Maxing roth 401k vs trad 401k in high income tax bracket

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Doggz
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Maxing roth 401k vs trad 401k in high income tax bracket

Post by Doggz » Thu Aug 07, 2014 1:25 pm

My wife and I live in CA and are in the 33% fed tax bracket. We both max out our 401Ks and chose traditional 401ks because we're in a high tax bracket. However, recently I've been thinking that money in a roth account is worth more than money in a traditional retirement account, so does it make sense even in a high income tax bracket to save in a roth as long as we are actually maxing it out?

dharrythomas
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by dharrythomas » Thu Aug 07, 2014 1:51 pm

I use the Roth though SC taxes are lower than CA. I'm saving more than I would the other way and I like knowing how much is mine as opposed to the uncertainty of future tax rates in a traditional account.

Will we pay more than we have to? Time will tell.

People here will do a great deal of math to prove a point, but since some of the inputs are estimates the numbers give you a false sense of precision. Since you get to pick the variables in the equation (within a historical range of reasonableness), the decision is a subjective decision where we use numbers to pretend it is objective.

In this case there is no "bad" choice.

Good luck

Harry

sdrone
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by sdrone » Thu Aug 07, 2014 2:39 pm

dharrythomas wrote:I use the Roth though SC taxes are lower than CA. I'm saving more than I would the other way...
Harry


How are you saving more in the Roth than in a traditional 401k? Am I missing something here? You'd have to contribute significantly more after tax money and take a bite out of your paycheck to save more in a Roth 401k, wouldn't you?

dharrythomas
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by dharrythomas » Thu Aug 07, 2014 3:27 pm

Yes.

Money in a Roth is more valuable than money in a traditional account or in a taxable account.

If you either max out the accounts or are saving a percentage, you put more aside using a Roth account.

Like many people, life style and savings are a trade off. DW will let me set aside 15% in TSP plus a small $ amount in taxable. She'll let me do the 15% in a Roth. I effectively save more money using the Roth than I'd be able to convince her not to spend if I put money in a traditional account.

Plus I forgot to add earlier, if I have issues and need money, it is easier to get money out of a Roth account penalty free.

dharrythomas
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by dharrythomas » Thu Aug 07, 2014 3:32 pm

A Roth account is also more valuable if there is any chance that you may leave it to heirs.

If I have some left, my preferred split is traditional to the church, taxable and Roth to the kids.

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jimb_fromATL
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by jimb_fromATL » Thu Aug 07, 2014 3:36 pm

dharrythomas wrote:Yes.

Money in a Roth is more valuable than money in a traditional account or in a taxable account.


If it seems that way, it's because it costs more money to put it in the Roth because you have to pay the income tax up front. If your total percentage of income tax on all you retirement income were the same as the top tax brackets you get to defer when you contribute to a traditional 401(k), the net after taxes would be exactly the same.

So it depends a lot on your current highest brackets; and your actual percentage of taxes paid, which is lower than the amount you get to defer. Then it depends on your total income and percentage of total tax after retirement.

If you live in a state like Georgia where I live, you get to defer state income tax for a tax-deferred 401(k), but will never pay it on the withdrawals. The same might apply if you work in a state that lets you defer income tax, but might move to a state that either has no income tax or does not tax retirement income.

jimb

thx1138
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by thx1138 » Thu Aug 07, 2014 8:11 pm

There are a lot of different answers and ways to look at this. You aren't going to find a "right" answer. But let's start with an assumption - if you are in 33% and maxing everything presumably that also means you have a taxable investment account.

So - going Roth means you pay more taxes now and have less to invest in your taxable account.

If everything was equal tax wise come retirement, meaning you live in the same state and have the same marginal tax rates, then Roth has a slight advantage in that you effectively have slightly more growing tax free in the Roth. Imagine a chunk of money that pays for a Roth and taxes on that income now, effectively the extra money you pay now in taxes is the same after growth as what you'd pay when you withdrew from a Traditional. So if we don't max our 401k the Traditional/Roth choice is notionally a wash. However, if you are maxing then the Traditional the money you saved from the tax deduction is invested in a taxable account that doesn't grow tax free. That puts it at a disadvantage to the Roth growth - but not necessarily by a lot. If you chose asset location wisely you'll only see capital gains tax rates on dividend growth, not realize any actual capital gains unless you chose to, have opportunities for tax loss harvesting and get stepped up basis for your heirs. So while Roth has an advantage assuming working and retirement marginal tax rates are the same it really isn't a gang busters advantage.

