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Is there a good way to figure out, at which point it is most beneficial to make your contributions to a 401k versus a Roth 401k? If at tax time my AGI reaches a certain point going forward, assuming all things remain equal, what number would it be where this would be beneficial?
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I believe the main thing that affects the choice of Roth 401k vs. 401k is the answer to this question:
Will your income tax rate during retirement be higher or lower than it is now?
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There is no crystal ball that accurately predicts future tax rates. You can estimate your future income.

Do you already have significant assets in tax deferred accounts?
How much will your required distributions be from tax deferred accounts? Will it make your SS taxable and put you in a higher tax bracket?

Will you have guaranteed income from pensions and/or Social Security?
Will you need at the RMDs from your retirement accounts? ROTH (at least for now) do not have required distributions.

Your current age.
ROTH contributions are considered to be more advantageous for younger investors because the time frame, but older workers who already have significant tax deferred investments can decrease their future RMDs by contributing to a ROTH.

Estate planning
For those who have estates that would be subject to estate tax, ROTH is better for the heirs. Income taxes are prepaid and removed from the estate.

There are separate contribution limits for pre-tax/ROTH and after tax contributions to a 401K. 401K plans can allow conversion of after tax contributions to ROTH. If this is true, it is possible to contribute the max pre-tax and then with limited tax consequences convert after tax contributions to a ROTH.
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Is there a good way to figure out, at which point it is most beneficial to make your contributions to a 401k versus a Roth 401k?

Seriously, it is a crapshoot.

Predicting your income needs is doable, but prone to inexactness due to inflation and health care expense.

Predicting tax rates at retirement is simply maddening. One thing we can be assured of is that tax revenues will rise. Whether than comes from income, investment, property, or plain extortion is best left to unseen forces.

I quit obsessing over this, and picked a plan and stuck with it.
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Seriously, it is a crapshoot.

I've long advocated for heading into retirement with three buckets of funds available: pre-tax accounts (IRA, 401k, etc), Roth accounts (again IRA or 401k), and ordinary taxable accounts.

When you start drawing from these funds in retirement, you can pick and choose which buckets to pull money from to take advantage of whatever the tax laws and rates are at that time.

If you had a good crystal ball, you could pick the one bucket that would provide the best benefit to you. But since you don't, using all three buckets keeps you from putting everything into the worst bucket.

--Peter
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If you had a good crystal ball, you could pick the one bucket that would provide the best benefit to you. But since you don't, using all three buckets keeps you from putting everything into the worst bucket.

Does a crystal ball have to be all that clear for some people? I'm tossing most of my retirement in the pre-tax 401k bucket. The reason is that I'm saving on my taxes at my marginal rate. When I go to withdraw in the future, I'll be paying income taxes at my effective rate. I have yet to see a situation where the effective rate is higher than the marginal rate. My future effective rate would need to exceed today's marginal rate. I don't see that happening. If it does, we're all in trouble.

PSU
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Does a crystal ball have to be all that clear for some people?

Nope. For some people, a bowling ball is clear enough. At one end of the spectrum, you've got folks who are looking at living off of social security plus a few grand they manage to sock away in the last couple of years before retirement. They should put it all in pre-tax accounts.

At the other end, there are those whose biggest problem in retirement is figuring out how to spend it all before they die. For them, it's not a question worth worrying about.

My 3 bucket method is more in the "standard advice" category. I believe it applies to a broad swath of people, but certainly not all.

And I never said those buckets need to be of equal size. ;-)

When I go to withdraw in the future, I'll be paying income taxes at my effective rate.

Not so fast, there. Since you are able to use a 401k, I will assume that you're gainfully employed. And I'll guess that you have been so for the vast majority of your adult life. That means you're going to have some social security benefits.

The taxation of those benefits is on a sliding scale. If you have little to no other income, none of the soc sec benefits are taxable. If you have a lot of other income, 85% of your benefits are taxable.

In between, things are on a sliding scale. Add another dollar of income, and another 50 to 85 cents of soc sec becomes taxable. This usually happens when you're in the nominal 15% bracket. That can become an effective 27.75% bracket.

Then you might have some other kinds of retirement income - pensions, annuities, rental property, interest, dividends, capital gains. Those all come into play as well.

As you plan for retirement, you might want to consider those 401k withdrawals as adding on to other income you expect to have. The effective rate on those withdrawals could be higher than you think.

Then again, I fully expect that you've done your own analysis using your own numbers. So I'm writing this more for the lurkers reading the thread than you specifically.

--Peter
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The taxation of those benefits is on a sliding scale. If you have little to no other income, none of the soc sec benefits are taxable. If you have a lot of other income, 85% of your benefits are taxable.

