Roth vs Traditional 401K

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Greenberry
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Post by Greenberry » Mon Mar 24, 2008 10:20 am

redbeard wrote:
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.
Hi redbeard, in this case, Sammy_M is correct: the difference should be calculated based on today's tax rates, because the two scenarios he described cost him the same amount today, so with the same amount of money to invest and pay today's taxes with, he could invest 15.5k into a Roth 401k, or 15.5k into a Trad 401k plus 4.3k into a taxable account.

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redbeard
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Post by redbeard » Mon Mar 24, 2008 11:13 am

Greenberry wrote:Hi redbeard, in this case, Sammy_M is correct: the difference should be calculated based on today's tax rates, because the two scenarios he described cost him the same amount today, so with the same amount of money to invest and pay today's taxes with, he could invest 15.5k into a Roth 401k, or 15.5k into a Trad 401k plus 4.3k into a taxable account.
In a later post he poses the question that way, but in the post I was quoting he is talking about how to get the maximum net value into tax advantaged accounts. When thinking about maximizing the amount he can contribute to tax advantaged accounts, his marginal rate in retirement is the right rate to consider. However, as you point out (and he referenced in a later post) he could take his tax savings from contributing to the traditional up to the limit and place that in a taxable account. The point being that at his 28% bracket, he wouldn't have been giving up $4,340 in net tax advantaged savings to free up the same amount for a taxable account. He would only be giving up $2,325 in lower tax advantaged savings (assuming a retirement marginal rate of 15%) to free up $4,340 for a taxable account. Add in state taxes and his new marginal bracket of 33%, and this gets even stronger. Additionally, the longer he contributes at a high rate to his ROTH, the lower his likely retirement bracket is making the TIRA more compelling as well.

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Post by Greenberry » Mon Mar 24, 2008 11:33 am

Good call -- I see now what you meant and you're indeed quite correct.

kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Mon Jun 16, 2014 6:30 pm

This is an old thread...but I was wondering...in deciding between 401(k) and Roth 401(k), do we also need to consider what to with extra money in hand with traditional 401(k)?

I want to see if my thinking is correct or wrong?

Overall it seems like if I contribute to Roth 401(k), I get a SMALLER paycheck today. So in my mind I'm thinking of this as "forced" saving, meaning I'm forced to live within my means.

But if I contribute to Traditional 401(k), I get more money in my hands today...so I'm responsible for that extra money. So I should ask myself:
Can I make better use of this money, or get better return, than what it would earn inside a Roth 401(k)?

If the answer is yes, then I should contribute to Traditional 401(k). But if the answer is No, then I should contribute to Roth 401(k), so this money is out of my hands.

In my case the answer is No...because either I'll spend the extra money, or even if I save it, the best I could do is put it in taxable account (to buy Total stock index, or Total international index)...so I'm leaning towards contributing 100% to Roth 401(k)...and only the 5% company match would go to Traditional 401k (which is automatic).

Is this the correct way to think about this?

Thanks.

livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Mon Jun 16, 2014 6:37 pm

That's a fine way to think about it. To me, I can put it in a taxable account in a fund like Total US Stock Market Index or Total Int'l Stock Market index. While I will get the same return as if I had it in a Roth 401(k), I will actually pay lower taxes on the combined traditional 401(k) + taxable investments than I would if I had paid taxes to put the money in Roth 401(k).

For example, I was paying something like 47% tax to put something in a Roth, but in retirement I will be paying close to 0% on traditional 401(k) withdrawals and taxable investments. I sure like saving that 47%.
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kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Mon Jun 16, 2014 6:52 pm

livesoft wrote:That's a fine way to think about it. To me, I can put it in a taxable account in a fund like Total US Stock Market Index or Total Int'l Stock Market index. While I will get the same return as if I had it in a Roth 401(k), I will actually pay lower taxes on the combined traditional 401(k) + taxable investments than I would if I had paid taxes to put the money in Roth 401(k).

For example, I was paying something like 47% tax to put something in a Roth, but in retirement I will be paying close to 0% on traditional 401(k) withdrawals and taxable investments. I sure like saving that 47%.
0% how?

Also I was looking at this calculator:
https://www.schwabplan.com/download/Rot ... ulator.htm

I thought if tax rates now and in retirement are same, it should be a wash? But It is showing Roth 401(k) as better?
Image

kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Mon Jun 16, 2014 7:00 pm

Also, another calculator:
https://www.americanfunds.com/retiremen ... ernal.html

It is saying that even if we reinvest the tax saving from traditional 401(k), Roth still comes out ahead?

