longer your horizon, the more you're likely to accumulate and therefore find yourself in a higher tax bracket. But many other things will affect that too--like the amount you save and how well your investments do. So saying it's the tax rate, rather than all the other factors that can indirectly affect the tax rate, seems to me to be a clearer statement of how it works.

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