Traditional 401k vs Roth IRA

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Topic Author
bank5
Posts: 260
Joined: Fri Jun 05, 2009 12:17 pm

Traditional 401k vs Roth IRA

Post by bank5 »

I'm wondering if it would make more sense to max out my traditional 401k before contributing to my Roth IRA. Here's some information about my situation:
  • - around the high 25% to low 28% tax bracket
    - part of my income is from self-employment so I pay an additional 7.65% on that income
    - my state income tax is 7.7%
    - my employer doesn't offer a 401k company match
    - I'm planning to retire in my early 50's and plan on saving a lot over the next 20+ years
Since I'm paying the Self-Employment tax and state income tax does it make more sense to get the tax saving of the traditional 401k? What are the benefits of contributing to my Roth IRA over my 401k?
livesoft
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Joined: Thu Mar 01, 2007 8:00 pm

Post by livesoft »

Self-employment tax is paid regardless of how much you contribute to traditional or not.

Here are many more threads on the same subject:
http://www.google.com/search?client=saf ... 8&oe=UTF-8

From the facts you presented maxing your traditional 401k before making Roth contributions is the way to go. It's all explained in the other threads.

Such as this one:

http://www.bogleheads.org/forum/viewtop ... +roth+401k
Last edited by livesoft on Fri Jun 05, 2009 1:08 pm, edited 1 time in total.
DSInvestor
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Joined: Sat Oct 04, 2008 11:42 am

Post by DSInvestor »

bank5, I agree with livesoft. In your tax bracket, trad401k is probably the better way to go to give you the tax deduction.

Since you have self employed income, you can shelter some of that income from fed tax (but not self employment taxes) by contributing to SEP-IRA. If you're sole proprietor, I believe 20% of net income can be contributed into SEP-IRA which is tax deductible. I am an S-Corp and with SEP-IRA, I was able to contribute 25% of my salary to SEP-IRA.

There's another plan for the self employed called solo or individual 401k that has the same contribution limits as SEP-IRA but solo 401k allows for much larger contributions than SEP on lower incomes. solo 401k has two components:
salary deferral: 16.5K (100% of first 16.5K of income can be contributed).
employer match: 20% of net income or 25% of salary.

The salary deferral portion of the solo 401k is the same as the 401k at your job so the if you contribute 10K to the work 401k, you can only contribute 16.5K minus 10K = 6.5K to the salary deferral of self employed 401k. If your self employment income is large enough to support 20-40K solo 401k contributions, you could open a solo 401k with vanguard (where you'd have great low cost investment options) and stop contributing to the employer 401k plan 401k.

On the other hand, if your employer offers great 401k options with low cost institutional funds, you could max out the office Trad 401k and go with a SEP-IRA for self employed income. If you can't contribute to the solo 401k salary deferral, SEP-IRA offers the same contribution limits with less administrative burden.

Here's a link to Vanguard's small business plans:
https://personal.vanguard.com/us/accoun ... llbusiness

If you're looking to retire in your early 50s, you're probably looking to max out retirement plans and max out tax deductions. You could consider:

1. Max out employer Trad 401k
2. Max out self employed retirement plan (SEP-IRA or solo 401k)
3. Max out ROTH-IRA
4. If not eligible for ROTH-IRA, consider non-deductible TradIRA and convert to ROTH-IRA in 2010 and later when IRS will eliminate the 100K income limit for ROTH conversions.
5. Invest in taxable.

If you have taxable assets when you retire at age 50, you can spend down your taxable assets with little tax implications since return of assets is tax free. Your income may be so low while spending taxable assets that you may have opportunities to convert the trad assets to ROTH with little or no tax cost.
Topic Author
bank5
Posts: 260
Joined: Fri Jun 05, 2009 12:17 pm

Post by bank5 »

Thanks for the replies. Based on the responses, I think I'll max out my trad 401k and then contribute to my Roth IRA if I have extra money in April.

DSInvestor, I've thought about opening a Solo 401k but am not sure if it would be worth the time and trouble (and fees) for my situation. My SE income fluctuates but is usually only $10k-$15k per year. I think I'll have the SE work for the next few years but I'm not 100% sure. Do you think it would be worth opening a solo 401k for my situation?
DSInvestor
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Joined: Sat Oct 04, 2008 11:42 am

Post by DSInvestor »

bank5 wrote:Thanks for the replies. Based on the responses, I think I'll max out my trad 401k and then contribute to my Roth IRA if I have extra money in April.

DSInvestor, I've thought about opening a Solo 401k but am not sure if it would be worth the time and trouble (and fees) for my situation. My SE income fluctuates but is usually only $10k-$15k per year. I think I'll have the SE work for the next few years but I'm not 100% sure. Do you think it would be worth opening a solo 401k for my situation?
Since you'll max out the office 401k, you're not allowed to make the salary deferral contributions to the solo 401k which removes the main advantage over SEP-IRA. Without the salary deferral contributions Solo 401k allows for the same contributions as SEP-IRA but with more paperwork. In your situation, I'd consider going with a SEP-IRA to shelter the self employed income from fed/state taxes. SEP-IRA has the same administrative burden as ROTH or TRAD IRA so it's simple.

1. Max out trad 401k
2. Max out SEP-IRA (~20% of sole proprietor net income, 25% of S-corp salary)
3. Max out ROTH-IRA if eligible.
4. Invest in taxable accounts.