There can, however, be a tax disadvantage to Roth for high income earners. Usually, but not always, your marginal taxes will be lower in retirement. Many people move to a tax advantaged state and unless you spend an awful lot your income from Traditional accounts will likely not put you in the same bracket as when you were working. Let's say you move to a tax free state and you end up in the 25% federal bracket then your marginal rate in retirement could easily be 15% lower. Traditional may have a significant advantage in that case.

But then there are plenty of other complications - RMDs from Traditional, how assets are treated in your estate and so forth. And who knows what tax rates will be when you retire. Nothing is very clear.

Basically I assume for a high income earner that all else being equal the Roth costs more in total taxes paid. It may still be worth doing though if you think future taxes will be higher, you won't ever spend the 401k money and want better tax treatment for your heirs or any of a variety of other factors. But notionally you are probably paying a bit now for those future contingencies.

learning_head
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by learning_head » Fri Aug 08, 2014 8:23 am

+1 on thx1138

In short, Roth = Traditional if your current tax situation is same as in retirement, except yes, there are some small advantages to Roth:
(1) if you contribute the maximum amount (which is same for them), more of your money is tax-advantaged (because of say 17k limit, only part of it belongs to you in Traditional, with rest belonging to government, and all of it belongs to you in Roth; or put another way, to contribute 17 to Roth you pay those 17 + taxes now but only 17 for traditional and so more of your money is put towards tax-advantaged accounts which are the same otherwise).
(2) A few other advantages of Roth relate to inheritance, no RMDs under current laws, and potentially diversifying tax advantaged accounts if you have no Roth at all, though backend Roth IRA is always available...

However, with high tax bracket, if future tax bracket is very likely to be (quite a bit?) lower, the difference in taxes would overwhelm all these small Roth advantages, and make traditional a better and pretty easy choice...

Certified Guy
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by Certified Guy » Fri Aug 08, 2014 9:12 am

Doggz wrote:My wife and I live in CA and are in the 33% fed tax bracket.


First post!

In this bracket, you earn over $225k a year. Great income. However...

1. Do you think you will need that entire amount in retirement?
2. Will you retire in CA? (this doesn't seem discussed enough IMO. If you save pretax now in CA, you save on both Federal and State taxes. If you retire in say FL or NV, then your withdrawals might not be Federal tax free, but they would be state tax free)

If you plan on living off a paltry 100k in retirement in FL, you definitely do not want to think about Roth 401k.

ArthurO
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by ArthurO » Fri Aug 08, 2014 9:44 pm

I max 401k ROTH and I am in 28 federal tax bracket + pretty high NJ. You just save more valuable money, you know exactly what you have and you can convert it to ROTH IRA before you retired to avoid RMDs. I have 9% employer match and that money has go to to pre tax account so that I will have flexibility in retirement. I would rather just pay taxes now and go for sure thing instead of speculating what the taxes will be when I retire. Also if I only have ROTH there will be no taxable income in retirement and so the SS income will NOT be taxable, this is something that most people forget...

I agree with you, just pay taxes now, bite the bullet and watch the savings grow tax free

Tanelorn
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by Tanelorn » Fri Aug 08, 2014 10:12 pm

learning_head wrote:+1 on thx1138

In short, Roth = Traditional if your current tax situation is same as in retirement, except yes, there are some small advantages to Roth:
(1) if you contribute the maximum amount (which is same for them), more of your money is tax-advantaged (because of say 17k limit, only part of it belongs to you in Traditional, with rest belonging to government, and all of it belongs to you in Roth; or put another way, to contribute 17 to Roth you pay those 17 + taxes now but only 17 for traditional and so more of your money is put towards tax-advantaged accounts which are the same otherwise).
(2) A few other advantages of Roth relate to inheritance, no RMDs under current laws, and potentially diversifying tax advantaged accounts if you have no Roth at all, though backend Roth IRA is always available...