I expect it all to be in the 85% range.

Then again, I fully expect that you've done your own analysis using your own numbers. So I'm writing this more for the lurkers reading the thread than you specifically.

Not a very detailed one. More like crayons on a napkin. But the 401k contributions are at a high marginal rate. I have difficulty seeing any of my income hitting that marginal rate in retirement.

PSU
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Not a very detailed one. More like crayons on a napkin. But the 401k contributions are at a high marginal rate. I have difficulty seeing any of my income hitting that marginal rate in retirement.

The money coming out of your retirement plan will also be taxed at your marginal rate. The unanswered question is whether that marginal rate will be lower, higher, or the same as your current marginal rate.

Your belief that your retirement distributions will be taxed at your effective rate is mistaken. Your effective rate is your total tax over divided by your income (it doesn't matter which measure of income you use, as long as you're consistent). If you didn't have to take a distribution from your retirement account, your taxable income would drop by $x and your tax liability would decrease by #x times your marginal rate.

Ira
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The money coming out of your retirement plan will also be taxed at your marginal rate. The unanswered question is whether that marginal rate will be lower, higher, or the same as your current marginal rate.

Not if all the income is coming from a retirement account. No other sources. Then you have to fill the lower brackets before hitting the next higher brackets.

Your belief that your retirement distributions will be taxed at your effective rate is mistaken. Your effective rate is your total tax over divided by your income (it doesn't matter which measure of income you use, as long as you're consistent). If you didn't have to take a distribution from your retirement account, your taxable income would drop by $x and your tax liability would decrease by #x times your marginal rate.

I know what effective rate means, thankyouverymuch. I know that right now my 401k contributions all fall at my highest marginal rate. I also assume that there is a good chance my distributions will fall over two separate marginal rates if I consider those distributions to be my last income earned just list my contributions today. To be specific, all my contributions are in the 33% bracket. The distributions will likely span the 15% and 25% brackets. You are quite right that it's not quite my effective rate because they will be income from another source that I would list as my first income received to keep things consistent.

PSU
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I'll probably be in the same tax bracket post-retirement as I am now. I already have sizeable pre-tax accounts, so I'm switching gears and adding to ROTH. My financial advisor said it's best to have BOTH because you can use the ROTH to manipulate your post-retirement tax bracket by taking the initial funds from taxable until you get to a certain bracket then back-filling the rest with ROTH funds to keep your taxes in-check.

Also - tax rates are at historical lows right now. I'm thinking they can only go up. ROTH will help if they do. And there's that "helping my heirs out" thing I can do with ROTH accounts.

So - yeah, years of not having the ROTH option meant my pre-tax accounts are huge and now that ROTH is an option for me, I'm back-filling with ROTH like mad. Hedge your bets.

SG
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I'll probably be in the same tax bracket post-retirement as I am now. I already have sizeable pre-tax accounts, so I'm switching gears and adding to ROTH. My financial advisor said it's best to have BOTH because you can use the ROTH to manipulate your post-retirement tax bracket by taking the initial funds from taxable until you get to a certain bracket then back-filling the rest with ROTH funds to keep your taxes in-check.

Also - tax rates are at historical lows right now. I'm thinking they can only go up. ROTH will help if they do. And there's that "helping my heirs out" thing I can do with ROTH accounts.


I retired this year. For the remainder of the year, I'm not taking distributions from the deferred tax retirement accounts because the impact of my earnings for the first 8 months mean traditional IRA distributions would effectively be taxed at 30% on the federal side (15% tax bracket, plus every dollar of ordinary income shoves a dollar of qualified dividends or LT capital gains from 0% to 15%).

Things get interesting in 2017. I can play with the numbers, which say I minimize my 2017 taxes by taking as little as possible from the traditional IRAs (inherited and rollover from 401(k)) while living to the extent I can on distributions from the taxable account and the Roth IRA. It's a lot less clear how to optimize lifetime taxes plus the effect on my daughter when I leave an estate.

There are a lot of moving parts. Ten years ago, who would have predicted that how I deal with health insurance would affect my marginal tax rate in early retirement? A 15% federal rate on marginal income plus the impact of the premium tax credit puts my effective federal marginal tax rate for ordinary income in 2017 between 24% and 25%, compared to the 25% tax rate I avoided for most of the 401(k) contributions. I do benefit from the first $20K of pensions and IRA distributions being exempt from NY taxes, and anything over that coming out at a lower NY tax rate than I avoided through contributing to the 401(k).

