I've been reading this board for awhile and have a question.

I know the conventional wisdom here is to contribute to the matching on the 401(k), then switch to the Roth up to the $3K per year. If funds for investing remain, then fully fund the 401(k). The assumption being that tax rate in retirement will be higher than present tax rate, so the Roth is better than the 401(k).

My question is regarding the higher tax rate in retirement. For example, if a person is making $100K now and contributing to retirement, obviously he/she doesn't need/have $100K to actually live on, or no funds to invest. Assuming a 4% withdrawal rate equal to $100K in retirement, he/she would need $2.5M in retirement accounts to accomplish this. That would mean that the tax rate would be the same (assuming no raise in tax rates), right?

So, is the belief that this person would actually increase withdrawals in retirement above present salary? More like $150K? This is the only way I could see tax rate being higher in retirement, i.e. withdrawals being higher than original working salary. Is this pretty standard - to INCREASE living standard in retirement?

The reason I'm asking is, we're a little late to retirement savings - 40's. We make over $100K per year. However, I've done the math and see no way we'll have over $2M saved in the next 15-20 years, even putting away 25% of our pay. (Or, am I just being pessimistic about returns?) That said, assuming we can withdraw about $50-70K per year "safely", won't this put us in a lower bracket? Wouldn't this be an argument for fully funding the 401(k) BEFORE contributing any to a Roth?

Just trying to decipher the advice here.

TIA
3MM

3MM

My question is regarding the higher tax rate in retirement.

I am concerned about this, since I am a late starter as well. I do not know if the tax rate is based on higher income or lower deductions at retirement time.

I do not anticipate having enough itemized deductions when I retire to file other than the standard deductions. The house will be paid for well before then.

Mike
who would be content to complain about being in the high tax bracket

I am concerned about this, since I am a late starter as well. I do not know if the tax rate is based on higher income or lower deductions at retirement time.

For me, I expect a higher marginal tax rate in retirement for 2 main reasons:

(1) My wife has not started work yet (she is in law school to become a patent attorney) and we are still saving almost 30% of our annual income. When she works (1 year from now), we will be saving even more, so our savings by the time we retire (25 years or so) will be quite significant and will have us in a higher bracket than the 15% bracket we are currently in.

(2) Tax rates are at a long-term low right now. Typically, I think we can only make assumptions that tax rates will remain the same. But if they are going to change in the next 25 years, the odds are they will go up rather than drop.

ACME

I do not anticipate having enough itemized deductions when I retire to file other than the standard deductions. The house will be paid for well before then.

Agreed. And, considering our house payment NOW is only 9% of our gross income, I doubt we'll be itemizing for much longer, anyway. So, that is a non-issue for us pretty soon.

I'm looking forward to the replies.

thanks
3MM

Wouldn't this be an argument for fully funding the 401(k) BEFORE contributing any to a Roth?

I would say yes, but some things that may counter that argument are: limited fund choices in the 401k or high fees on funds in the 401k. If I was in your situation and liked the 401k choices I would max the 401k first.

Regardless of your current 401k choices, this is a good argument for you not converting past 401ks to ROTHs (if you have any and are eligible).

My wife has not started work yet (she is in law school to become a patent attorney) and we are still saving almost 30% of our annual income. When she works (1 year from now), we will be saving even more, so our savings by the time we retire (25 years or so) will be quite significant and will have us in a higher bracket than the 15% bracket we are currently in.

If your wife is getting ready to start a career as an attorney, seems like you'll be in a higher bracket than 15% WAY before retirement. Do you still anticipate your bracket after retirement to be lower than the one you'll move into once she starts working?

thanks
3MM

I wrote:Do you still anticipate your bracket after retirement to be lower than the one you'll move into once she starts working?

Sorry, I meant Do you still anticipate your bracket after retirement to be higher than the one you'll move into once she starts working?

3MM

Hi 3MM,

If you like you fund choices, I think you have a good argument for funding the 401(k) first. We follow the conventional advice because many of the expense ratios in our 401(k) are at 2%+. Once we have gotten are maximum matching amount, I would rather fund the Roth, where I can control the fund choice and the fees.