Is this correct :confused

I put in this:
Image

Output 1/2:
Image

Output 2/2:
Image

Caduceus
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Re: Roth vs Traditional 401K

Post by Caduceus » Tue Jun 17, 2014 4:07 am

I think you should use something like an excel spreadsheet and briefly simulate what the effect of a Roth vs. Traditional 401(k) would be. There are so many moving parts that going through this exercise is really the best way of seeing how it will work out as you vary different elements. All you need are two columns and you can run a pretty cool simulation. Some things to think about:

Don't forget to start with the correct initial amounts. For a Roth 401(k), you use the after-tax amount, but for a traditional 401(k) you will use the pre-tax amount for the base that is to be compounded. If you will be tempted to spend the "extra" you get from choosing the traditional 401(k), that won't be a fair comparison.

Estimate the dividend tax drag. The money in the Roth and traditional 401(k) will grow at a faster rate than the part that you place in the taxable account. Depending on what you intend to hold in the taxable account, you can adjust the rate of growth for the dividend tax drag (do a rough estimate of the average dividend yield and the applicable tax depending on whether they will be qualified dividends or not.)

Estimate the beginning and ending tax brackets. Don't forget to account for state taxes. Maybe some of your ending traditional amounts will be taxed at the 0% bracket. Maybe not.

Try varying the years and the rate of compounding to see when the breakeven point between the two options is.

Basically, once you have the simulation flow down, you can play around with everything simultaneously and see how changes in your assumptions will predispose you one way or another. You could vary the tax brackets, the dividend tax drag, the number of years of compounding, etc. When I did this, I was pretty surprised at how clear things became for my own situation. One option was clearly superior.

There are things that you might not be able to directly value. For instance, a Roth will be worth more if future tax rates increase. Also, if you will have low-income years where you will be able to take advantage of conversions (e.g. you plan to go to graduate school), that is also a consideration.

Generally, if you can get money into a Roth at the 15% tax bracket, especially if you have decades to go before retirement, I would lean toward that option. At higher brackets, given the current tax regime, the Traditional vehicles will probably come out ahead. But again ... I think running the simulation is best.

kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 7:04 am

Caduceus, one thing: when folks discuss or compare 401(k) to Roth 401(k), is that with the assumption that the tax money saved (more money in hand), is also invested?
When I see some suggestions that traditional is better, in those cases is traditional better despite not saving the tax money?

Caduceus
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Re: Roth vs Traditional 401K

Post by Caduceus » Tue Jun 17, 2014 9:50 am

Hey kayanco, I think for the comparison to work, yes, it is with the assumption that the money "saved" initially from not paying taxes is also invested. The traditional won't be better if you don't take the tax savings into consideration because you will basically be saving more in a Roth than in a traditional ($100 in a Roth now is worth much more than $100 in a traditional vehicle because the former has already been taxed).

If you're maxing out your accounts, you should compare the Roth 401(k) vs. 401(k) + Taxable; and if you're not yet maxing out the accounts, you can compare the post-tax Roth amounts with the higher pre-tax Traditional amounts given the same starting savings.

It's really hard to come up with a general rule that traditional is better, or that Roth is better, which is why I suggested running some simulations to experiment. But here are some general ideas ...

The lower your current tax rate, the more likely the Roth is advantageous (since you're prepaying taxes at a low rate now)

The longer you are from retirement, the more likely the Roth is advantageous. That's not only because a larger ending amount will be subjected to tax in a regular 401(k), but because if you're young, your exposure to tax uncertainty is far greater than many of the posters here. Tax rates right now are, from a historical perspective, very low. It's possible that they will stay the same or go down, but also quite possible (if not likely) that they will go up by the time you retire. All things equal, a Roth has some value akin to that of a protective put.

The higher your dividend drag in the taxable account, the more likely the Roth is advantageous. This is largely within your control though, as you can choose efficient investments to place in taxable.

The traditional is better when you are in a relatively high present income tax bracket, because there is a good chance you will be able to withdraw some of your 401(k) money at the end at lower tax rates.
Last edited by Caduceus on Tue Jun 17, 2014 10:36 am, edited 1 time in total.

