Roth vs Traditional 401K

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gvernon
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Post by gvernon » Mon Mar 10, 2008 4:43 pm

Ok, try this one on for size...

Married filing jointly - 28% marginal bracket (barely) 0% state income tax.
22 and 23 yrs old.
Both have pension plans at current jobs (granted, not much built up yet).
Anticipate steady increase of income but not drastic.
Both max out Roth IRA's.
She's not yet eligible to participate in her 401k.
I max out my 401k (traditional) but I have a Roth 401k option.

What would you do in my shoes?

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Post by livesoft » Mon Mar 10, 2008 4:51 pm

Since you are not in the sub-15% tax bracket, the traditional 401(k) is the way to go for you.

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Post by tfb » Mon Mar 10, 2008 4:56 pm

Hedgy wrote:Tfb - first, I enjoy your blog.
Thanks. I'm actually contemplating writing this out to my blog. The title will be "The Case Against Roth 401k."
Hedgy wrote:Second, thanks for feedback. We are anticipating a dramatic wage increase in the enxt 1.5 years, but not enough to put us into 35% bracket - only into 33% bracket.
My plan was for my wife to max out traditional 401k, and for me to hedge the unknown future tax treatment of retirement assets by maxing out Roth401k. That way, no matter what happens, we'll be ok.

So I guess there seems to be unanimity that traditional 401k is the best option for me at this point. I'm still sort of scratching my head on that one.
If you are only talking about between now and 1.5 years from now, Roth 401k might be OK but only marginally in my view. You are prepaying 35% tax (fed + state) to hedge that your marginal tax rate in retirement will be higher than 35%. You might move to a no/low tax state when you retire. If that's the case, the 7% tax you are paying to the state is a dead loss. I won't use Roth 401k if I were you but if it's only for 1.5 years, it's not much money anyway in the grand theme of things. Once you get into 33% though, I'd switch to 100% traditional 401k if I were you. Prepaying 40% tax is insane IMO.
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Hedgy
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Post by Hedgy » Mon Mar 10, 2008 5:04 pm

Holy sh!t I never thought of it that way, but you are 100% right. I'm paying 34.85% up front by doing a Roth401k. I must be an idiot!

Second, I would really urge you to write up a post on the case against Roth401k. For me and many others, I think it would clarify a lot of the issues that have been muddled in the popular media.

Thanks again.

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Post by mptfan » Mon Mar 10, 2008 5:10 pm

Hedgy, I agree this issue is muddled and befuddled by the popular financial media, including most so called financial experts. If you want to see a post that makes the case against the Roth 401k, look at my previous post in this thread, on March 5 at 11:07 a.m.

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Post by Hedgy » Mon Mar 10, 2008 5:13 pm

Will do, right now.
Thanks.

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Post by redbeard » Mon Mar 10, 2008 5:17 pm

Hedgy wrote:Thanks very much for the feedback.

And just to make sure I understand correctly, the reason I should prefer the traditional 401k to the Roth401k is that I am now paying tax on my Roth contributions at a 28% marginal rate, whereas a 401k contribution would save me $0.28 of taxes for every dollar contribution now, PLUS I will be taxed at my effective rate in retirement, which (based on the current bracket structure which may change) will be lower in retirement than it is now.

Is this correct?

Thanks once again for your help.
Hi Hedgy,

I'm hesitant to weigh in yet again on this particular question, but want to make sure it is clear that mptfan's view on this is contradicted by every scenario we've walked through on this thread. As tfb stated on page 2, it is hard to believe that it took us 80 posts to come to agreement (besides mptfan) that marginal rates (not "effective rate") in retirement are the ones to use when evaluating adding some ROTH to the mix.

If you had to choose only a TIRA or ROTH then you would make your decision by comparing your current marginal rate and your expected effective rate. However, since you have the option to use a blended approach you should compare your current marginal tax rates with estimated marginal tax rates in retirement when deciding if you want to add more ROTH to the mix. The kicker here (aside from not having a crystal ball) is that as you elect to put more into the ROTH over the TIRA eventually you will start to lower your future marginal rate. For this reason you probably don't want to go overboard on the ROTH if you decide to use one at all.

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Post by mptfan » Mon Mar 10, 2008 5:21 pm

redbeard, I don't want to ressurect the same argument, but I would like to point out that your statement that my view is contradicted by every scenario we have walked through is patently false. I presented a scenario which supports my view. Also, there are many people who agree with my view, including livesoft, emergdoc, simplesimon, and others.

Please feel free to disagree with me, but please do not make false statements that imply I am alone in my views.

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Post by redbeard » Mon Mar 10, 2008 5:36 pm

I was curious about past tax brackets and did some searching. I came across this site: http://www.truthandpolitics.org/top-rates.php I don't know anything about the folks who made this site or if their data is accurate. Perhaps someone here can help clarify that. If their data is correct, it is pretty amazing how low our top marginal rates are today compared to where they have been in the past.


Also, several posters have commented on ROTH not having RMDs. From what I have been able to learn this is true for the ROTH IRA but not for the ROTH 401k. However, it seems you could simply roll over the ROTH 401k to a ROTH IRA so I'm a bit perplexed. If anyone can offer some expertise in this area I would greatly appreciate it.

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redbeard
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Post by redbeard » Mon Mar 10, 2008 5:53 pm

mptfan wrote:redbeard, I don't want to ressurect the same argument, but I would like to point out that your statement that my view is contradicted by every scenario we have walked through is patently false. I presented a scenario which supports my view. Also, there are many people who agree with my view, including livesoft, emergdoc, simplesimon, and others.