At my old job, we had a great 401(k) - Vanguard funds - and I maxed that out first. So, I would say it comes down to fund choice as well as tax bracket issues. This is where the Actuary in me wants to pull out the spreadsheets and start putting together different scenarios according to possible tax law changes, expense ratios, fees, etc.

Good Luck to you,

-4

The assumption being that tax rate in retirement will be higher than present tax rate, so the Roth is better than the 401(k). <P>

Actually, this is not the assumption in either the Roth or the 401(k).

A 401(k) is presumed to be advantageous because income will probably be less in retirement and you have been able to defer paying taxes on both the income and the investment returns to this lower income time period, with a potentially lower marginal tax rate. Many of us are beginning to realize this may not be true. Inflation will likely make desired retirement income higher than income at an earlier age and if we presume no changes in the tax code (a dubious assumption) there is little, if any, advantage to a 401(k) plan from the tax standpoint.

Notice I said desired retirement income, your actual income may vary downward significantly.

As far as I can see, the most significant advantage to a 401(k) plan comes from a company match, if you get one.

The Roth IRA is advantageous because of the promise to not tax the principal or the returns on the principal of the money saved. The principal has already been taxed once, but not taxing the returns can be very significant. Of course, the way the government gets its bite anyway is the sales tax.

If your tax rate stays the same and there is no company match, a 401(k) has no advantage over conventional savings. You can prove this algebraically, or with a few simple examples. In fact, with today's tax structure where capital gains and dividends are taxed a a lower rate than ordinary income a non-matched 401(k) has a disadvantage. It moves both capital gains and dividends into the higher ordinary income bracket.

If your wife is getting ready to start a career as an attorney, seems like you'll be in a higher bracket than 15% WAY before retirement. Do you still anticipate your bracket after retirement to be [higher] than the one you'll move into once she starts working?

(Corrected the quote per your succeeding post...)


You make a good point...one I will discuss in a bit of length momentarily.

First, though, the tax bracket we will be in a couple of years from now does not impact our decision regarding current retirement contributions. Presently, we are putting "cheap" dollars into our Roth IRA. If we were to assume future tax rates are identical to today's, it would be fair to say our retirement tax rate will be at least 25% with 28% (or higher) more likely.

I already max out my 401(k), so when it comes to retirement savings, the only real question is whether the Roth or Traditional IRA is better. Since we are almost certainly going to be in a higher bracket in retirement than we are today current IRA contributions go to a Roth IRA.

The same is true this year when my wife will work for 11 weeks this summer. And it will probably be true next year when she will work about 4 months...but with the way we max out our 401(k) plans we will likely still be in the 15% bracket next year.

Now...in 2006, things change dramatically for us. Between our two incomes, we will probably make too much to be eligible for a Roth IRA. So at that point, the decision becomes Traditional IRA (with no deduction) or after-tax brokerage account. We will then be in the 28% tax bracket with the 33% bracket being a definite possibility a few years later.

So, to get back to the original question now...do we anticipate our tax bracket in retirement will be higher than our tax bracket once we are both working? For 2005-2008, I think our tax bracket will be the same or lower than our retirement bracket. After 2008, I think it is tough to say. It depends on a number of things: (1) how my career progresses; (2) how my wife's career progresses; (3) what we decide in terms of savings.

Addressing each of those:

(1) I have a great job making excellent money. If I decide to stick with this job, I should be happy and do well. BUT, staying with this job "permanently" will significantly reduce my earnings potential. I can make a lot more money doing other things or the same thing with a different company. For now, I am happy and have no desire to go elsewhere.

(2) As a patent attorney, my wife will make big money right away. But her pay can rise fast depending on her path to becoming a partner.

(3) Our savings rate is near the 30% level (18% to my 401k plus 6% match plus we max out our Roth IRAs). When my wife starts working, we will have a choice of saving more -- we could get as high as 50% if we wanted -- or spending more and living even better now (we already live well). 30% will be the baseline that we would not consider dropping below.

Each of these problems is "interesting" in its own way. We will have to make some decisions...but IMO they are much easier to work through since we are saving at a rate that will have us comfortable no matter what.

Anyway, that was a heck of a ramble to say that I don't know.

Hope it was informative.

