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Author: MurrayS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75539  
Subject: 401k/IRA better than Roth Date: 2/1/2006 1:55 PM
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I was involved with a 401k vs Roth discussion and I think I hit on a significant factor that favors a 401k:

Let's assume we have a single tax filer making $50k per year. If that person contributed $10k to a 401k, they would pay tax on $40k which, according to HRBlock, would be $4621 leaving $35,379 in after tax income.

Now, if that same person could contribute $7500 to a ROTH, the numbers come out the same ($50,000 income MINUS $7121 in fed taxes MINUS $7500 EQUALS $35,379).

If the ROTH and the 401k are both invested similarly, the ROTH will always be 25% less in value than the 401k since the present value is 25% less.

Assuming this person can live on the same $35,379 per year in retirement and that they receive $10k in social security (which I believe is taxed as regular income), that means they would have to withdraw $30,000 from the 401k and pay $4621 in taxes.

Using the ROTH scenario, they would only be taxed on $10,000 of income which comes to $181 in federal taxes which means they would have to take $25,560 out of the ROTH each year to reach the same $35,379 ($35,379 – $10,000 + $181).

Using these numbers, the ROTH would need to be worth 85% as much as the 401k to yield the same long term income (30,000 / 25,560 = 85.2%), but we calculated above that the ROTH is only 75% of what a 401k would be.

Another way to look at it, the taxes paid on the 401k withdrawal is ($4621 - $181) = $4440. The average tax rate paid on the withdrawal is ($4440 / $30,000) = 14.8%, significantly less than the 25% rate that was paid on the ROTH contribution.

Conclusion, 401k is much better in this fictitious example!


Factors:

If tax rates increase, that will help the ROTH.

If Social Security or other income is not used in the calculations, that helps the 401k.

If retirement spending goes down, that will help the 401k.

Anyone with me here?

-murray
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Author: SirTas Big gold star, 5000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49612 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/1/2006 3:05 PM
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Assuming this person can live on the same $35,379 per year in retirement and that they receive $10k in social security (which I believe is taxed as regular income), that means they would have to withdraw $30,000 from the 401k and pay $4621 in taxes.

Isn't the money that is withdrawn from a 401(k) taxed as ordinary income? (Are you assuming it will be taxed at a lower rate--that of long term capital gains?)

--SirTas




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Author: MurrayS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49613 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/1/2006 3:11 PM
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Isn't the money that is withdrawn from a 401(k) taxed as ordinary income? (Are you assuming it will be taxed at a lower rate--that of long term capital gains?)

Yes, I assumed that a withdrawal from a 401k is taxed as ordinary income. When I plug in $40k of income into the HRBlock tax calculator, I get $4621 in federal tax. http://www.hrblock.com/taxes/tools/quickcalc/index.html

The standard deduction, personal exemption and progressive tax lower the effective tax rate significantly below the 25% marginal tax rate.

-murray


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Author: Watty56 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49626 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/1/2006 5:05 PM
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What your example is showing is that your current IRA contribution calculations are dealing with your current MARGINAL tax rate but in retirement, if most of your funds come from an IRA then you need to consider your future EFFECTIVE tax rate in your calculations.

See my post;
http://boards.fool.com/Message.asp?mid=23512123

Which is related to this.

Greg


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Author: TurkeyBreath Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49632 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/1/2006 9:20 PM
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...
Assuming this person can live on the same $35,379 per year in retirement and that they receive $10k in social security (which I believe is taxed as regular income),


My understanding is that Social Security is tax free for a single up to $25k, married $33k or is it $35k (don't remember). Provided you have reached full retirement age as defined by SS. It used to be 65 for everyone.

TB

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Author: MurrayS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49641 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/2/2006 8:45 AM
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My understanding is that Social Security is tax free for a single up to $25k, married $33k or is it $35k (don't remember). Provided you have reached full retirement age as defined by SS. It used to be 65 for everyone.

Thanks for pointing that out, that makes a 401k even better than a Roth!

-murray

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Author: TurkeyBreath Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49643 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/2/2006 10:44 AM
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...My understanding is that Social Security is tax free for a single up to $25k, married $33k or is it $35k (don't remember). Provided you have reached full retirement age as defined by SS. It used to be 65 for everyone.

Thanks for pointing that out, that makes a 401k even better than a Roth!

-murray


And with careful planning, standard deductions and exemptions, I shall be in the 15% tax bracket upon retirement. Yet remain within my current or better lifestyle. [I'm frugal.] With $0 Federal Capital Gains tax set for 2008 for those in the 10% & 15% tax bracket I may do exceptionally well by selling some real estate.

Another strategy I'm considering is to begin withdrawing my 401k [after its been rolled into a traditional IRA] a little each year before the mandatory 70.5 years old, pay the necessary taxes and roll this into my Roth IRA. Thus, by the time significant withdrawals are required little will remain within said IRA to be taxed that would place me above the 15% tax bracket. My goal is to remain within the 15% tax bracket.

TB

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Author: billjam Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49644 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/2/2006 11:21 AM
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TurkeyBreath,

I like your thinking. The kind of tax planning you're doing takes a little effort but it can pay off big.

I've been able to stay in the 15% bracket since retiring. In 2005 I maximized my cap gains at the 5% rate. Expect to do the same in 2006 and 2007. I'll be collecting SS in 2008 and I think it's going to be tricky to get any large amount of cap gains at 0%, but I'll do the best I can.



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Author: AcmeFool Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49670 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/3/2006 7:56 AM
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Murray,

Near as I can tell, there is just one thing you are missing...

Your analysis appears correct for a 401k. But for a Traditional-IRA, you have to consider whether or not the contributions will be tax-deductible or not. In your scenario, it is entirely possible the person would not be able to make tax-deductible contributions to a Traditional-IRA. If this is the case, any investment money left after hitting the cap on the 401k would be best placed in a Roth IRA...

Acme

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Author: MurrayS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49740 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/3/2006 10:14 PM
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Your analysis appears correct for a 401k. But for a Traditional-IRA, you have to consider whether or not the contributions will be tax-deductible or not. In your scenario, it is entirely possible the person would not be able to make tax-deductible contributions to a Traditional-IRA. If this is the case, any investment money left after hitting the cap on the 401k would be best placed in a Roth IRA...

Certainly! I also assumed a higher Roth contribution than is allowed, but I think it's useful for those making decisions on what investment options to use.

-murray

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Author: AcmeFool Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 49744 of 75539
Subject: Re: 401k/IRA better than Roth Date: 2/4/2006 8:11 AM
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I also assumed a higher Roth contribution than is allowed,

With the advent of the Roth 401k, you really did not assume a higher Roth contribution than is allowed...

Acme

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