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rob
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Re:

Post by rob » Tue Jun 17, 2014 9:51 am

gvernon wrote:
allenmickers wrote:One large previously unmentioned advantage to the Roth for me personally, is that I know exactly how much money I have for retirement. The number in my account, is the number I have. I dont have to estimate tax costs or anything else. This is why I refuse to buy any funds that have an exit cost like VEIEX emerging markets. I want to know exactly how much I have.
this is appealing. but i suppose i'm willing to live without that conveinence if a traditional would net me more money in the end.
Might be appealing but it's not true..... For example (there are a million question like this one): What will the sales tax rate be? Tax will affect a roth indirectly (especially if "something" changed to cause higher taxation on the consumption side rather than the income side). Personally... I will have some of both so will be able to say I picked the right path and forget to mention I also picked the wrong path... maybe I can write books if they still exist :D
| Rob | Its a dangerous business going out your front door. - J.R.R.Tolkien

Caduceus
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Re: Roth vs Traditional 401K

Post by Caduceus » Tue Jun 17, 2014 10:53 am

My guess is most people in the 25% bracket will be better served with traditional vehicles, but this is partly a behavioral issue. I very much doubt that those who saved $17,500 in a regular 401(k) are consciously thinking they now need to set aside the extra few thousand dollars in taxable. Quite possibly, the "extra" cash flow is spent. So even if a regular 401(k) is better, some people might just end up saving more money if they use a Roth.

livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 11:02 am

kayanco wrote:0% how?
Judicious tax planning as described in the well-worn ZERO taxes thread:
http://www.bogleheads.org/forum/viewtopic.php?t=87471
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Re:

Post by RedPen » Tue Jun 17, 2014 11:15 am

mptfan wrote:For those in their peak earning years, it is usually better to maximize tax deductible plans (401k, 403b, SIMPLE IRA, SEP IRA, deductible traditional IRA) before investing in non-tax deductible plans (Roth IRA) because:

1) You get an immediate tax reduction equal to your marginal tax rate. If you are currently in your peak earning years, you are probably in a high marginal tax bracket, say 25% or higher, and you will save 25% or more of every dollar you invest in a tax deductible plan. 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.
Thanks. This is a really nice explanation.

kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 12:03 pm

Hmmm...ok, can you please tell me if the following way to think about it is correct or flawed?

If one person is maxing out Traditional 401(k) with $17,500 and another guy is maxing out Roth 401(k) with $17,500...both having the same fund in it, will grow to the same $ value...but at retirement time, the Roth will be worth more because of 0 tax whereas the Traditional will have to pay taxes? Irrespective of current or future marginal/average taxes, the Roth will be better under the condition that every year the SAME $ amount goes in Roth vs. Traditioanl?

Is that much of my understanding correct?

livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 12:15 pm

That way to think about it is flawed because you have ignored the taxes that were paid before the $17,500 was contributed to the Roth IRA.

Suppose one is in the 28% tax bracket and no state income tax and a "clean" tax return (no credit expiring, etc), then in order to be able to contribute $17,500 to the Roth, one needed to start with $24,305. The first thing that happened to the $24,305 was that 28% of it went to IRS, leaving one with 72% of it: $24,305 * 0.72 = $17,500.
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livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 12:20 pm

So let's have 2 people in the 28% tax bracket start out with $24,305 to be invested.
Person A, pays $6805 in income taxes and puts $17,500 into a Roth 401(k).
Person B, puts $17,500 into a traditional 401(k) which causes their tax bracket to drop to 25% and then pays 25% taxes on the remaining $6805 leaving them with about $5104 which they put into a Roth IRA.

Now what happens when they reach age 60 and retire? Can you guess who will have more money after taxes to pay expenses?
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kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 12:31 pm

livesoft wrote:That way to think about it is flawed because you have ignored the taxes that were paid before the $17,500 was contributed to the Roth IRA.

Suppose one is in the 28% tax bracket and no state income tax and a "clean" tax return (no credit expiring, etc), then in order to be able to contribute $17,500 to the Roth, one needed to start with $24,305. The first thing that happened to the $24,305 was that 28% of it went to IRS, leaving one with 72% of it: $24,305 * 0.72 = $17,500.
livesoft, thanks. Yes I understand that part...taking your numbers, so the Traditional guy will have $6,805 ($24,305-$17,500) more money in his hands,that he can do stuff with.

If he takes all of that money and spends it (e.g. cable, movies, bla bla)...THEN will the Roth guy be better off in retirement (irrespective of starting or ending tax rates)?

Is this much correct, or still flawed?