Please feel free to disagree with me, but please do not make false statements that imply I am alone in my views.
I hate to dredge this up as well. However you never presented a scenario that supports your view, or explained why I've been able to find so many "exceptions" to the effective rate during retirement model (two detailed two period models, and one more simple one provided to emergdoc). Instead you have told me I'm "wrong", "confused", etc and offered a link to the tax codes. Your counter to two detailed examples showing where effective rates would lead one to the wrong conclusion was to complain that I reduced the amount the amount going into a ROTH in my model by subtracting taxes upfront.

You treat this as a matter of opinion, when in fact it is a simple math problem (aside from the whole none of us can predict the future issue). I believe your last effort at persuasion was:
mptfan wrote:AzRunner, I understand what redbeard is saying, I just disagree. I also disagree with your assertion that my understanding is fundamentally incorrect.

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Post by mptfan » Mon Mar 10, 2008 6:00 pm

redbeard, please look at my post on March 6 at 5:25 pm. That post shows real numbers and uses real math and supports my view. You have never disputed the validity of that specific example, so I will assume you agree that it is a valid example.

Please note that I have NEVER said that in EVERY situation it is better to use a tax deductible account over a Roth. I agree that you can construct situations where a Roth is preferable. Indeed, Roths have certain benefits that make them preferable in some circumstances. (eg, there are no RMDs, and no taxes due upon withdrawal in retirement, so you can leave a larger inheritance). Please look at what I have said, not what I didn't say.

P.S. I agree it is a math problem, and not a matter of opinion, and my use of the phrase "I disagree" was an attempt to be diplomatic, and an attempt to avoid saying that you are simply wrong.

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My experience

Post by ElLobo » Mon Mar 10, 2008 8:05 pm

I haven't read through all of the posts in this thread, but here is what I found, and did/do.

I contributed the maximum amount I could to my 401k plan, while working. I saved the higher tax bracket taxes.

Upon retirement, I started converting about 10% of my tax deferred portfolio to a Roth each year. The objective is to get it all into a Roth before RMDs kick in. The tax rate for this conversion is 25%, since I convert an amount that maxes me out in that bracket.

So, my first 'savings' is the difference between my working tax bracket and this 25%.

Then, I convert all of that 10% into a Roth, paying the 25% tax due for it from my regular taxable account. The reason is that the amount of tax paid, if kept in the taxable account is, well, taxed forever after. In a Roth, it grows tax free.

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Post by simplesimon » Mon Mar 10, 2008 8:37 pm

Thus, they get to have their cake and eat it, too. Too many studies ignore this ability to convert to a Roth IRA. So just because one choose traditional 401(k) now, does not mean that one cannot get tax diversification, avoidance of RMD, and other benefits of a Roth. They just choose to go to a Roth when they are in a lower marginal income tax bracket which is a tremendous benefit!
Question: Does this work if I leave my employer, go back to school, and decide to roll over my 401k to a rollover IRA and then to a Roth IRA? And if my income's really low while working during school, is the tax on the rollover IRA going to be really small?

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Post by White Coat Investor » Mon Mar 10, 2008 8:54 pm

Hedgy wrote:So the notion that young people who have no pension, and whose income is likely to rise considerably as they age, should invest in a Roth401k now is fundamentally wrong?

Is this the bottom line?
No, I think one who is not in their peak earning years will probably benefit from a Roth. If you are in the 25% bracket now, and expect to spend most of your career in the 33% bracket, chances are good you'll be in at least the 25% bracket in retirement. The Roth 401K is great because it automatically hedges your bets in this situation, since the employer contributions go into the traditional and yours into the Roth. When the income goes up, I'd probably advocate 100% traditional.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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Post by White Coat Investor » Mon Mar 10, 2008 8:57 pm

simplesimon wrote:
Thus, they get to have their cake and eat it, too. Too many studies ignore this ability to convert to a Roth IRA. So just because one choose traditional 401(k) now, does not mean that one cannot get tax diversification, avoidance of RMD, and other benefits of a Roth. They just choose to go to a Roth when they are in a lower marginal income tax bracket which is a tremendous benefit!
Question: Does this work if I leave my employer, go back to school, and decide to roll over my 401k to a rollover IRA and then to a Roth IRA? And if my income's really low while working during school, is the tax on the rollover IRA going to be really small?
Yes. and yes.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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Post by White Coat Investor » Mon Mar 10, 2008 9:02 pm

mptfan wrote:Also, there are many people who agree with my view, including livesoft, emergdoc, simplesimon, and others.

Please feel free to disagree with me, but please do not make false statements that imply I am alone in my views.
I'm not entirely sure who I agree with here, since I'm not entirely sure who is arguing for what, and I'm not going back to read the whole thread again. I believe (as stated above) that most people in their peak earnings years want most of their retirement money going into a traditional 401K, but probably not all of it, but the decision has to be analyzed individually to make the best decision, taking into account future pensions/social security/other sources of income, anticipated future tax rates, opportunities for cheap Roth conversions, anticipated tax bracket in retirement, and total amount of savings each year compared to amount of tax-protected space available.
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Seems legitimate.

Post by iceport » Mon Mar 10, 2008 10:35 pm

redbeard wrote:I was curious about past tax brackets and did some searching. I came across this site: http://www.truthandpolitics.org/top-rates.php I don't know anything about the folks who made this site or if their data is accurate. Perhaps someone here can help clarify that. If their data is correct, it is pretty amazing how low our top marginal rates are today compared to where they have been in the past.
redbeard,

I've seen that data before. It seems legitimate to me, though I can't find a reference in the PDF document linked via the graph.:

Image

I'm with you on the tax rates. A quick scan of this graph, consider the federal budget challenges ahead, and it's very difficult to conceive of any scenario that doesn't involve tax hikes in some form (though I know that wasn't the OP's focus).