However, with high tax bracket, if future tax bracket is very likely to be (quite a bit?) lower, the difference in taxes would overwhelm all these small Roth advantages, and make traditional a better and pretty easy choice...

Thx1138 laid out the situation pretty clearly for a high income earner. I reach different conclusions though and think that under such assumptions (i.e. if your tax rate is high now, and the same later), Roth is clearly superior.

In a 33% tax bracket, a Roth gets you 50% more tax sheltered space - think $15k traditional (worth $10k) vs a $15k Roth worth the full amount. That's saving you putting $5k in a taxable account where it will suffer tax drag for years if not decades. We know that small differences can compound into large ones, especially for those in their middle career years with a long time ahead of them to invest. Unless you assume negligible dividend taxes, never rebalancing in taxable to realize gains, and leaving all your taxable money to your heirs, you'll be paying a lot of taxes on your taxable investments even if you delay them by holding stocks for the long term.

Here's another way to look at it. The first $15k traditional and $10k Roth are complete equivalent under these tax assumptions. But the Roth allows you to save an extra $5k in a Roth that you couldn't do if you took the traditional option. Would you ever advise this hypothetical rich person to "not bother with their $5k Roth IRA each year", because tax efficieny of buy and hold is pretty good? Of course not, for the same reason retirement accounts are good in the first place, this extra Roth option is very valuable.

Now you do want to make sure the assumptions apply to you, but roughly speaking factors to consider for going Roth are:

+ no RMDs
+ better for heirs than taxable in an estate (inherit a stretchable Roth tax shelter)
+ avoid tax drag on equivalent taxable investment
+ more tax advantaged space to facilitate tax-free rebalancing
+ hedge against higher income taxes in retirement

Vs

- possibility of lower tax rates in the future, due to state tax changes (moving), high medical expenses/deductions despite high income, lowered future income taxes (ha!), etc.

With 20-30 years to go and reasonable assumptions about market returns and taxes, I would go one step farther than say that I would max out the Roth over the traditional even if my expected future tax rate was a little lower than my present marginal one (say up to 5% lower).

rkhusky
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by rkhusky » Sat Aug 09, 2014 5:47 am

If the US replaces the income tax with a federal sales tax, then those that invested in tax-deferred would pay no tax on their investment and those with Roth would see no tax benefit. It's difficult to predict the future, especially if you are 40+ years from retirement.

DSInvestor
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by DSInvestor » Sat Aug 09, 2014 6:50 am

If you have a goal of early retirement and very high savings rate, you may be maxing out all retirement accounts and investing in taxable accounts. If you retire early without a pension, there may be many years that you can convert your Traditional IRA assets to Roth for little or no tax cost before social security/RMD kick in. In this type situation, I think Traditional 401k contributions would be better than Roth 401k.

Also, what does it mean to retire in a the same tax bracket? Taxcaster shows that a couple age 60 with 250K of Traditional 401k/IRA withdrawal as only income is in 33% fed tax bracket. The Fed Tax is 52K which gives an average tax rate of 20% on all 250K of withdrawal. This is because not all of the income is taxed at the 33% marginal rate. Some is taxed at 0%, some at 10%, 15%, 25%, 28% etc. In order for your entire withdrawal to be taxed at 33% average tax rate, you'd need to have other income that consumes all of the lower brackets. For 2014, it would take over 240K of other income (assuming MFJ std deduction and 2 exemptions) to fully consume all tax brackets below 33%.

The tax benefit at the time of contribution comes off the top of your income stack at your highest marginal brackets.

You should run some numbers to consider your anticipated taxes without the traditional withdrawals and see how much the tax increases with Traditional withdrawals. This would give you the average tax for those withdrawals.

learning_head
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Re: Maxing roth 401k vs trad 401k in high income tax bracket

Post by learning_head » Sat Aug 09, 2014 10:06 am

Tanelorn wrote: possibility of lower tax rates in the future, due to state tax changes (moving), high medical expenses/deductions despite high income, lowered future income taxes (ha!), etc.


You forgot the most important one... possibility of lower tax rates in the future because you retired and no longer have that huge paycheck... This could move you way down in the brackets...

Regarding SS, you'd have to have <18k taxable income to have SS untaxed under today's laws (which will likely change anyway).

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