ACME

If your tax rate stays the same and there is no company match, a 401(k) has no advantage over conventional savings. You can prove this algebraically, or with a few simple examples. In fact, with today's tax structure where capital gains and dividends are taxed a a lower rate than ordinary income a non-matched 401(k) has a disadvantage. It moves both capital gains and dividends into the higher ordinary income bracket.

The last time someone tried to show me this, that person started by ignoring the pre-tax benefit of contributing to a 401(k), which of course invalidates any comparison from that point on.

Let's take a simple example: someone in the 25% marginal tax rate, 15% future capital gains rates, an investment in either a good 401(k) or taxable investment grows by an annualized 9%, investment horizon of 30 years, then liquidated (ignoring effect of being pushed into a higher marginal tax rate--presumably the brackets would increase).

    401(k) example   Taxable example
 
      $10,000.00        $10,000.00      Amount of wages to invest
            0.00         -2,500.00      Taxes before inveting
      $10,000.00          7,500.00      Amount that gets invested
      132,676.78         99,507.59      Future Value (30 years @ 9%)
                         92,007.59      Amount of growth (assuming all
                                        capital gains)
                        -13,801.14      Capital gains taxes
      -33,169.20                        Income taxes
 
       99,507.58         85,706.45      After-tax amount.

So, at least from the numbers I cranked out above, the 401(k) is better than taxable investments.

Some of the assumptions are over-simplifications. For example, taxable investments tend to have some capital gains and dividend distributions, which would reduce the overall growth (making taxable investments lag even more than the idealized 100% capital gains all realized after 30 years assumption), and many 401(k) plans have more expensive investment options, which would reduce the 401(k) final amount.

Howeve, within the scope of the simplifying assumptions presented above, the 401(k) is clearly superior to taxable investments if the objective is to maximize after-tax income.

I think MarrOYoung has a good point about the initial advantage of the 401(k) and how that plays out--advantageously--over the term of the investment.

Isn't this also a further consideration: If you receive your income now, pay taxes on it, and then invest it, the taxes you will be paying will be in 2004 dollars. But if you pay taxes on money 30 years from now (as in MarkOYoung's example), the taxes will be paid in 2034 dollars--which are bound to be worth less than 2004 dollars. Right?

--SirTas

I second Mark's example and comments. Folks, a taxable account will not beat a 401k given equal investment returns.

Isn't this also a further consideration: If you receive your income now, pay taxes on it, and then invest it, the taxes you will be paying will be in 2004 dollars. But if you pay taxes on money 30 years from now (as in MarkOYoung's example), the taxes will be paid in 2034 dollars--which are bound to be worth less than 2004 dollars. Right?

No, you will get the same final value whether you pay taxes upon deposit or upon withdrawal, all else equal. 2034 dollars will be worth less than 2004 dollars, but taxes aren't based on dollars, they're based on percents.

Nick

The last time someone tried to show me this, that person started by ignoring the pre-tax benefit of contributing to a 401(k), which of course invalidates any comparison from that point on. <P>

I have come to believe that you are correct.

Clearly the advantage of the 401(k) disappears at a sufficiently high marginal tax rate.

OTOH, there have been many years in which I maxed out my 401(k) pre-tax contributions and just continued making the same deposits, but on an after-tax basis. The after-tax contributions are disadvantaged compared to just investing the money in a taxable account in a tax-efficient manner. Either SPY or QQQ will do for me.

there have been many years in which I maxed out my 401(k) pre-tax contributions and just continued making the same deposits, but on an after-tax basis. The after-tax contributions are disadvantaged compared to just investing the money in a taxable account in a tax-efficient manner.

Yes, when it comes to after tax contributions to a 401(k) or non-deductible contribution to a Traditional IRA, I agree with you: tax-efficient investments in a taxable account are likely to do better! (My choice would be more in lines of VTSMX but that is another discussion.)

Actually, the only advantage I can see for after-tax contributions to a 401(k) or non-deductible contributions to a Traditional IRA would be to "shelter" an investment that throws off a lot of fully-taxable dividends, e.g., taxable bonds or REITs, since that would allow the dividend stream to be reinvested without the annual drag of taxes. But a substantial bond holding would probably be more appropriate when one gets close to retirement, not early in one's wage-earning years.