Take this scenario, for example:
The Cost of Allowing Tax Cuts to Expire...And the Cost of Extending Them

--Pete

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Post by tfb » Mon Mar 10, 2008 11:17 pm

redbeard wrote:I was curious about past tax brackets and did some searching. I came across this site: http://www.truthandpolitics.org/top-rates.php I don't know anything about the folks who made this site or if their data is accurate. Perhaps someone here can help clarify that. If their data is correct, it is pretty amazing how low our top marginal rates are today compared to where they have been in the past.
You can't just look at the maximum. You also have to look at what kind of income level was taxed at the maximum rate. If let's say in today's dollars, $1 million a year was taxed at 70% in the 1980s and you anticipate the tax structure will go back to that in the 1980s, if you are not earning $1 million a year, that 70% rate does not apply to you. You have to look at what the tax rate was for your anticipated income level. Do a plot for the tax rate in the past for your anticipated income level (after adjusting for inflation) and compare that with the current rate. That's more meaningful than looking at the maximum rate.
Harry Sit, taking a break from the forums.

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redbeard
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Post by redbeard » Tue Mar 11, 2008 10:36 am

tfb wrote:
redbeard wrote:I was curious about past tax brackets and did some searching. I came across this site: http://www.truthandpolitics.org/top-rates.php I don't know anything about the folks who made this site or if their data is accurate. Perhaps someone here can help clarify that. If their data is correct, it is pretty amazing how low our top marginal rates are today compared to where they have been in the past.
You can't just look at the maximum. You also have to look at what kind of income level was taxed at the maximum rate. If let's say in today's dollars, $1 million a year was taxed at 70% in the 1980s and you anticipate the tax structure will go back to that in the 1980s, if you are not earning $1 million a year, that 70% rate does not apply to you. You have to look at what the tax rate was for your anticipated income level. Do a plot for the tax rate in the past for your anticipated income level (after adjusting for inflation) and compare that with the current rate. That's more meaningful than looking at the maximum rate.
I agree. When I was searching I was hoping to find the kind of plot you refer to. It is entirely possible that although top rates have fluctuated wildly the rates for most middle class earners have remained largely stable. I'd love to see the kind of data you described to see if this is the case.

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Post by Hedgy » Tue Mar 11, 2008 12:51 pm

TFB - if it's possible, when you do your blog post on The Case against Roth 401k, could you provide some data entry fields so each reader can try to crunch numbers for him/herself?
I'm thinking in particular of the post you did on which VG MMF is right for you, which I have found very helpful
Thanks.

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Post by livesoft » Tue Mar 11, 2008 2:31 pm

EmergDoc wrote:
Hedgy wrote:So the notion that young people who have no pension, and whose income is likely to rise considerably as they age, should invest in a Roth401k now is fundamentally wrong?

Is this the bottom line?
No, I think one who is not in their peak earning years will probably benefit from a Roth. If you are in the 25% bracket now, and expect to spend most of your career in the 33% bracket, chances are good you'll be in at least the 25% bracket in retirement. The Roth 401K is great because it automatically hedges your bets in this situation, since the employer contributions go into the traditional and yours into the Roth. When the income goes up, I'd probably advocate 100% traditional.
I was in the 33% tax bracket last month. I have run the numbers to show that I will be in the sub-15% marginal income tax bracket when I am retired from the ages of 50 through 70. Therefore I assert that EmergeDoc's statement about "... be in at least the 25% bracket in retirement" is not necessarily true.

Why does my tax bracket drop so much? The reason is that from age 50 to 70 my expenses are paid by the taxable portion of my portfolio. And that portfolio has the following types of income: return of capital (tax-free), long-term capital gains (taxed at 15%) and qualified dividends (taxed at 15%). I will have 20 years before I need to think about RMD and even perhaps SS benefits. During that time, I will be converting my traditional IRA/401k to a Roth.

Now I will admit that not everyone is lucky enough to stay in a low tax bracket in retirement. But folks in the 33% tax bracket now are more likely to have large taxable portfolios to do what I have described.

You have got to consider your own numbers.

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Post by Greenberry » Tue Mar 11, 2008 8:13 pm

Apologies if this post ends up long. In it, I'll explain why mptfan's conclusions are generally correct, even if his reasoning about effective tax rates is flawed, and that redbeard is correct in saying that marginal rates matter, although the disagreement seems to have resulted from a simplification of marginal analysis. If you're not interested, please feel free to skip. I appreciate both mptfan and redbeard's posts, and don't particularly care who "wins" the discussion and hesitate to step into it, but post this message in the hope that other readers don't come away from the thread with a misunderstanding of how this stuff works.

From mptfan's March 5, 11am post:
mptfan wrote:...Then, when you retire and begin withdrawing that money, you will pay taxes based on your lower AVERAGE tax rate (aka effective tax rate) in retirement, not your marginal tax rate in retirement. Your average tax rate is almost always lower than your marginal tax rate. If you pay state income tax, your savings are even more dramatic. People who suggest that a Roth IRA and a 401k are a wash if you will be in the same tax bracket in retirement simply don't understand this.
I posted a counter example to this earlier and thought that would help settle the issue, but it apparently hasn't, so I'll repeat it with more commentary that explicitly refutes mptfan's claim above.

