How can I determine of it is better for me to contribute more after tax or before tax dollars? I just received a letter from Mercer saying they now are offering us "deferred salary participants" an option to contribute our money AFTER taxes by making Roth 401k contributions. I am currently contributing with them on my standard 401k. Thanks.
The classical answer is that before (deductible IRA or pretax 401k) and after tax (Roth IRA or Roth 401k) are mathematically identical when tax rates are the same now and in retirement.No one knows what tax rates will be 30 years from now, but generally if your tax rate is low now, after tax Roth could be better. If its high now pretax IRA/401k could be better. Personally I use the 25% fed tax rate as a reference point. Below 25% after tax may be best; above pretax.Of course the fact that Roth distributions are tax free in retirement, makes Roth the right place to put any investment you expect to do well over the years.
We were having the same discussion at work this week.Consider this, if you make $100k in 2013 as a married couple, you will pay 25% in federal tax by shifting dollars from a traditional IRA to a Roth.OTOH, if you are retired and pull $100k from a traditional IRA in 2013 with no other income, you would pay $11,800 in federal tax or 11.8%. In this simplified scenario, a traditional 401k wins by a landslide.Due to our tiered tax system, we are likely pay a lower tax rate in retirement if you have little other income.Of course, RMDs and future tax rates add uncertainty.My advice, go all Roth if your marginal tax rate is 15% or less. Go with a mix of Roth and traditional if your marginal rate is 25% or more.-murray
Just a followup to my previous post, I wanted to factor in Social Security. Let's assume you take $40k in SS benefits in a year and $50k in Roth distributions. In this scenario, you would owe $0 in taxes. Great deal, eh?The alternate scenario would be to take $40k in SS benefits and $60k out of a traditional IRA. In that case, you would owe a total tax bill of $8,500. The effective tax rate on the $60k of IRA withdrawals is 8500/60,000 = 14.2%, still a heck of a lot less than 25% deferred when taken out of your paycheck.Tax estimates taken from: http://www.foxbusiness.com/personal-finance/tools/how-much-o...-murray
There are two taxable events that occur with increasing taxed income (ordinary and capital gains) coming into a household: increasing income tax and increasing % of Social Security that is treated as ordinary income. So for most, its not that the marginal or effective tax rates are the same pre and post retirement....its also how much of SS is includable as ordinary income, as murray's calculations show.But the other point that usually gets skipped over in these calculations is that yes, a deductible contribution to one's retirement plan (employer sponsored or TIRA) does reduce one's income tax for the year....but what do you do with the tax savings? If this is simply absorbed into household cash flow and consumed, then the household lifestyle is that much higher, year after year, and requires that much more income in retirement to be able to sustain the same lifestyle, which requires a greater savings amount. Using after tax dollars, as one would contribute to a Roth, doesn't do this. In fact, like home equity and cash value in life insurance (ugh), the individual reduces available free cash flow in the accumulation years (less available discretion cash flow to spend) and decreases the income tax expense in retirement years while building one's available savings.And as mentioned, with the individual Roth, one does not have to deal with RMDs, and for amounts in the Roth the retiree does not need, they make great college savings plans for grandchildren.Each condition is unique and needs to be analyzed based on its own needs and goals. But if given a choice, I think I'd lean towards funding the Roth first.BruceM
Sorry Murray, I don't completely understand.
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