As I look at the moving parts and consider which levers I want to move, I'm satisfied with the advice of having investments in multiple buckets with different tax status. Yeah, it would be nice to have it all in a Roth bucket now; but there were those higher taxes I avoided by contributing to the 401(k).

Patzer
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For those who are still working, it may be worthwhile to determine if your 401(k) plan allows for after-tax (*not* the same as Roth) contributions. If so, these funds can later be rolled into a Roth IRA. This can open up more Roth space without impacting the current tax deferral of your pre-tax 401(k) contributions.

-Steph
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Is there a good way to figure out, at which point it is most beneficial to make your contributions to a 401k versus a Roth 401k? If at tax time my AGI reaches a certain point going forward, assuming all things remain equal, what number would it be where this would be beneficial?

If you are at or over the MAGI limit to make contributions to a Roth IRA, one thing that you might want to look at is whether contributing to a pre-tax 401(k) will lower your MAGI enough to be able to make a Roth IRA contribution.

AJ
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Great insight folks! I really appreciate it. I guess a little detail about my situation would have helped, although still no definitive answer could be reached.

-I'm 33, this year I expect to have an effective tax rate of around 20%
-Within the next 2 years, assuming I don't lose my job, I expect to have a 28-30% effective tax rate
-I'm maxing out my Roth IRA for myself and my wife and continue to do so via the backdoor Roth going forward. I will exceed the income limit for a Traditional IRA in about 2 years.
-This year I will be able to contribute up to the max IRS 401k contribution limit
-Next year my contributions and my employer's contributions should reach the IRS $53k limit
-I have 32 years until I retire which will be funded via my 401k. No pension is available at this time and I will be collecting social security
-Spouse will have a pension

A lot of variables. I tend to lean towards pre-tax contributions starting in about 2 years when my income will increase and put me in a 30%+ effective tax rate. I'm making that decision is based on the assumption that my effective tax rate in retirement will be lower. I don't expect to make as much money yearly from my 401k as I did as a wage earner, but still live comfortably. I will continue to contribute post-tax earnings to mine and my wife's Roth via backdoor Roth as long is that is allowed.

Seems like a logical plan, for now anyways. Anything I'm missing in my assumptions?
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Just a heads-up:

If you're doing back-door ROTH contributions, be aware that moving your 401K to an IRA when you switch jobs could make this un-doable due to something called the Pro-Rata rule.

Google it.
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I googled it. Don't necessarily understand it. Assuming I do not change employers, will this not affect me? I'm not sure how a 401k and an Individual Roth IRA affect one another.
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I got this from an article

"The barrier to the backdoor Roth—in many folks’ minds—is the pro rata rule. The rule says that you have to aggregate all your IRAs to determine how much income tax you owe when you convert. If you have no other IRAs and you open a $5,000 nondeductible IRA and then convert it, you only owe tax on the earnings, if any. By contrast, if you have a $95,000 traditional IRA (pre-tax contributions), and you convert a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable."

Is what you're referring to converting a 401k pre tax contributions into a Roth IRA that would be an issue?
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http://news.morningstar.com/articlenet/article.aspx?id=36486...

Doing a normal 401k conversion to an IRA usually means that there is a lot of pre-tax money in your IRA account.

If at that point you try to put $5000 into a Roth IRA via the "Backdoor Roth" it won't turn out as you probably intended.
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Is what you're referring to converting a 401k pre tax contributions into a Roth IRA that would be an issue?

No. The 'back door' Roth is making a non-deductible traditional IRA contribution and then immediately converting that contribution to a Roth IRA. If you don't have any other traditional IRAs, it's a process that won't cost any additional taxes. However, if you have, say, a $94k rollover IRA, and you want to make, and then convert a $6k non-deductible contribution, you will end up paying taxes on 94% of the converted amount, because taxes on conversions from a traditional IRA to a Roth IRA are pro-rated across ALL traditional IRAs you own - not just a particular IRA that happens to have the non-deductible contribution.

AJ
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Assuming I do not change employers, will this not affect me? I'm not sure how a 401k and an Individual Roth IRA affect one another.

The situation assumed that:
1. you switched employers and
2. you rolled the 401(k) from your old employer over into a traditional IRA

While you may not PLAN on switching employers, sometimes you are forced to do so. Therefore a blanket assumption that you aren't going to change employers may not be valid.

AJ
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Thanks AJ,

That makes sense. I guess I didn't give the full info on the backdoor conversions I do. I don't convert any of my pre-tax 401k money, I just put $5500 in a Traditional, let the cash settle and the convert it to the Roth. This is completely separate from my 401k. What I learned last night in talking with Fidelity, I have the option after I reach my $18k limit to continue to make after-tax contributions up to the $53k allowed (minus employer contributions) and then roll my AFTER TAX contributions into a Roth. Apparently, the plan allows me to completely roll it out of Fidelity to my personal broker where I pay $0 commissions. It's a nice option I have!