Consider the following situation for a married couple:
(a) 15% marginal bracket during working years
(b) 25% marginal in retirement, but effective at 13%.

First, let's see if those numbers above are possible. Let's simplify a bit and say the couple has $20k in deductions and personal exemptions. With about $80k in income during their working years, their AGI would be about $60k, putting them into the high end of the 15% bracket (for 2007), so (a) is possible. Turning to (b), let's assume they have $100k in ordinary income , which would be $80k after deductions and exemptions, leaving them in the 25% marginal bracket. That leaves the effective tax rate, which in this case would be ($8772+0.25*$16300)/$100k = 12.8%, so (b) is possible.

Second, let's look not just at feasibility, but reasonability. The couple has a higher real income in retirement than they did during working years, but only by $10k. Any of the following might contribute to that situation: their investments did unexpectedly well, they 'oversaved', they actually want to spend more in retirement, they won the lottery or received a moderate inheritance, tax bracket cutoff values changed, tax bracket rates changed, they have a pension in addition, etc. We could debate reasonability, but I think it's reasonable, and certainly not impossible.

Let's give the couple $10k pre-tax to contribute to a 401k plan and see what mptfan would have them do. From his previous posts, it would seem that because the effective tax rate in retirement is lower than working years' marginal rate, they should contribute to a traditional 401k and not a Roth. Here's how that's wrong (and the key is that your 401k contributions can affect your later marginal rates):

For the couple's $100k income, let's simplify again and say it all comes from retirement plan withdrawals. Because it's all from a traditional 401k, it's all taxable. The first $20k is tax-free due to deductions and exemptions and the next $15.6k is taxed at 10%. The remainder up to $83.7k is taxed at 15% and the final $16.3k is taxed at 25%. Note that even with a 13% average tax rate, you're still paying 25% taxes on some income.

In order to show that mptfan's claim is wrong, we have to show how we could do better. In this case, if the couple had put $8,370 of their annual contribution into a traditional 401k and the remaining $1,630 into a Roth 401k (and the associated tax bill that year), then when they withdraw the money in retirement, the final $16.3k per year that would have been taxed at 25% would have been withdrawn instead from a Roth account on which 15% tax had already been paid (the amount withdrawn from the Roth would be $13855 after-tax). Because there is a better strategy than the one that would result from just looking at effective tax rate, then looking at effective tax rate to find the best strategy is demonstrably wrong.

The key point about marginal analysis is not that you look at the marginal rate after contributing the $10k to either plan, or the marginal rates before contributing to either plan, but that you start with $0 assigned to both, then consider where the optimal place to put the first dollar is, then consider where the best place for the next dollar is, etc.*

*The tax code is non-linear, so with $10k, you (or your computer) would ideally do as dbr has suggested and look at all possibilities of $0 to Traditional, $10,000 to Roth; $1 to Traditional, $9999 to Roth; $2 to.. and so on.
mptfan wrote:redbeard, please look at my post on March 6 at 5:25 pm. That post shows real numbers and uses real math and supports my view. You have never disputed the validity of that specific example, so I will assume you agree that it is a valid example.

P.S. I agree it is a math problem, and not a matter of opinion, and my use of the phrase "I disagree" was an attempt to be diplomatic, and an attempt to avoid saying that you are simply wrong.
The problem with the specific example you cite is that it has the marginal rate after retirement equal to the marginal rate before retirement. In that specific subcase of the analysis above, a traditional 401k is always as good or better than a Roth IRA, but there are other examples (as I pointed out above) where the math of average or effective tax rate is "simply wrong" and redbeard's points about marginal rates being important (although simplified) are closer to correct -- it's the marginal rate for each incremental dollar that matters.

Finally, as livesoft demonstrates above, I do think that many people are better off with a traditional 401k than a Roth 401k (especially if they're not contributing the max), which is mptfan's main point.

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Post by bdpb » Tue Mar 11, 2008 9:55 pm

livesoft wrote:
Why does my tax bracket drop so much? The reason is that from age 50 to 70 my expenses are paid by the taxable portion of my portfolio. And that portfolio has the following types of income: return of capital (tax-free), long-term capital gains (taxed at 15%) and qualified dividends (taxed at 15%). I will have 20 years before I need to think about RMD and even perhaps SS benefits. During that time, I will be converting my traditional IRA/401k to a Roth.

Now I will admit that not everyone is lucky enough to stay in a low tax bracket in retirement. But folks in the 33% tax bracket now are more likely to have large taxable portfolios to do what I have described.

You have got to consider your own numbers.
It may not change your decision overall, but to be fair you need to
account for the annual tax drag on your taxable account portion difference
between the Roth and the deductible 401k. With significant taxable
relative to tax deferred, you may end up with bonds in taxable which
can make this cost significant. Also, the currently favorable CG and QD
taxation is scheduled to go away after 2010.

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Post by mptfan » Tue Mar 11, 2008 10:43 pm

Greenberry, I think you misunderstood what I have said. I have never said that it is ALWAYS better to contribute to a 401k than a Roth. I said that it is usually better to do so, for those in their peak earning years, and who find themselves in a relatively high tax bracket. I stand by that assertion, and I think you agree. I agree that you can construct examples where someone expects to be in a higher tax bracket in retirement, and that person would benefit from a Roth IRA for some of their marginal income dollars in retirement. I agree it is a good idea to have some Roth money and some pretax money in retirement for tax diversification. I think we agree more than we disagree, and perhaps redbeard agrees with me on these points as well. However, I continue to maintain that for high income earners during their peak earning years, most will find themselves in a lower marginal, and lower effective tax rate in retirement (as compared to their marginal tax rate during their working years). Indeed, studies have shown this to be true, that most people have a lower income in retirement. So, for those people, it is usually better to max out their tax deductible plans first, then go for the Roth.