Well, actually, there is a second reason why one might want to make after-tax contributions after maxing out one's pre-tax contributions to a 401(k): if one or one's spouse works in an occupation that tends to attract lawsuits, the ERISA protection of 401(k) plans may be worth it even though the tax benefits aren't there.

Yes, when it comes to after tax contributions to a 401(k) or non-deductible contribution to a Traditional IRA, I agree with you: tax-efficient investments in a taxable account are likely to do better!

Another reason to make after tax contributions to these is the ability to convert to a Roth in a later year.

If you can make the Roth conversion at any future date, an after tax 401k/IRA contribution is equal in value to a Roth contribution made in the same year as the original after tax contribution (tax rates equal, of course).

Nick

Yes, when it comes to after tax contributions to a 401(k) or non-deductible contribution to a Traditional IRA, I agree with you: tax-efficient investments in a taxable account are likely to do better! (My choice would be more in lines of VTSMX but that is another discussion.)


LOL! Actually, most of this thread is another discussion!

As you can see by the original question and the tag line, I was asking about 401(k) and Roth.

Anyway, thanks to the original responders. I think we can start maxing both in a couple of years. I was just curious about the conventional advice for those who don't have $15K+ a year to put away and don't have the time to get the retirement accounts to the point where they'll actually be able to withdraw more in retirement than they make while working.

thanks everyone
3MM

My, we do get off on tangents at TMF, don't we ;-)

We make over $100K per year. However, I've done the math and see no way we'll have over $2M saved in the next 15-20 years, even putting away 25% of our pay. (Or, am I just being pessimistic about returns?) That said, assuming we can withdraw about $50-70K per year "safely", won't this put us in a lower bracket? Wouldn't this be an argument for fully funding the 401(k) BEFORE contributing any to a Roth?

I assume that I will be in a much lower tax bracket during retirement. I am currently saving 30% of my gross income toward retirement, or 44% of my after-tax net. Based on these numbers, I can assume that I will need 56% of my after-tax net to live on in retirement and (hopefully) SS will pay a portion of that. I also intend to move from a high-tax city and state to a low tax state. That's how I arrive at the conclusion that I'll be in a much lower tax bracket after I retire. And I do fully fund my 401K, but I'm not eligible for a Roth. The balance of my retirement savings after 401K goes into a non-deductible TIRA, an annuity, and a taxable account. These accounts should give me some flexibility in retirement as to the most tax-effective way to make withdrawals.

assuming we can withdraw about $50-70K per year "safely", won't this put us in a lower bracket?

My assumptions are also based on the fact that I have no children (and therefore no tax savings from them now). To do this assessment properly, one really has to determine their current overall tax rate and compare that to an estimated future overall tax rate, taking into account the fact that many of the deductions/allowances that you're saving taxes with now won't be available during retirement (i.e. home mortgage interest, 401K contribution and children).

Wouldn't this be an argument for fully funding the 401(k) BEFORE contributing any to a Roth?

You really have to do the analysis above with 'real' numbers to determine the answer to this question in your individual case--generalizations are never true for everyone.

2old

My assumptions are also based on the fact that I have no children (and therefore no tax savings from them now).

Thanks, 2old4bs.

Same here - no kids. And, our mortgage is so small compared to our income (9.4% of gross pay each month) that I assume we'll soon be using the standard deduction, anyway. Haven't run the numbers, but I smell the AMT looming on the near horizon. Do you pay AMT?

By the way, does anyone know if 401(k) contributions keep the AMT at bay? Or, is this one of the deductions you lose? (probably more appropriate for the tax strategies board, I guess)

thanks for your reply
3MM

Do you pay AMT?

3MM, So far I haven't had to pay the AMT. I don't own any investment properties, and I don't have any stock options. Also, more than half of my investments are in tax-deferred accounts. But it wouldn't surprise me if sometime within the next few years I have to pay it.

I downloaded Form 6251 and Form 6251 Instructions (the AMT form and instructions) from the IRS website, but I had a preparer do my tax return this year, so I didn't have to use it.

By the way, does anyone know if 401(k) contributions keep the AMT at bay?

Sorry, don't know the answer to the 401K question--I'd have to fill out 6251 in order to figure that one out!

2old