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Author: 2gifts Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76078  
Subject: Roth 401k vs. traditional 401k Date: 3/17/2014 10:08 AM
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I think this is the right board for this question, but please redirect me if that is not the case.

DD, who is 22 years old and makes just under $40k per year, has just found out that her employer will be adding a Roth 401k to her benefits. She doesn't have the details yet, but has asked me for guidance on what she should do. They already have a 401k, and she contributes enough to get the match.

My employer does not offer a Roth 401k, so I don't know much about them. I am guessing that Roth and standard 401k allow for the same contribution limits, and that the big difference is probably the same as a Roth vs. Traditional IRA in that the Roth is funded with post-tax dollars, grows tax-free, and distributions are tax-free vs. the Traditional IRA which is funded with pre-tax dollars, grows tax-free, and distributions are taxed as ordinary income.

Given that and the fact that she is in a low tax bracket, I am thinking that she will be better served to push all her 401k contributions over to the Roth 401k (assuming she has the same matching) because she most likely will be in a higher bracket later, including in retirement.

Anyone know any more about these? Do I even understand the differences correctly? Anything else that she should be considering?

I'm not knowledgeable in this area, and so do not know how to advise her.
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Author: DolonAltekar Three stars, 500 posts SC1 Red Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74539 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 11:09 AM
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Sounds like you got it about right.

The roth is a great deal, because you never have to pay taxes on those earnings in the future.

Also, $1000 added to a Roth is equivalent to $1000 * your tax rate added to a traditional 401K, so the $17500 limit allows you to have much more spendable money at retirement. The $1000 put in the Roth costs you more up front, but you get more at the end.

What I mean is that if you have 1M in a Roth and in a traditional 401K, at retirement, with the Roth, you get to keep the 1M. With traditional, you get to pay taxes on that money.

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Author: JLC Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74540 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 11:58 AM
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What I mean is that if you have 1M in a Roth and in a traditional 401K, at retirement, with the Roth, you get to keep the 1M. With traditional, you get to pay taxes on that money.

Of course trying to predict the tax code 40 years from now is impossible. There are already ideas afoot to change Roth IRAs to force minimum distributions (I'm sure they'd apply to 401ks as well).

The best you can do is plan with current law, keep abreast, and make changes when necessary.

JLC

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Author: 2gifts Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74541 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 12:00 PM
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Thanks.

What happens if the employer matches contributions to the Roth 401k? Does that get added to your income and you pay taxes on it? That seems logical to me, but I've learned that taxes are not always logical.

Anyone know how the match is treated?

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Author: CABob Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74542 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 12:05 PM
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Employer contribution (matching funds) go into the traditional 401k even if the employee's contribution go to the Roth.

Bob

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Author: DolonAltekar Three stars, 500 posts SC1 Red Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74543 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 12:07 PM
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The match is always contributed to the traditional part of the 401K and remains pre-tax.

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Author: 2gifts Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74544 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 12:12 PM
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Thanks to all. That does make sense that the match would go into the pre-tax 401k so that it all gets taxed on the way out.

Once I see the info that DD brings home, I'll let you know if there are any more questions, but the Roth 401k certainly sounds like the way to go for her.

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Author: zol Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74545 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 2:43 PM
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Once I see the info that DD brings home, I'll let you know if there are any more questions, but the Roth 401k certainly sounds like the way to go for her.

One thing she may want to check is whether she can invest differently for the Roth portion of the 401k. The plan I have does not allow for that. They just have all the money in one pot and apply the instructions by percentages. However the administrator keeps track of what is part of the Roth and what isn't and further tracks what is contributions vs earnings. If I remember correctly I used to manage another 401k account (same administrator but different employer) where it was possible to make different investments based on the source of the money.

- zol

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74546 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 2:54 PM
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The general rule is that Roth is the better choice if you qualify.

The one exception might be if you are in a high tax bracket now and expect to be in a low tax bracket in retirement. But that situation is not very common and who knows what tax rates will be 30 or 40 yrs from now.

Roth and traditional 401k are identical in value if the tax rate is the same now and in retirement. That is to say, given amount invested pretax and then taxed after growth is mathematically the same as given amount invested after tax, allowed to grow and then not taxed in retirement.

Of course, if your investments grow as you hope they will, having no taxes to pay in retirement (and no concerns about mandatory distributions) makes Roth look very attractive.

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Author: PSUEngineer Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74547 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 3:08 PM
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The one exception might be if you are in a high tax bracket now and expect to be in a low tax bracket in retirement. But that situation is not very common and who knows what tax rates will be 30 or 40 yrs from now.

I don't know how uncommon but I'm expecting to be in a lower tax bracket in retirement than I am now.

Roth and traditional 401k are identical in value if the tax rate is the same now and in retirement. That is to say, given amount invested pretax and then taxed after growth is mathematically the same as given amount invested after tax, allowed to grow and then not taxed in retirement.

Is it really? The pretax contributions can be considered your last dollar earned. Therefore your contribution savings are at your marginal rate. When you take withdrawals from those pretax accounts, you need to fill your lower tax brackets before reaching the equivalent marginal rate when you worked and saved at the marginal rate. Your taxes paid when withdrawal are at your effective rate. The effective rate is lower than the marginal rate.

PSU

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74548 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 3:48 PM
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When you take withdrawals from those pretax accounts, you need to fill your lower tax brackets before reaching the equivalent marginal rate when you worked

This can be true if Roth or 401k is your only asset in retirement. For many lower rates are filled by Social Security and sometimes pension. Then add in required mandatory distributions from your TIRA or 401k and you can find yourself in a higher tax bracket than planned.