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Post by redbeard » Wed Mar 12, 2008 10:30 am

Greenberry wrote:The key point about marginal analysis is not that you look at the marginal rate after contributing the $10k to either plan, or the marginal rates before contributing to either plan, but that you start with $0 assigned to both, then consider where the optimal place to put the first dollar is, then consider where the best place for the next dollar is, etc.*

*The tax code is non-linear, so with $10k, you (or your computer) would ideally do as dbr has suggested and look at all possibilities of $0 to Traditional, $10,000 to Roth; $1 to Traditional, $9999 to Roth; $2 to.. and so on.
You are making this way too complicated. You don't need to perform 10,000 calculations on a $10,000 contribution. There is no set rule as to where one needs to begin marginal analysis. If you start at 100% TIRA and add ROTH until you find adding more would make you worse off, then stop there. To make this even easier you can take a shortcut and look only at the points where marginal rates change (as I did in my examples on the first page).

The only exception to the above is in the rare case where tax rates rise with income, then drop as income rises, and then rise again. In this case you could find two different optimums so where you start would determine which one you ran into. This is a pretty weird corner case though so not something one should worry about from a practical perspective when thinking about TIRA vs ROTH.

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Post by redbeard » Wed Mar 12, 2008 10:44 am

mptfan wrote:Greenberry, I think you misunderstood what I have said. I have never said that it is ALWAYS better to contribute to a 401k than a Roth. I said that it is usually better to do so, for those in their peak earning years, and who find themselves in a relatively high tax bracket. I stand by that assertion, and I think you agree. I agree that you can construct examples where someone expects to be in a higher tax bracket in retirement, and that person would benefit from a Roth IRA for some of their marginal income dollars in retirement. I agree it is a good idea to have some Roth money and some pretax money in retirement for tax diversification. I think we agree more than we disagree, and perhaps redbeard agrees with me on these points as well. However, I continue to maintain that for high income earners during their peak earning years, most will find themselves in a lower marginal, and lower effective tax rate in retirement (as compared to their marginal tax rate during their working years). Indeed, studies have shown this to be true, that most people have a lower income in retirement. So, for those people, it is usually better to max out their tax deductible plans first, then go for the Roth.
Yes. In fact I agree with the entire post.

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Post by CaptMidnight » Wed Mar 12, 2008 7:08 pm

dphmd wrote:One other advantage to Roth accounts (I assume this is the same for 401k's as it is for IRA's, anyway) is that there are no MRD's.
Not true. Roth 401k do have a required mimimum distribution, unlike Roth IRAs. The govt only made that mistake once.

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Post by Oddibe McDowell » Wed Mar 12, 2008 7:43 pm

Someone correct me if I'm wrong -

but it's my understanding you can roll a Roth 401(k) directly into a Roth IRA.

Therefore, the Roth 401(k) effectively has no RMD either (unless the law changes).

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Post by Norton750 » Wed Mar 12, 2008 8:13 pm

Nearly 90% of my net worth (not counting home) is in tax deferred accounts. I'm thrilled to now have access to a Roth 401(k) and am maxing it out, with an eye towards diversifying the "taxableness" of my investments.

Here's my contribution to the ideas being presented here:
In 1981 my wife and I had a taxable income of $54,500. Does anyone care to take a guess at what our marginal Federal tax rate was that year?
49% is the answer. I believe that the maximum Federal tax rate that year was 70%! This did *not* include state tax or Social Security, etc - just the straight Federal income tax.

Yes, they could change the rules on Roth taxation. But if I care to bet on the future, my bet is that it won't be long before marginal federal tax rates of twenty some percent are going to be just a fond memory for anyone earning a living wage.

Nick

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Post by Greenberry » Wed Mar 12, 2008 8:49 pm

mptfan wrote:Greenberry, I think you misunderstood what I have said. I have never said that it is ALWAYS better to contribute to a 401k than a Roth....
As I think I said, I agree with your conclusion that traditional 401k is usually better than Roth and it seems we are almost completely in agreement about that and other points. However, the reasoning you use about effective tax rate to arrive there is mathematically incorrect. The only thing my post above was addressing is that the PROCESS you use to arrive at that conclusion is just plain wrong.

Example:
mptfan wrote:
redbeard wrote:It really is the marginal tax rate you need to consider in the future, not
the average one. At some point if you trade off enough from the IRA to the Roth, you will start to impact your future marginal tax rates. However, even then it is still the marginal tax rates you need to consider, not the new average tax rates.
redbeard, I understand your point, but it is wrong.
Redbeard is correct in his explanation, and with all due respect, mptfan, it is you who is not understanding the math.
redbeard wrote:You are making this way too complicated. You don't need to perform 10,000 calculations on a $10,000 contribution. There is no set rule as to where one needs to begin marginal analysis. If you start at 100% TIRA and add ROTH until you find adding more would make you worse off, then stop there. To make this even easier you can take a shortcut and look only at the points where marginal rates change (as I did in my examples on the first page).