Thanks livesoft

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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 12:53 pm

kayanco wrote:If he takes all of that money and spends it (e.g. cable, movies, bla bla)...THEN will the Roth guy be better off in retirement (irrespective of starting or ending tax rates)?
No, the Roth guy won't be better off, but will have missed out on becoming a cultured, sophisticated, man-about-town from all those movies he didn't watch.
http://www.youtube.com/watch?v=2p5AG0Tqh3A start watching at 2:43
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kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 1:25 pm

livesoft wrote:
kayanco wrote:If he takes all of that money and spends it (e.g. cable, movies, bla bla)...THEN will the Roth guy be better off in retirement (irrespective of starting or ending tax rates)?
No, the Roth guy won't be better off, but will have missed out on becoming a cultured, sophisticated, man-about-town from all those movies he didn't watch.
http://www.youtube.com/watch?v=2p5AG0Tqh3A start watching at 2:43
LOL, come on now :p
I mean financially...I'm trying to get a baseline understanding to level set. If the Traditional guy didn't save the extra money, in that case would the Roth guy be better off financially, irrespective of starting/ending tax rates?

livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 2:11 pm

You are right. The person who didn't save money is worse off. However, I think it is better to spend money on experiences and stuff than it is to spend it on taxes. What do YOU think? Taxes? Experiences and stuff?
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kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 3:20 pm

livesoft wrote:You are right. The person who didn't save money is worse off.
Thanks livesoft! Like I said just trying to get a base level understanding of when one is better than other....regarding your question:
livesoft wrote:... However, I think it is better to spend money on experiences and stuff than it is to spend it on taxes. What do YOU think? Taxes? Experiences and stuff?
Agree...one hundred percent!
Even if the experience is trivial, I'd still prefer it over taxes any day :D

kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 3:30 pm

livesoft wrote:So let's have 2 people in the 28% tax bracket start out with $24,305 to be invested.
Person A, pays $6805 in income taxes and puts $17,500 into a Roth 401(k).
Person B, puts $17,500 into a traditional 401(k) which causes their tax bracket to drop to 25% and then pays 25% taxes on the remaining $6805 leaving them with about $5104 which they put into a Roth IRA.
..
livesoft, can you please run this one more time please, with the following mod:
So let's have 2 people in the 25% tax bracket start out with $23,333 to be invested.
Person A, pays $5833 in income taxes and puts $17,500 into a Roth 401(k).
Person B, puts $17,500 into a traditional 401(k) which causes their tax bracket to remain at 25% and then ...??...

Does that example only work if paying pre-tax will cause a lowering of the tax bracket? Or can we still run it if tax bracket remains same? Or would it make it a wash? Please clarify...

Thanks.

livesoft
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Re: Roth vs Traditional 401K

Post by livesoft » Tue Jun 17, 2014 3:41 pm

I'm going to let you think about this for yourself for a few days.
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kayanco
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Re: Roth vs Traditional 401K

Post by kayanco » Tue Jun 17, 2014 4:16 pm

livesoft wrote:I'm going to let you think about this for yourself for a few days.
I don't know what formula you are using, but I just used compound interest calculator

Image

Case 1. Roth 401(K):
Income: 70,000
25% tax on 70,000 = 17,500
Contribute 17,500
In hand: 70,000-17,500-17,500 = 35,000
Investment per screenshot = 767,640

Case 2. Traditional 401(K):
Income: 70,000
Contribute 17,500
25% tax on 52,500 = 13,125
In hand: 52,500-13,125 = 39,375
Saving vs. Roth = 4,375
401(k) Investment = 767,640
Pay 25% tax on investment, actual worth = 575,730 - So Roth 401(k) is 33% greater!
So only if:
Invest the extra 4,375 in Roth IRA, = 191,910
575,730 + 191,910 = 767,640 = Roth 401(k) worth

It seems like a wash to me :confused

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Re: Roth vs Traditional 401K

Post by grabiner » Tue Jun 17, 2014 4:36 pm

kayanco wrote:Also, another calculator:
https://www.americanfunds.com/retiremen ... ernal.html

It is saying that even if we reinvest the tax saving from traditional 401(k), Roth still comes out ahead?

Is this correct :confused

I put in this:
Image
I believe the model assumes that your taxable returns are taxed in full every year; that is, if your taxable account returns 8% and you are in a 30% tax bracket, you will lose 2.4% to taxes every year. But if you invest in stock index funds, you will probably pay tax only at the qualified dividend rate, and only on the dividend yield; if you pay 25% federal and 5% state taxes, your tax rate is 15%+5% on dividends, on the 2% fund yield, for a tax cost of 0.4%. You will also lose 20% of all gains when you sell in retirement.