For many I suspect 70-1/2 and RMD gets you to your maximum income tax rate in retirement.

For early retirees, the numbers can be completely different, but then if they retired early, what income did they have in mind? A nice pension? Income from investments?

Your mileage may vary. But these are some details to think about as you decide what is best for you.

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Author: reallyalldone Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74549 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 4:34 PM
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I am not a fan of general rules. Post that and it's what people remember without thinking.

Let me mention one more time. If you are part of a couple, there will be a point in retirement when that is no longer true and the tax situation will change.

Roth = pay taxes now.
Reg 401k or Trad IRA= pay taxes later.

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Author: inparadise Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74550 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 5:45 PM
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For many I suspect 70-1/2 and RMD gets you to your maximum income tax rate in retirement.

For early retirees, the numbers can be completely different, but then if they retired early, what income did they have in mind? A nice pension? Income from investments?


I took our current TIRA/401K balances and used a compound savings calculator to approximate what those TIRAs would be worth at 70.5. Then I used an RMD calculator to see what the mandatory minimum income would be and the tax bracket based on today's tax rates. If we do nothing, our tax rate during RMDs will be at least the same as now while working.

Since we will be retiring early, we will take that time to convert to Roths up to the top of the 15% tax bracket. We'll use savings/cap gains, also taken at 15%, to live on and pay conversion taxes for the years we have until taking SS. We'll have to see how that goes and run the numbers more closely to see if we should go higher than the 15% tax bracket, but IMO that much is a slam dunk...assuming things I have no control over don't change. Converting faster may be worthwhile if we decide to take SS earlier.

IP

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Author: bighairymike Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74551 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/17/2014 9:53 PM
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We'll have to see how that goes and run the numbers more closely to see if we should go higher than the 15% tax bracket, but IMO that much is a slam dunk... - IP

--------------

Agree about the 15% bracket being a no brainer. I weighed this same question and for the past three years I have been maxing out the 25% bracket with Roth Conversions. My reasons:

This cuts exposure to future RMDs and the loss of control over taxable income.

More of the funds I eventully leave to my kids will be after tax, an advantage to them.

25% is a pretty good rate. Considering Uncle Sugars appetite for money, rates are likely to go up or certainly won't be going down.

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Author: jgc123 Big gold star, 5000 posts Top Recommended Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74552 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/18/2014 9:53 AM
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"For many I suspect 70-1/2 and RMD gets you to your maximum income tax rate in retirement."

We may be headed in that direction because of recent distortions in the economic picture, but it hasn't always been that way. Dad was in his late 80's when I had to take over his accounts. By that time he had spent the previous 17 or 18 years accumulating dividend and interest income in his sheltered account which he took out near the end of the year (along with additional money from sales of stocks/bonds as needed to satisfy the RMD requirements), and had put them directly into his non sheltered 'main' account each year as required.

His main account consisted of stocks and bonds, but many of the bonds were directly purchased muni's generating 6-8% in untaxed income and some of the others were muni funds.

The result was that he had shrunk his IRA to a few hundred thousand dollars and grown his main account to a larger number. The main account had a combination of interest, dividends and bond interest that had a pretty low effective tax rate overall.

Dad was much more assiduous than I, but I am now emulating some of his moves at the age of 58 in preparation for my retirement. I am now trying to contribute more to my main account than I contribute to my IRA (at the moment, with kids grown and both still working we can max our sheltered accounts and contribute to our main account) so that I can have greater control over the taxation of income from that account.

The lesson that I wish I had learned earlier was to be more disciplined about saving money above and beyond our sheltered accounts.

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Author: reallyalldone Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74553 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/18/2014 10:26 AM
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The lesson that I wish I had learned earlier was to be more disciplined about saving money above and beyond our sheltered accounts.

Posts suggesting investing in taxable accounts to complement sheltered accounts were mostly shouted down over the years. Kind of went hand in hand with posts not heralding getting money into Roths at any cost.

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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: 74558 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/19/2014 6:51 PM
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I agree with most of the posts here; at a 15% marginal tax rate or lower, a Roth is a no brainer. At 25% and higher, it becomes murkier. Consider that a married couple making $100k would pay under $12k in taxes or less than 12%. Even if you made $20k in SS and the $12k in taxes came out of the remaining $80k, you'd be paying 12/80 or 15%. That's still a heck of a lot less than 25% or the 30%+ that I'm paying.

I disagree that paying no taxes in retirement would be a good thing...I consider it a lost opportunity since it likely means higher tax rates were paid earlier in life which could have been invested to yield more income in retirement. Having a mix so you can control your taxes is ideal.

If RMDs happen to push my withdrawals into rates higher than I'm paying now, I'll know my retirement is financially set.

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Author: TMFHockeypop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 74559 of 76078
Subject: Re: Roth 401k vs. traditional 401k Date: 3/19/2014 8:11 PM
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I think you know this, but don't confuse the marginal tax rate with your effective tax rate in figuring the advantages or disadvantages of the tax-deferral. Here are the 2014 brackets:
http://taxfoundation.org/blog/2014-tax-brackets

Generally while working, in higher brackets you are saving at the marginal tax rate by adding to a traditional 401k or TIRA. In many examples this is 25%. When withdrawing from those funds in retirement you most likely are paying tax through each bracket.

Even if being taxed on 85% of your social security payments AND tax-deferred accounts to the 25% marginal rate or 100% of your old earnings, your overall effective tax rate is more likely something like 15%. That's a pretty good reason for higher income individuals to take the TIRA or traditional 401k.

Bob
RYR Home Fool

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