The only exception to the above is in the rare case where tax rates rise with income, then drop as income rises, and then rise again. In this case you could find two different optimums so where you start would determine which one you ran into. This is a pretty weird corner case though so not something one should worry about from a practical perspective when thinking about TIRA vs ROTH.
What you've proposed is called a greedy search and it works just fine as long as the tax rate is smooth, as you've noted. And in many cases it is smooth enough that the simplification you mentioned is good enough. However, I'm not sure that the "rare case" you've described is actually all that rare given the numerous phase outs of credits and deductions in the tax code, the interaction of capital gains/QDI rates with regular income, and AMT; in those cases, greedy search may not find the global optimum and you would need to do the 10,000 calculations I mentioned if you want to be sure you have the "correct" answer, which of course is trivial for a computer to do but much harder for people, which is why we often use those shortcuts. For what it's worth, I only included it for completeness and use the greedy marginal analysis myself.

Finally, yes, a Roth 401k can be rolled into a Roth IRA, which currently has no RMD provisions, and you can thus easily evade the RMD requirements of a Roth 401k.

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Post by tfb » Wed Mar 19, 2008 10:12 am

Hedgy wrote:Second, I would really urge you to write up a post on the case against Roth401k. For me and many others, I think it would clarify a lot of the issues that have been muddled in the popular media.
I posted The Case Against Roth 401(k) on my blog today. Please feel free to comment either on the blog or here.
Harry Sit, taking a break from the forums.

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Post by redbeard » Wed Mar 19, 2008 12:14 pm

tfb wrote:I posted The Case Against Roth 401(k) on my blog today. Please feel free to comment either on the blog or here.
Wow. You really nailed a very complex issue. Nice job!

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Post by Hedgy » Wed Mar 19, 2008 12:53 pm

Thanks, tfb! Will read it and let you know.

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Post by Yuba » Wed Mar 19, 2008 2:17 pm

Good article. A couple of points:

-> 3. Leave the option open for Roth conversion in the future.

This is a good point, but is more complex than saying you have the option to convert when you feel like. The conversion rules (unless changed in the next few years and made permanent based on the 2010 rules) still only allow certain people to convert (under 100k AGI), so based on your personal situation, you may *never* have an option to convert in the future. (if you income never drops below the limit).

-> 4. Avoid triggering phase-outs and AMT
Great point and needs to be addressed for people around each of the "trigger" points.

You also fail to address how pensions and Social Security can quickly "fill-up" the lower tax brackets of the progressive tax code before the Traditional 401k withdrawals.

I would also like your opinion if you feel contributing to a Roth IRA is still recommended before or after filling up your Traditional 401k allotment.

Would also be helpful to add a section on potential Traditional account sizes whose RMD's would put you into larger brackets. If your RMD forces you into a higher bracket because you have been putting 15k/year into traditional 401k then (although its a nice problem to have) it is a problem that could have been remedied with distributions from both Roth and Traditional accounts.

Rick dba Yuba

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Post by Hedgy » Wed Mar 19, 2008 4:18 pm

tfb wrote:
Hedgy wrote:Second, I would really urge you to write up a post on the case against Roth401k. For me and many others, I think it would clarify a lot of the issues that have been muddled in the popular media.
I posted The Case Against Roth 401(k) on my blog today. Please feel free to comment either on the blog or here.
Thank you for cutting through all thejunk and clarifying this critical issue.
The post was great!

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Post by tfb » Wed Mar 19, 2008 6:10 pm

Yuba wrote:Good article. A couple of points:

-> 3. Leave the option open for Roth conversion in the future.

This is a good point, but is more complex than saying you have the option to convert when you feel like. The conversion rules (unless changed in the next few years and made permanent based on the 2010 rules) still only allow certain people to convert (under 100k AGI), so based on your personal situation, you may *never* have an option to convert in the future. (if you income never drops below the limit).
We can work only with the current law which says you can convert if your AGI is under 100k in 2008 and 2009, no limit on conversion in 2010 and thereafter. That's the assumption until the law changes.
Yuba wrote:-> 4. Avoid triggering phase-outs and AMT
Great point and needs to be addressed for people around each of the "trigger" points.

You also fail to address how pensions and Social Security can quickly "fill-up" the lower tax brackets of the progressive tax code before the Traditional 401k withdrawals.
I did say if someone has a good pension, it makes sense to use Roth. For my generation (40's and younger), most people don't have any pension at all. SS probably won't be as rich either.
Yuba wrote:I would also like your opinion if you feel contributing to a Roth IRA is still recommended before or after filling up your Traditional 401k allotment.
Roth beats non-deductible IRA and taxable account for sure. If someone is still eligible for a deductible IRA, then it's the same decision as Roth 401k versus Traditional 401k.
Yuba wrote:Would also be helpful to add a section on potential Traditional account sizes whose RMD's would put you into larger brackets. If your RMD forces you into a higher bracket because you have been putting 15k/year into traditional 401k then (although its a nice problem to have) it is a problem that could have been remedied with distributions from both Roth and Traditional accounts.
I don't think RMD is a big problem for people without good pension. For most people the problem is having insufficient savings for retirement, not having too much in the Traditional IRA after they reach 70-1/2. People who accumulate a lot in the Traditional IRA will retire early because they can afford to do so. The IRA will be drawn down to meet income needs and converted into Roth before 70-1/2. If you don't have a lot in the Traditional IRA, you don't have much to worry about RMD anyway.
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Post by AzRunner » Wed Mar 19, 2008 11:03 pm

While a nice problem to have, the RMD is an issue for those who socked away a lot in a 401(k) over the years. Even with retiring early there is no practical way to convert these funds to a Roth without quickly getting into the 25% marginal tax bracket.

Just looking at my situation this year, a Roth conversion would end up with a tax on the conversion at 25% due to long term capital gains moving from 5% to 15% and the conversion being taxed at 15%. Also the conversion dollars increase the hurdle on medical expenses so that without a conversion I can itemize and get about $3K more in deductions than the standard deduction that exceeded my itemized deductions with the conversion.