The question will remain and really has no answer it seems. Whether or not contribute pre or post tax to my 401k. I think what makes sense for me in a couple of years once I start dipping into that 33% bracket is to start making those pre-tax contributions to help keep me out of that. That seems like my only respite from lowering my AGI in the immediate term.

On the post-tax front
I'll also make 529 contributions, I'll continue to do the backdoor Roth for my wife and I and I'll roll my post-tax 401k contributions to a Roth as well.

This seems like a good mix as it will allow me immediate tax benefits right now and then I'll also have a tax free bucket of money to withdraw from during retirement as well. Some people have said having both types of accounts to draw from is a good idea, not sure why exactly, but it looks like I can set myself up in that way going forward.
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I don't convert any of my pre-tax 401k money, I just put $5500 in a Traditional, let the cash settle and the convert it to the Roth. This is completely separate from my 401k.

Yes, that's how backdoor Roth contributions are supposed to work. And that's fine as long as you don't have ANY pre-tax IRA money in your name. But if you were to change jobs and roll the money from your current 401(k) over to an IRA because your new job's 401(k) was expensive and your old job's 401(k) was charging you fees because you were no longer an employee, then that wouldn't work any longer. That's what you were being warned about. But it doesn't seem to me that the possibility of that happening should have much impact on deciding where to put your current contributions.

What I learned last night in talking with Fidelity, I have the option after I reach my $18k limit to continue to make after-tax contributions up to the $53k allowed (minus employer contributions) and then roll my AFTER TAX contributions into a Roth. Apparently, the plan allows me to completely roll it out of Fidelity to my personal broker where I pay $0 commissions. It's a nice option I have!

Yes, I wish I had that option.

The question will remain and really has no answer it seems. Whether or not contribute pre or post tax to my 401k. I think what makes sense for me in a couple of years once I start dipping into that 33% bracket is to start making those pre-tax contributions to help keep me out of that. That seems like my only respite from lowering my AGI in the immediate term.

I would say if you are in the 28% or above bracket, and maxing out your 401(k) contribution, with more money to invest, you should probably consider making the current contributions as pre-tax (rather than Roth) and then using the tax savings (at least $5k), plus some of your extra investment dollars to do the after-tax contributions that can be converted to a Roth. That will allow you to put more money into tax advantaged accounts, and give you a mix of taxable, tax-deferred and tax-free money for retirement.

AJ
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Thanks, AJ!

I've heard a lot of people mention having a mix of taxable earnings and nontaxable earnings in retirement. What would be examples of each one having its benefit in retirement? The tax-free withdrawals of a Roth in retirement seem self-explanatory. Is there a benefit of having taxed withdrawals from a pre-tax contribution in a 401k during retirement?
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Some people have said having both types of accounts to draw from is a good idea, not sure why exactly ...

I'm one of those people.

A lot of retirement planning is based around a slightly crazy assumption that you'll take some fixed amount out of your savings each year for your spending. That's fine, except that it doesn't match up too well with reality.

The reality is that some years you'll take more, some less. They might average out to something around that planned amount, but it won't be that amount each and every year.

For example, you know you want to travel while you're retired and you have the money for it. Will you spend the same amount every year on this travel? Probably not. Maybe you decide to take three trips one year and none the next. If everything you have saved is in pre-tax accounts, you'll have to take more out of those accounts in the big travel year and much less in the stay home year. Those larger withdrawals might push you into the next tax bracket, or make more of your social security taxable.

But if you have both pre-tax and Roth accounts, you can take a more fixed amount out of the pre-tax account and use the Roth for the balance. That limits your taxes without crimping your travel plans.

--Peter
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Is there a benefit of having taxed withdrawals from a pre-tax contribution in a 401k during retirement?

Absolutely. Congress (through the tax code) gives you a standard deduction and personal exemption each year. That means you automatically get to shelter that amount of "taxable" income each year. Why waste that on income that is already tax-free (eg., from a Roth distribution)?

Of course, this argument only holds to the extent you don't have other taxable income during your retirement years.

Ira
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After some thought, as a reservist, I participate in their Thrift Savings Program. Upon separation, I can move the funds out of the TSP into an IRA and I'm wondering if this could perhaps be a player in the future. I do have the option of pre or post tax contributions to the TSP and ideally, they will be moved to an IRA for a little more control. Anyone have any experience with this?
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I moved my TSP money to an IRA. The Federal government borrows the TSP money every year now to help extend the day of reckoning about the budget to run the government. If heard that the government is not obligated to return the money but so far they have. So I moved to a IRA just in case.