The model is closer to correct if you use American funds, because American funds are actively managed, and most of their gains are taxed each year. Even then, it still undervalues a taxable account, because much of the returns from American funds is in long-term capital gains and qualified dividends taxed at a lower rate.

Traditional versus Roth on the wiki has more realistic estimates. If you can max out a Roth 401(k), it's just about break-even to use Traditional or Roth if you are in the 28% bracket and will retire in the 25% bracket.

Another factor is the quality of the 401(k). If you work for the government and can max out the Roth TSP, you get the extra advantage of more savings in an account which is better than anything available at retail. If you work for an employer with American funds in your 401(k), you have slightly better to much better options for your non-401(k) investing, depending on which share class you have.
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FiveK
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Re: Roth vs Traditional 401K

Post by FiveK » Sun Mar 06, 2016 2:43 am

Greenberry wrote:
redbeard wrote:...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.
...I'm not sure that the "rare case" you've described is actually all that rare...
A plausible example of the local maximums described above is this:
- 25 years of $19K pre-tax contributions for a couple subject to 22% marginal tax on any Roth contributions. Growth is 8%.
- Constant withdrawals over 30 years, drawing proportionately from traditional and Roth, and taking the balances to $0 at the end.
- Social security (SS) income of $30K/yr during the 30 year withdrawal period
- Taxable income $23,100 less than the traditional withdrawal amount plus the taxable portion of the SS income. 2015 tax brackets. No credits, phaseouts, etc., other than the SS taxable income calculation.

Four results are plotted:
- Blue is the annual total of Roth plus the after-tax amount of (traditional plus SS). I.e., the spendable amount. Values are on the center y-axis.
- Pink is the nominal tax bracket of the taxable income. Where pink is not visible, it is equal to the green points.
- Green is the marginal withdrawal tax rate paid on traditional withdrawals, including the effect of making SS income taxable.
- Yellow is the average withdrawal tax rate paid on traditional withdrawals. Values for all tax rates are on the right y-axis.

The absolute value of the x-axis is the number of years the contributions go to a traditional account. Negative x-axis values mean contributions start with Roth and change to traditional, while the positive x-axis has traditional contributions first and Roth last.

Summary (looking only at the positive x-axis):
- The first maximum spendable amount occurs when the marginal withdrawal rate steps up from 18.5% to 27.75%, crossing the 22% marginal contribution rate. This happens when taxable income reaches $18,450, the divide between the 10% and 15% brackets, and requires ~3.3 years of tIRA contributions.
- The minimum between the two maximums occurs when the marginal withdrawal rate steps down from 27.75% to 15%, crossing the 22% marginal contribution rate. This happens when the tIRA withdrawals reach ~$51,941/yr so the taxable amount of SS income reaches its maximum of $25,500, and comes at ~5.8 years of tIRA contributions.
- The second maximum spendable amount occurs when the marginal withdrawal rate steps up from 15% to 25%, crossing the 22% marginal contribution rate. This happens when taxable income reaches $74,900, the divide between the 15% and 25% brackets, and requires ~9 years of tIRA contributions.

Image
Last edited by FiveK on Sun May 20, 2018 1:09 pm, edited 1 time in total.

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Re: Roth vs Traditional 401K

Post by jarhead_jr » Sun Mar 06, 2016 11:26 am

Is there some minimum tax rate that would be applied to a Traditional to Roth 401 rollovers?

What if you retired early with a full years worth of expenses on hand and did not claim SS until the following year; could you perform a rollover of your 100% traditional 401k to a Roth 401k at a 0% tax bracket due to no earned income? That seems like too easy a loop hole.

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Re: Roth vs Traditional 401K

Post by grabiner » Sun Mar 06, 2016 11:42 am

jarhead_jr wrote:Is there some minimum tax rate that would be applied to a Traditional to Roth 401 rollovers?

What if you retired early with a full years worth of expenses on hand and did not claim SS until the following year; could you perform a rollover of your 100% traditional 401k to a Roth 401k at a 0% tax bracket due to no earned income? That seems like too easy a loop hole.
The tax brackets still apply, because rollovers and conversions from traditional to Roth are taxed as ordinary income. You could convert an amount equal to your standard deduction and personal exemptions, less any other income, tax free. The next $9275 single/$18550 married would be taxed at 10%, then up to $37650/73500 at 15%, and then 25% and higher brackets would cut in. Converting a large 401(k) all at once would not work well.

Thus, after early retirement, converting up to the top of the 15% bracket every year before you take SS could be a good strategy. (Once you start taking SS, your marginal tax rate is likely to be 27.75% because of the phase-in of SS taxation.)
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