All this and the market downturn led me to recharacterize my conversion.

Bottom-line: there is no free ride regarding a Roth conversion. The IRS is still going to extract their money.

Norm

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Post by sippyCUP » Sat Mar 22, 2008 6:59 pm

I don't know if I'm missing something crucial here, but if I were to contribute 200k over the years to both a Roth IRA and a traditional IRA, assume that I make 800k in returns. I would have paid income taxes on 200k of basis for the Roth, whereas I'd have to pay income taxes on one million of traditional IRA over the whole distribution process. Doesn't this clearly tip the scales in favor of the Roth?

Sorry if this point is implicit in the previous arguments.

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Post by livesoft » Sat Mar 22, 2008 7:34 pm

You left out the tax-deferred growth of the taxes you pre-paid on the Roth. If the tax rates are the same, the taxes (and their growth) would equal the taxes you paid upon withdrawal of the traditional IRA. But tax rates are not the same. They are likely lower with the traditional IRA in many (but not all) cases.

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Post by redbeard » Sun Mar 23, 2008 1:34 am

sippyCUP wrote:I don't know if I'm missing something crucial here, but if I were to contribute 200k over the years to both a Roth IRA and a traditional IRA, assume that I make 800k in returns. I would have paid income taxes on 200k of basis for the Roth, whereas I'd have to pay income taxes on one million of traditional IRA over the whole distribution process. Doesn't this clearly tip the scales in favor of the Roth?
You would pay far more in taxes for the TIRA in the scenario you describe, but assuming your marginal rates were equal in retirement and accumulation you would be no better or worse off choosing the TIRA vs the ROTH. You have to look at the net result in retirement to see why this is the case. Using your example of $200k pre tax growing 5x to $1,000,000 in retirement, here is how this would work if you were in the 25% marginal tax bracket for both accumulation and retirement.

TIRA
$200k pre tax deposited into TIRA gives an initial balance of $200k
$200k X 5 = $1,000,000 in retirement
25% tax on $1,000,000 = $250,000
$1,000,000 - $250,000 = $750,000 after tax in retirement

ROTH
$200k pre tax deposited into ROTH gives an initial balance of $150k after taxes paid ($200k X 25% = $50k, $200k - $50k = $150k)
$150k X 5 = $750,000 in retirement (no tax due)

However, as livesoft pointed out you may well be in a lower marginal rate in retirement than you are now. Also, even if the marginal rates are the same in both accumulation and retirement phases, in most cases not all of your IRA withdrawals would be taxed at your retirement marginal rate because of our progressive tax structure. Unless you had significant other sources of income in retirement much of your IRA withdrawals wouldn't be taxed at all or taxed in a lower bracket. When you take this last part into account, for a large part of your savings (>80% ?) you would be better off with a TIRA over a ROTH.

Also, when you choose to fund one form or the other depends on your current marginal tax bracket. Lets assume that based on expected marginal tax rates in accumulation and retirement you decide your optimal mix is 85% TIRA and 15% ROTH. This doesn't necessarily mean you want to split your savings each year this way. In years where you are in a relatively low tax bracket (just getting started, pre retirement, lots of deductions, etc) this is your best opportunity to fund the ROTH (but don't give up a 401k match to do so!). In years where you are in a relatively high tax bracket you probably only want to fund the TIRA.

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Post by Sammy_M » Sun Mar 23, 2008 12:36 pm

This was an excellent discussion.

For the past 2 years I have been in the 28% marginal tax bracket and have been contributing the full 15k (2006)and 15.5k (2007) max to my Roth 401k. My rationale for doing so was I could get more money in tax advantaged accts (i.e., $15,500 of my money vs. $11,160 of my money and $4,340 of the Govt's). My company's contribution, which almost matches mine, obviously goes into the Trad'l 401k and is unaffected by what I do. I thought this was a pretty good "hedging" strategy - half Roth, half Tradl.

Next year I expect to be just into the 33% marginal tax bracket. After reading this discussion, I am thinking I should go back to the Trad'l 401k for my contribution and invest the difference in a taxable acct.

Does this sound like the best approach? I realize no one has a crystal ball, but would appreciate opinions. Btw, I have no pensions and the only other income in retirement may be some rental property. I have 20-25 years to retirement.

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Post by bdpb » Sun Mar 23, 2008 1:19 pm

Sammy_M wrote: Next year I expect to be just into the 33% marginal tax bracket. After reading this discussion, I am thinking I should go back to the Trad'l 401k for my contribution and invest the difference in a taxable acct.
I know I've said this before and it may not change your decision, but there
is an additional cost of doing this that some folks either fail to recognize or
are unwilling to acknowledge. You may have to pay taxes every year
on this difference in the taxable account. Probably a minimum of 30 bp,
more if you hold inefficient asset classes and even more when current
favorable tax laws expire in 2010.

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Post by White Coat Investor » Sun Mar 23, 2008 3:19 pm

Sammy_M wrote:
Next year I expect to be just into the 33% marginal tax bracket. After reading this discussion, I am thinking I should go back to the Trad'l 401k for my contribution and invest the difference in a taxable acct.

Does this sound like the best approach? I realize no one has a crystal ball, but would appreciate opinions. Btw, I have no pensions and the only other income in retirement may be some rental property. I have 20-25 years to retirement.
This discussion is Roth vs traditional NOT tax-protected vs taxable. With 20-25 years to go I think it would probably be pretty dumb to use a taxable account if a tax-protected account (Roth or traditional) were available to me.