Originally in my life, the government fiscal year was July 1st. But congress couldn't get it together to pass the budgets for the various segments of the government (12) in time so the government always had to have a continuing resolution to operate. So the date was changed to October 1st to allow the congress more time to approve budgets. This was called the transition quarter and was a big mess. Of course congress continued not to meet the deadline of the new date. They will dawdle all they can.

I believe there was at least one year when the government ran on a continuing resolution the whole year, but I cant verify this.

The worst continuing resolutions are short term ones of weeks or a few months. Continuing resolutions usually fund the government at the previous year's value or, often, somewhat less (up to 10%) This really makes work difficult because of inflation and some workers getting within grade raises so operating funds can be scarce or non-existent. Thus workers may have to laid off. Sometimes this can be done through releasing temporary workers unless it is 10%. but it makes progress more difficult. Often bureaus have on about 10% of operating funds.

When you work for the Federal government, you have to realize you are a political football. Often a law is passed is made saying you should do something when there is another law that says you can't do that. So you choose which one to follow, hoping that is the right choice.

brucedoe
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What would be examples of each one having its benefit in retirement? The tax-free withdrawals of a Roth in retirement seem self-explanatory. Is there a benefit of having taxed withdrawals from a pre-tax contribution in a 401k during retirement?

It's not so much as there is a benefit to having taxed withdrawals from a pre-tax contribution account in retirement, it's that you can delay paying taxes on the contributions until you start making withdrawals. Any contributions made while working is income that would have been taxed at your marginal bracket - in your case, you talked about the possibility of the 33% bracket for some of your income, so that would mean that you are likely paying at least 28% in taxes on the money that is going into the Roth 401(k).

If you instead contributed the maximum $18k ($24k if 50 or older) to the pre-tax account, you would pay $5,040 ($6,720 if 50 or older) less in in Federal taxes. If you don't make any changes to your W-4, most/all of that money should show up as an increase in your net pay on your take-home pay, compared to contributing to a Roth account.

The extra money in your paycheck can be spent or invested, as you see fit. Since you have the opportunity to make after-tax contributions that can be converted to Roth accounts, I would suggest doing that - this will allow you to put $23,040 ($30,720 if 50 or older) into your 401(k), rather than the $18,000 ($24,000 if 50 or older) that you would have been able to put in by making only contributions to the Roth 401(k). And you will still end up with the same take-home pay.

Then, when you are retired, you can use exemptions, deductions and the brackets that are lower than 28% to pay zero/lower rates on the withdrawals. Considering that in 2016, a couple MFJ will have $8,100 in personal exemptions, $12,600 in standard deductions and $151,900 in taxable income (a total of $172,600 in taxable income) before they would start being taxed at a 28% rate, many people are able to pay lower tax rates by deferring taxation of their income while working.

AJ
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After some thought, as a reservist, I participate in their Thrift Savings Program.

Be careful! Your pre-tax and Roth contribution amounts to the combination of the 401(k) and TSP accounts is limited to a total of $18,000 ($24,000 if 50 or older). So if you are maxing out your 401(k), any TSP contributions are excess contributions, and will need to be withdrawn, potentially incurring taxes and penalties.

AJ
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Bruce,

On the Guard side, we are the political football every month. We submit our pay, the unit doesn't have enough pay days in their bucket to pay us, we wait for a CR from the president or congress and we eventually get paid sometimes 2 months later. It's a really really sad state of affairs. I don't see myself doing 20 years. People say the pension and the tricare is worth it, but by the time I'm 60 (27 years from now) I doubt these things will exist in the form that they do today. With their new "blended" retirement which includes a 5% match at least, I'll walk away with something. If given the opportunity before 10 years hits, I'd get out. It's just to much hassle for such little pay and that's not taking into account how much money it takes away from my civilian job.
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AJ!

Glad you mentioned that. I'd like to think I would have caught that, but I'm not sure I would have. There's no way I'll be able to do both then. Within 2 years I'll be hitting the $53k max at my civilian employer. They contribute 16% without me doing anything and I put in the remainder of what takes me up to $53k. I suppose, however, I could figure out how much the TSP match the federal government will be (I do 5% and they do 5%) and then contribute that much less to my company 401k. I don't care much for the TSP options they have, however. But, free money is free money I suppose. Thanks for helping me explore the multiple angles of my situation.

Patrick
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