You can go with Vanguard Star fund which has a minimum of $1000 to open your SEP-IRA. Once you exceed 3K, you can switch into other funds like Target Retirement or stock/bond funds making sure to maintain your asset allocation across all accounts.

Assuming 10K of net income, you could contribute 2K to SEP-IRA, 16.5K to 401k, 5K to ROTH IRA which would be 23.5K/yr. Assuming worst case where you're starting with ZERO assets today, if you saved 23.5K/yr for the next 20 yrs and earned average of 5%, you'd have 815K in retirement accounts. Once you hit age 50, you'd be able to contribute more with catch up provisions.
thenextguy
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Post by thenextguy »

I've never fully understand the idea of 1) 401(k) to the match, 2) invest in a Roth IRA, and then 3) go back to the 401k.

I suppose if your 401k plan is horrible, it makes sense. Or if you're trying to diversify future income tax risks.

But it seems like the 401k plan is better if you expect to pay a lower average tax rate in retirement, which probably applies to most (not all) people.
Last edited by thenextguy on Fri Jun 05, 2009 8:05 pm, edited 1 time in total.
Topic Author
bank5
Posts: 260
Joined: Fri Jun 05, 2009 12:17 pm

Post by bank5 »

DSInvestor wrote:
bank5 wrote:

1. Max out trad 401k
2. Max out SEP-IRA (~20% of sole proprietor net income, 25% of S-corp salary)
3. Max out ROTH-IRA if eligible.
4. Invest in taxable accounts.
Seems like a great plan. I didn't realize setting up a SEP-IRA was as easy as setting up a Roth IRA. I'll definitely set one up this this year and contribute close to 20% of my SE income.
DSInvestor
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Joined: Sat Oct 04, 2008 11:42 am

Post by DSInvestor »

bank5 wrote:
DSInvestor wrote: 1. Max out trad 401k
2. Max out SEP-IRA (~20% of sole proprietor net income, 25% of S-corp salary)
3. Max out ROTH-IRA if eligible.
4. Invest in taxable accounts.
Seems like a great plan. I didn't realize setting up a SEP-IRA was as easy as setting up a Roth IRA. I'll definitely set one up this this year and contribute close to 20% of my SE income.
If you're a sole proprietor your max SEP-IRA contribution is based on your net income which includes income and all business expenses. Your tax preparer or your tax software will be able tell you want your max SEP-IRA contribution is. My girlfriend is a sole proprietor and she makes some smaller contributions that she knows will be within safe limits and tops off at the end of the year when all the income and expense numbers are tallied and the SEP max is known. You don't want to contribute too much and have to back out contributions.

If you're an S-Corp, SEP is limited to 25% of self employed W-2 wages. So if you pay yourself 10K salary, you can contribute $2500. It doesn't matter if the S-Corp is operating at a loss.
Topic Author
bank5
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Joined: Fri Jun 05, 2009 12:17 pm

Post by bank5 »

DSInvestor wrote: If you're a sole proprietor your max SEP-IRA contribution is based on your net income
Oh yeah, I meant net income in my previous post.

This is off topic but do you know anything about estimated tax payments?
I was planning to safe harbor my estimated tax payments this year. However if I max out my 401k it will significantly decrease my taxable income this year. I guess another option is to take a percentage of my net SE income and base my tax payments off of that.
Topic Author
bank5
Posts: 260
Joined: Fri Jun 05, 2009 12:17 pm

Post by bank5 »

thenextguy wrote:I've never fully understand the idea of 1) 401(k) to the match, 2) invest in a Roth IRA, and then 2) go back to the 401k.

I suppose if your 401k plan is horrible, it makes sense. Or if you're trying to diversify future income tax risks.

But it seems like the 401k plan is better if you expect to pay a lower average tax rate in retirement, which probably applies to most (not all) people.
Exact same thing I was wondering. I've often heard to invest in that order too. :?
DSInvestor
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Joined: Sat Oct 04, 2008 11:42 am

Post by DSInvestor »

Estimated taxes. Here's a page from irs.gov:
http://www.irs.gov/publications/p505/ch04.html

My CPA advised that if the total of tax withholding and estimated tax payments was at least as much as last years tax, I'd owe no under payment penalty. The link above seems supports this but also states that if AGI was higher than 150K MJF, you'd need to put in 110% of last years tax. I plan my estimates so I don't have to pay the penalty. In years where I have a dramatic increase in income, I may have to write a big check on APR 15.

Your higher 401k contributions will reduce your tax liability but your self employment income will increase your tax liability for fed, state and self employment taxes. Self employment tax is equal to employer plus employee social security and medicare. If your income at work breaks the 2009 income limit for social security (106.8K), this will reduce your self employment tax to just employer plus employee medicare.

It may be OK to leave your work tax withholding as they are and monitor your taxes closely and make tax estimate payments if necessary to avoid under payment penalty.

Once you have a year of full 401k contributions, you'd have a clearer picture of how self employment income will affect your taxes and you make your tax estimates quite easily.
Topic Author
bank5
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Joined: Fri Jun 05, 2009 12:17 pm

Post by bank5 »

^^^
I think that's the best bet for my federal taxes.

I'm not sure if I can "safe harbor" for my state taxes (North Carolina). There wasn't much information on the DOR website. I'll probably just pay 7.75% of my net SE income each quarter for the state taxes.

At the end of the year, I'll expect to get a little back from my state return but owe a couple thousand (because of my SE income) to the IRS.
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