The lower after-tax contribution limit of a traditional IRA vs a Roth IRA is an issue though.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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Post by Sammy_M » Sun Mar 23, 2008 6:06 pm

EmergDoc wrote: This discussion is Roth vs traditional NOT tax-protected vs taxable. With 20-25 years to go I think it would probably be pretty dumb to use a taxable account if a tax-protected account (Roth or traditional) were available to me. The lower after-tax contribution limit of a traditional IRA vs a Roth IRA is an issue though.
Perhaps I should have been clearer when I said "traditional...and invest the difference in taxable"

Faced with these two choices, which is preferable?
(A) $15,500 in Roth 401k
(B) $15,500 in Tradl 401k + plus $4,340 in Taxable

Both result in roughly the same take-home pay (after taxes) assuming a 28% tax rate (ignoring state tax for now).

Like I said, the reason why I've opted for the Roth 401k option in the past is simply that I prefer not to share my precious $15.5k space with the government. I thought the Roth simply allowed me to put away more of MY money in tax advantaged accts. After reading this thread, I am rethinking my logic. Thoughts?

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Post by White Coat Investor » Sun Mar 23, 2008 6:17 pm

Sammy_M wrote: Like I said, the reason why I've opted for the Roth 401k option in the past is simply that I prefer not to share my precious $15.5k space with the government. I thought the Roth simply allowed me to put away more of MY money in tax advantaged accts. After reading this thread, I am rethinking my logic. Thoughts?
You could be right. Hard choice though.
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Post by redbeard » Sun Mar 23, 2008 10:45 pm

Sammy_M wrote:Like I said, the reason why I've opted for the Roth 401k option in the past is simply that I prefer not to share my precious $15.5k space with the government. I thought the Roth simply allowed me to put away more of MY money in tax advantaged accts. After reading this thread, I am rethinking my logic. Thoughts?
Wow. There are a lot of moving parts to this scenario! I'm not sure the best way to evaluate the options one has when hitting max contribution limits. Absent a proper model, I think I'd try to set a target allocation for ROTH vs TIRA at the beginning of retirement, and then decide when you want to fund each one based on expected marginal tax rates during your accumulation years.

I may be all wet on this, but I thought you could max out both IRA and 401ks. Do you qualify to put another $5k into a ROTH IRA above and beyond your 401k? If so, I think I'd probably put $5k into a ROTH IRA and move towards more traditional on the 401k side.

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Post by Sammy_M » Mon Mar 24, 2008 6:57 am

redbeard wrote:I may be all wet on this, but I thought you could max out both IRA and 401ks. Do you qualify to put another $5k into a ROTH IRA above and beyond your 401k? If so, I think I'd probably put $5k into a ROTH IRA and move towards more traditional on the 401k side.
Thanks for your thoughts. I think you are correct, and I'm maxing both an IRA (5k) and 401k (15.5k). I'm ineligible to contribute to the Roth IRA due to income limits, but my company has a Roth 401k option. I'm putting $5k in non-deductible TIRA (with goal to convert in 2010 to Roth). For my $15.5k max in the 401k, and I've got the option to put it (i) all in Roth (as I've done for past 2 yrs), (ii) all in Trad'l, or (iii) some mix. One last piece to this, my company's profit sharing contribution almost equals mine, and it is going into Tradl. Maybe a reasonably sound approach would be to keep contributing the max to the Roth side of the 401k until I reach the edge of the next tax bracket, and then put the rest in the Tradl side? I guess I should also look at the income limits for certain tax credits too.

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Post by redbeard » Mon Mar 24, 2008 9:33 am

Sammy_M wrote:For the past 2 years I have been in the 28% marginal tax bracket and have been contributing the full 15k (2006)and 15.5k (2007) max to my Roth 401k. My rationale for doing so was I could get more money in tax advantaged accts (i.e., $15,500 of my money vs. $11,160 of my money and $4,340 of the Govt's).
I wanted to point out an assumption you seem to be making that you may not have considered. Your calculation above that a ROTH allows you to save a net additional $4,340 each year in ROTH over TIRA assumes your marginal rate in retirement will be 28%, which just happens to be your most recent marginal rate. If your marginal rate in retirement will only be 15%, then a $15,500 TIRA contribution would be equal to $13,175 in ROTH (not $11,160); in that case the ROTH would only allow you to save an additional $2,325 each year. As you go up in brackets in your accumulation years, this becomes more important to consider the right way. Also, the more savings you move into ROTH vs TIRA today, the more you likely lower your marginal rate in retirement.

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Post by tfb » Mon Mar 24, 2008 9:45 am

At 33% + state tax, I'd do Traditional + tax efficient funds in taxable. The money in the taxable account becomes a good source for paying the tax for Roth conversion if you ever get a window of being in a lower tax bracket.
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Post by redbeard » Mon Mar 24, 2008 10:12 am

Sammy_M wrote:Thanks for your thoughts. I think you are correct, and I'm maxing both an IRA (5k) and 401k (15.5k). I'm ineligible to contribute to the Roth IRA due to income limits, but my company has a Roth 401k option. I'm putting $5k in non-deductible TIRA (with goal to convert in 2010 to Roth).
You are most welcome.

Again I may be all wet on this, but in reading the above I was wondering if you might be able to change your eligibility to either a ROTH IRA or a deductible TIRA by moving from ROTH to Traditional in your 401k contributions. Would $15,500 less MAGI make the difference on either one? If so, I guess the more important question is does the tax code allow you to do it this way.

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